Greece Economy Watch

Greece: Last Exit To Nowhere?

2011-05-15T14:34:00.000-07:00

"Some economists, myself included, look at Europe’s woes and have the feeling that we’ve seen this movie before, a decade ago on another continent — specifically, in Argentina" - Paul Krugman: Can Europe Be Saved

"Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."
Paul Krugman - How Reversible Is The Euro?

Krugman is certainly right. Looking over towards Athens right now, you can't help having that horrible feeling of deja vu. Adding to the uncomfortable feeling of travelling backwards rather than forwards in time (oh, I know, I know, when history repeats itself it only piles one tragedy onto another) is the uncomfortable presence of Charles Calomiris, a US economist of Greek origins. I can still remember reading, back then in the autumn of 2001, an article by the then Argentine Economy Minister Domingo Cavallo published in the Spanish newspaper El Pais which proudly proclaimed that everything was going well, and that the country's reforms were being generally well received with the regretable exception of "a small number of neurotic US economists who continue to insist that we will default and break the peg". He was, of course, referring to Calomiris, and at the time we were only a matter of weeks away from the dramatic moment when Adolfo Rodríguez Saá (the man who was President for a mere 8 days) would enter both history and the Argentine parliamentary chamber to utter the now immortal phrase "vamos a coger el torro por los cuernos" (we are going to take the bull by the horns). A phrase which was obviously belonged to the class of so called Austinian performatives, since at one and the same time as uttering it he effectively ended the peg. Well today Calomiris is again with us, and he is still hard at work going through the numbers, only this time round he is using his special insights to scrutinise his family homeland, for which he is prophesying not only eventual default, but also the generation of sufficient contagion to bring the whole Euro project itself to an untimely end. In an article in Foreign Affairs entitled "The End Of The Euro", he tells us:

Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo. At this point, several European countries will likely be forced to abandon the euro within the next year or two....The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency. Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing

Really, I don't think of Calomiris as a prophet (or even as a Cassandra), I don't even think of him as an especially insightful economist when it comes to the macro problems of the real economy, but I do think he has one exceptionally strong merit: he can do the math, and as he says, if it gets down to a battle between legal details and arithmetic, arithmetic will always win.

Easy Said & Easy Done, Down the Argentina Path We Go!

As it happens, the issue of Argentina as a reference case for Greece has surfaced again this week, in the form of an Op-ed in the New York Times by the co-director of the Center for Economic and Policy Research Mark Weisbrot.

Weisbrots's argument is not new, but it is different, not only because he thinks Greece would be better off leaving the euro (many economists share that opinion), but because of the apparent eulogy he makes of the Argentine case.

"For more than three and a half years Argentina had suffered through one of the deepest recessions of the 20th century......Then Argentina defaulted on its foreign debt and cut loose from the dollar. Most economists and the business press predicted that years of disaster would ensue. But the economy shrank for just one more quarter after the devaluation and default; it then grew 63 percent over the next six years. More than 11 million people, in a nation of 39 million, were pulled out of poverty"

.

Now these are strong claims. But let's leave aside the issue of whether or 11 million people were pulled out of poverty or not, and dig a bit deeper into what actually happened in Argentina, and let's do this by comparing it with another country, one which arguably has similar social and economic development characteristics, Chile (see chart above). At the turn of the century Chile had a population of more or less 15 million, as compared with the 39 million Argentinians mentioned by Weisbrot. Now in 1998, just before Argentina entered its depression, Chilean GDP was some 79 billion dollars, while Argentina's was 299 billion dollars. Now let's fast forward to 2010, Argentina's GDP at the end of last year was 370 billion dollars, and Chile's 203 billion. That is to say, between 1998 and 2010 Argentina's GDP (as measured in dollars, we'll come back to this) increased by 24%, while Chile's increased by 156%. As they say in Spanish "no hay color" (there is simply no comparison). Especially when you take into account when that Chile has only 38% of Argentina's population, while it has 55% of Argentina's GDP. So over the 12 years between 1998 and 2010 Chile (which maintained a floating currency throughout) evidently did a lot better than Argentina (despite Argentina's abandonment of the float). And here's another relevant piece of information: between 1998 and 2010 the Argentinian price level rose by 143%, while in Chile the price level rose over the same period by 48%.

So why use USD as the measure of comparison? I do this since it gives the most convenient yardstick evaluation (euros would do equally well) of the relative external values of the two economies. This is important, since Argentina apparently high growth levels have been also associated with high inflation levels, which have been constantly compensated for by devaluing the peso. In fact Bank of America Merrill Lynch currency strategist - and former IMF economist - Thanos Vamvakidis makes an essentially similar point (although with different conclusions) in a research note covered recently by FT Alphaville's Tracy Alloway:

"In our view, ...(the results of our study).... point to the conclusion that exchange rate devaluations do not lead to permanent competitiveness improvements in rigid economies, such as in the Eurozone periphery. In this context, tail risk scenarios about EUR exit are misplaced. Structural reforms are the best bet to improve the periphery’s growth prospects, within or outside monetary union".

Does this whole debate sound familiar to anyone? Anyone remember when Italians were paying themselves in million lira notes? In fact, it was precisely to break the Southern European countries from the high inflation, high interest rates, periodic devaluation dynamic that the Euro was thought to be such a good idea in the first place. It hasn't worked as planned, but that doesn't mean that the most traditional and the most simplistic solutions are necessarily going to be the best ones.

On the other hand, does this mean we should then go on to dismiss the coming out of the euro option out of hand for Greece? Evidently not. Let's look at another comparison, this time Argentina and Turkey.

Now in 1998 Turkey had a dollar GDP of $269 billion, and by 2010 this had become $742 billion. That is it had nearly tripled. Yet Turkey's dollar GDP dropped sharply in 2001 following a substantial devaluation of the Lira. Conclusion, competitive devaluations are sometimes useful, so what makes the difference?

Well Paul Krugman got near to it, when he said in his article on Weisenbrot's proposal:

"Greece, as a relatively poor country with a history of shaky governance, has a lot to gain from being a citizen in good standing of the European project — concrete things like aid from cohesion funds, hard-to-quantity but probably important things like the stabilizing effect, economically and politically, of being part of a grand democratic alliance".

We can sum the essence of all this up in a couple of phrases "institutional quality" and "structural reforms". Or put another way, Turkey devalued as part of an IMF programme (it was actually recommended, in the days before the heavy hand of the EU took management control at the IMF), while Argentina broke the peg and devalued in order to get out of one. Turkey was not only able to benefit from the reform pressure instigated by the IMF (the stick), but also by the promise of EU membership under certain conditions (the carrot). Indeed, curiously, EU cultural reservations about Turkish membership have probably lead to far stricter reform hurdles than were either applied to the current members in the South or the East, and Turkey is undoubtedly the great beneficiary of this strictness.

Which brings us to the main point: should Greece leave or not leave the Euro? Well, let's go back to something Krugman said in another blog post (How Reversible Is The Euro):

"Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."

or as he argues in his latest post:

"That said, Weisbrot is right in saying that the program for Greece is not working; it’s not even close to working. At the very least there must be a debt restructuring that actually reduces the debt burden rather than simply stretching it out. And the longer this situation remains unresolved, the less hope I have that Greece will be able to stay in the euro, even if it wants to".

The present situation is unworkable, and unsustainable, not only because the accumulated debts are unpayable by Greece alone, but also because the tiny size of the manufacturing industry Greece has ended up with and the general lack of international competitiveness of the Greek economy make an export-lead growth process with the present state of relative prices virtually impossible. There are solutions to both these problems consistent with remaining within the Eurone and without default - issuing Eurobonds to accept part of the Greek debt and enforcing a substantial internal devaluation to restore external competitiveness, for example - but since the adoption of these two strategies is virtually unthinkable given the current mindsets in Brussels, Frankfurt, Berlin and Madrid then we are more or less guaranteed to find ourselves facing some kind of Greek default, and given that the programme as it stands isn't working (this is where the situation so resembles pre-default Argentina as the extent of the fiscal correction means the economic contraction feeds on itself given that exports cannot expand fast enough to counteract the decline in government spending and domestic consumption), it would be strongly advisable to accompany this default with some sort of devaluation.

Put another way, if the most valid argument against going back to the Drachma always was that this would imply default, now that default is coming, why not allow Greece to devalue? As Krugman says, the issue isn't whether Greece would openly decide to exit the euro, the issue is what happens if the markets force this solution on Greek and European leaders against their will? Given the programme isn't working, the likelihood of this kind of event occurring in the next 2 or 3 years is far from being negligible, so why not be proactive rather than always relegating ourselves to being reactive? What matters is whether Greece becomes Turkey (oh, what a historical irony) or Argentina. If the powers that be can agree on an ordered restructuring of Greek debt, and a controlled exit from the Eurozone, then Greece has some possibilities of turning the situation round. If exit is forced on Greece in order to escape the clutches of both the EU and the IMF then the move will be, as I suggest in my title, simply the last exit to nowhere. And especially in a historic context of ageing populations and rapidly rising elderly dependency ratios, ratios which will only rise further if thousands of young people exit Greece in the search for work elsewhere, as young Argentinians did in 2002/3. That's another difference most people who make this comparison don't mention: when Argentina devalued the country still had a fertility rate which was slightly above replacement level. Greece has just had more than 30 years with a total fertility rate in the region of 1.3. So while Argentina could look forward to years of demographic dividend and rapid "catch up" growth, if things go wrong Greece can only look forward to an ever older population and ongoing social and economic decline

The tragi-comic events surrounding the fate of IMF Director General Dominique Strauss Kahn may well mean that we are about to see significant changes in that organisation. It is to be hoped that, if this is the case, such changes will also involve a rethink of the IMF's role in Europe's crisis, and in particular of the objectives and means of implementation of the Greek programme, with the Fund moving towards a less-eurocentric and more balanced position, one which would be in the collective interest of the community of citizens of the wide variety of countries the institution represents.

The Great Greek And Spanish GDP Mystery - One Hypothesis

2011-05-15T04:01:00.000-07:00

Many an economic eyebrow must have been raised last Friday when Europe's first quarter GDP data was released, and people discovered that the Greek economy had suddenly surged forward, rising by 0.8% over the level it had attained in the last three months of 2010 (or at a 3.2% annual rate, or faster than the US). Since almost everyone with knowledge of the situation is forecasting a further contraction in the economy this year, the result may have been thought to be a surprising one.

Well, there is no need to call in Sherlock homes just yet, or even the strong-arm boys from Eurostat, since I think I may have worked out what happened to Greek GDP in Q1, or at least I have a good working hypothesis. In the process we will also examine why it was that, against all prognoses, and against a colossal amount of anecdotal evidence that the Spanish economy is falling back towards recession, Spanish GDP actually accelerated.

But first, a brief intro to Econ 101 macro. It is important to grasp the fact that GDP isn't the be all and end all of economic analysis, and certainly doesn't give us a complete measure of economic activity. Indeed there are many economic processes which may be of interest to economists - levels of indebtedness, for example, which are simply not captured by the measure, since GDP is what it is: a measure of domestic value added, according to the following formula:

GDP = Consumer Demand + Investment Demand + Government Spending + Net Trade (change in exports minus change in imports) + Net Change in Inventories

Now, in general we know that the first three items on the list are falling in Greece. even if there does seem to have been some slight improvement in retail sales during the quarter, after a very steep fall in the autumn.

But what about the net trade component? Well, before going further it is important to consider is how this calculation works. Basically net trade can improve either by the rate of export growth accelerating, or by the rate of import growth decelerating. Now in Greece we know that exports have improved, but Greek exports are proportionally so small, and form such a limited part of total economic activity, how can they possibly pull the economy upwards in this way (causing a 0.8% q-o-q increase in GDP)? Well, looking at the chart for imports it can be seen that just as exports have been accelerating, imports have been decelerating, so the combined impact might be quite large (please note we don't yet have the March data).

This impression that it was as much a drop in imports as a rise in exports that was behind the sharp quarterly rise in GDP is further reinforced if we look at the year on year performance of the two variables. In recent months Greek imports are sharply down y-o-y (despite the surge in energy prices) while exports are up.

So GDP rose, but what about does this tell us about living standards? Well, this is just the point. Since the fall in imports reflects a fall in demand, it implies a fall in living standards,and this is the strange thing about what GDP measures and what it doesn't measure. GDP can rise sharply, even when unemployment is rising, and people are getting poorer. This is largely because one of the things GDP doesn't measure is the evolution of what some call the "financial balances" (for more explanation of this idea see the pioneering work of the Canadian economist Rob Parenteau (here in somewhat polemical form, and here as a more technical explanation).

In countries running an ongoing trade and current account deficit, the rise in living standards which comes from an increasing excess of imports over exports figures in national accounts as an output negative (apart from the transport and retail outlet activity which are a spin-off), and the counter party to all that "living beyond our means" feel-good added credit-driven purchasing power really only shows up as a negative item on the financial side of the accounts, as money borrowed from the exterior, money which is used to finance the deficit. It is a negative item, because all that potential capacity to spend is being diverted away from national activity to external activity. So while you pay for the products consumed (through debt) others get the long term benefit of your spending. Which is why it is such a bad idea to run sizeable current account deficits over any great length of time, since they are financed by credit, and credit is only a way of transferring demand from the future to the present, which means you will feel richer now, and poorer in the future, and this is exactly what is happening to Greece. It is also why the only way to put the situation straight is to export more, and run a trade and current account surplus, since then the value of your net external debt falls. So the correction is necessary and inevitable, although the curious thin is that while it is taking place, and while exports are rising and imports and living standards falling GDP rises, even though people feel much worse off.

Obviously, having an economy appearing to accelerate like this is a bit counter intuitive. Evidently it is not the same as having a devaluation-induced import-reduction with demand remaining equal, and more productive activity taking place inside the country as relative prices result in steady import substitution, but then demand deflation policies have these peculiarities attached. Maybe we could think of the type of correction Greece is engaged in as less future demand being brought forward to today, under the hope that the subsequent path of the economy will eventually be on a higher level than it otherwise would have been. Pay now, live later.

In the Greek case, since private sector borrowing is at a total standstill, and public sector deficit borrowing is being steadily reduced, the current account deficit is being forced to close, with the consequence that since exports can't rise much (due to competitiveness issues, and their low base) imports will need to fall while unemployment will probably continue to rise.

If this analysis of what has been going on in Greece is correct, then it can also help us understand the latest set of Spanish GDP numbers a bit better. According to the latest data, in the first quarter of this year Spain's GDP rose by 0.3% over Q4 2010 and by 0.8% over the year earlier quarter. This surprised many analysts since the Bank of Spain has previously estimated growth to be around 0.2%, and a number of 0.1% was often anticipated.

In theory the Q1 performance marks an acceleration over the 0.2% quarterly rise registered in the last quarter of 2010. Such an acceleration seems odd, since all the recent data, industrial output, retail sales, unemployment has been negative, and doubly so since the government is in the process of a very sharp (3.2%) fiscal adjustment process.

Yet, if we come to look at the relative import/export performance, we will see a milder version of the same phenomenon. It seems exports rose and imports fell in the first quarter, creating a very special kind of "win-win" situation.

This is a much milder version of the Greek story, but possibly similar processes are at work in both cases, as Spain's previously large current account deficit is also being steadily forced to close.

On the other hand, in Spain's case other factors might be at work, like overspending before this month's regional and local elections. In any event, I am describing all the above as a hypothesis because we still don't have either the March trade data or the detailed GDP data. When we have access to both of these we will have a better idea of just how valid this hypothesis of mine actually is. At the end of the day, one swallow doesn't make a summer, and one month's GDP surprise is simply a drop in the ocean in relation to the major challenges which face these economies in the quarters and years ahead.

Greece Is Almost Certainly "On Track" - But Towards Which Destination Is It Headed?

2010-11-28T10:22:00.000-08:00

"There is a difficulty that is widely recognized that the amount [of debt] to be repaid is high in 2014 and 2015," Giorgios Papaconstantinou (the Greek Finance Minister).

"We are confident that Greece will be able to return to the markets. But whether it will be able to return to the markets on a scale that allows Greece to pay off its European partners and the IMF, that is a question."..."We have a number of options. If paying off the €110 billion loan proves to be a question, we stand ready to exercise some of those options" - Poul Thomsen, head of the IMF team in the ECB-EU-IMF troika delegation.

"In the rushed last-minute deal to forestall certain bankruptcy, everyone missed one very important fact. That the memorandum created an unrealistic and immense borrowing squeeze on the feckless Greek state for the next five years."
Nick Skrekas - Refusing Greek Loan Extensions Defies Financial Reality, Wall Street Journal

Get On The Right Track Baby!

According to the latest IMF-EU report Greece’s reform programme remians “broadly on track” even if the international lenders do acknowledge that this years fiscal deficit target will now not be met and that a fresh round of structural measures is needed if the country is to generate a sustained recovery. My difficulty here must be with my understanding of the English lexemes "remains" and "sustainable", since for something to remain on track it should have been running along it previously (rather than never having gotten on it), and for something - in this case a recovery - to be sustained, it first needs to get started, and with an economy looking set to contract by nearly 4% this year, and the IMF forecasting a further shrinkage of 2.6% next year, many Greeks could be forgiven for thinking that talk of recovery at this point is, at the very least, premature. A more useful question might be "what kind of medicine is this that we are being given", and "what are the realistic chances that it actually works". Unfortunately, in the weird and wonderful world of Macro Economics, witch doctors are not in short supply.

As the representatives of the so-called `troika`mission (the IMF, the ECB, and the EU) told the assembled journalists in last Tuesday's press conference “The programme has reached a critical juncture." Critical certainly (as in, in danger of going critical - just look at the 1,000 basis point spread between Greek and German 10 year bond yields, or the 4% contraction in GDP we look set to see this year), but the question we might really like to ask ourselves is what are the chances of the patient surviving the operation in one piece?

The statement came at the end of a 10-day mission visit to Athens to review the extent to which the country was complying with the terms of the country’s €110bn bail-out package and take a decision on whether or not to authorise the release of the third tranche of the agreed loan.

In the event the decision was a foregone conclusion, with the rekindling of the European Sovereign Debt Crisis as a background, and the very survival of the common currency in the longer term in question, this was no time to tell the markets the tranche was not being forwarded. But still, the expression "on track" continues to fall somewhat short of expectation with the lingered issues like the recent upward revision of the Greek deficit numbers (up to 15.4% for 2009), the failure to increase revenue as much as anticipated, and the need for a further round of “belt tightening” measures in 2011 to try to attain the agreed objective of a 7.4% deficit as a backdrop. The upward revision in the deficit numbers only added to all the doubts many economists have about the long term payability of the Greek debt, which the IMF now expect to peak at around 145% of GDP in 2013, although again, many analysts put the number much higher.

Independent analyst Philip Ammerman who is based in Greece, and whose expectations about the evolution of Greek debt have proved to be reasonably realistic, now expects debt to GDP to come in much higher than anticipated in 2010, due largely to 10 billion euros in debt from the train company OSE being added to the total and downward revisions in 2009 GDP from the Greek statistics office.

The key to payability is of course a resumption of economic growth, which at the present time looks even more distant than ever. The IMF is arguing for another round of structural reforms – like opening up “closed-shop” professions, or simplifying administrative procedures and modernising collective wage bargaining, and while many of these are necessary, none of these are sufficiently “short sharp shock” like to restart the economy, and in general don’t target the main issue which is how to restore competitiveness to the country’s struggling export sector.

Just One More Moment In Time!

Doubts about how Greece was going to start financing its debts in the market after the expiry of the loan programme in 2013 had only been adding to market nervousness in recent days, since in addition to the fact that loan repayments to the EU and the IMF would need to start in 2014. Most critical are the first two years, when the bulk of the debt to the EU and IMF falls due. Under current repayment schedules, In fact, as things stand now, Greece's gross borrowing needs for 2014 and 2015 (when most of the EU-IMF debt falls due) will balloon to over 70 billion euros a year from around 55 billion euros a year in 2011-2013. This represents having to finance about 40% of GDP each year. Not an easy task. The difficulty presented by this looming repayment mountain lead the FT’s John Dizard to speculate that the Greek parliament might be tempted to go for the rapid passage of a law allowing for the application of “aggregate collective action” on bondholders – using the reasoning that, since the money being borrowed at the moment is basically being used to pay off existing bondholders (who are relatively easy to haircut) while the new lenders (the IMF and the EU) are (at least on paper) not. As John says, “Greece is exchanging outstanding debt that is legally and logistically easy to restructure on favourable terms with debt that is difficult or impossible to restructure. It’s as if they were borrowing from a Mafia loan shark to repay an advance from their grandmother”.

What a (retroactive) aggregate collective action clause would mean is that if a specific fraction, say 80 per cent or 90 per cent, of existing Greek bondholders agree to a restructuring that lowers the net present value of Greek debt by, say, half, then the remaining “holdout” bondholders would be forced into accepting the same terms. It is the consideration that the Greek Parliament might be tempted to go down just such a road that possibly lies behind this weekends Reuters report that The EU and the IMF could extend the period in which Greece must repay its bailout loans by five years, to make it easier for it to service its debt. According hot the agency Poul Thomsen, the IMF official in charge of the Greek bailout, stated in an interview with the Greek newspaper Realnews "We have the possibility to extend the repayment period ... from about six years to around 11," This follows earlier reported statements from Mr Thomsen the the IMF “could provide part of the funding on a longer repayment period, or give a follow-up loan.” Indeed the announcement of the Irish Bailout details seems to suggest there has been a general change of position here, since the Irish loan is initially to be for seven and a half years (which certainly does suggest we are all trying hard to kick the can further and further down the road), while - in what you might think was a token nod in the direction of John Dizard's argument, aggregate collective action clauses are now to be written into all bond agreements after 2013. It will be interesting to see how the existing bondholders themselves respond to this proposal when the markets open tomorrow (Monday) morning.

So now we know that in fact Greece is likely to be able to extend its dependence on the IMF all the way through to 2020, the only really major question facing us all is: just how small will the Greek economy have become by the time we reach that point.

To start to answer that question, let’s take a look at some of the macro economic realities which lie behind the “impressive start” the Mr Thomsen tells us the Greek economy has made.

Austerity Measures Provoke Sharp Economic Contraction

The IMF-EU-ECB austerity measures have - predictably - generated a sharp contraction in Greek GDP, with falling industrial output, falling investment, falling incomes, falling retail sales, and rising inflation and unemployment. The big issue dividing Macro Economists at this point is whether countries forming part of a currency union which have a competitiveness problem are best served by their fiscal difficulties being addressed first.

Arguably countries which do not have the luxury of implementing a swift and decisive devaluation to restore their competitiveness would be best served by receiving fiscal support from other part of the monetary unionion to soften the blow as they implement a comprehensive programme of internal devaluation to reduce their price and wage levels. That is to say the current approach has the issue back to front, and will undoubtedly lead the countries concerned into even more problems as slashing government spending at a time when no other sector is able to grow is only likely to create a vicious spiral which leads nowhere except towards eventual and inevitable default. To date Greek GDP has fallen some 6.8% from its highest point in Q1 2008, yet far from bottoming out, the contraction seems to be accelerating under the hammer blows of ever stronger fiscal adjustments, and the downard slump still has a long way to go.

The Greek economy contracted by 1.1% quarter-on-quarter in the third quarter of 2010, making for the eighth consecutive quarter of contraction. And evidently there are still have several more quarters of GDP contraction lying out there in front of us.

Year on year the Greek economy was down by 4.5% on the third quarter of 2009. This is the fastest rate of interannual contraction so far. Far from slowing the contraction seems to be accelerating at this point.

Domestic Consumption In Full Retreat

Looking at the chart below, it is clear that Greece enjoyed quite a consumption boom in the first years of the Euro's existence, a boom which is in some ways reminiscent of those other booms in Ireland and Spain, and a boom which came roundly to an end when the credit markets started to shut down. As in other countries, the government stepped in with borrowing to try to keep the boom going, with the major difference that deficitfinance went to levels well beyond those seen in other European countries in 2009, as did the efforts the Greek government went to to try to cover its tracks.

One of the clearest indications that the party is now well and truly over is the way in which the level of new car registrations is slumping.

Retail sales have now fallen by something over 15%.

And With It The End Of The Credit Boom

The Greek consumption boom came to an end, just as it did in Spain and Ireland, when the credit crunch started to bite in 2008. Pre-crisis household borrowing was increasing at the rate of around 20%, the interannual rate of change has now fallen more or less to zero, and will stay there for some time to come. Since in a mature modern economy aggregate demand (whatever you do in the way of supply side reforms) can only grow in a sustained way as a result of either credit expansion or exports, export growth is going to have to give the Greek economy what little demand growth it can eventually get.

Along with the general stagnation in household credit, lending for mortgage borrowing has also ground to a sharp halt.

And credit to companies has also become pretty tight if we look at the next chart.

Asin many other heavily indebted countries (the US, the UK, Spain) the only sector which is still able to leverage itself is the public one, or at least which was still able to drive demand by leveraging itself, but now, with the IMF EU adjustment programme, increases in government borrowing are also going to suddenly come to an end, with the evident consequencethat the economy goes into reverse gear. I can't help feeling that people aren't using enough emotional intelligence here. Obviously people are outraged by the level of fiscal fraud that was going on in Greece. But outrage and demogogic press headlines seldom form the basis of sound policy. Arguably the competitiveness issue is more important at this point than the fiscal deficit one, since the position is asymmetric - solving the competitiveness issue will automatically open the door to solving the fiscal deficit one, while addressing the fiscal deficit does not necessarily resolve the competitiveness problem, and does not return the country to growth - only a strong supply side dose of ideology can lead you to (mistakenly) think that.

The Best Way Not To Restore Competitiveness: Raise VAT

In fact, the fiscal adjustment programme contains two components, reducing spending, and increasing taxes. Of these the most damaging measure as far as growth and competitiveness goes is without doubt the decision to raise VAT by 5%. Not only (as we shall see) does this increase not raise the extra money anticipated (in an economy which is increasingly export dependent the tax base for a consumption tax weakens by-the-quarter in relative terms), it also sharply raises the domestic inflation rate, effectively ADDING to the competitiveness problem. I would say this obsession of the IMF with raising VAT in these economies which are effectively unable to devalue is just plain daft, frankly. And it doesn't impress me how many times respected micro economists describe raising VAT as the most benign of measures: all this does is convince me that they don't really have an adequate understanding of how economies work from a macro point of view, and especially not export dependent economies.

As we can see in the chart below, the VAT rise not only adds to the consumer price index, it also affects producer prices, and even export sector producer prices, which are sharply up.

I would say that policymakers have fallen into two "Econ 101 simpleton" type errors here. The first is to think that since part of the objective is to raise nominal GDP to reduce debt to GDP, and since GDP is falling, raising the price level might help (I would call this the "fools gold" discovery), and the second is to imagine that since exports don't attract VAT, the impact is relatively benign, without stopping to think the the VAT hike also acts on inputs, and especially in an economy which suffers from chronic price and wage rigidity issues like the Greek one.

If a first year student had sent me these kind of arguments in a term essay, aside form awarding a "fail", I think would recommend to the person that they would perhaps be better off studying another topic, physics maybe, since the demonstrated aptitude for applied macro economics would be very low indeed. Could it be that bondholders who normally understand quite a lot more than many imagine about how economies work are also noticing this, hence their growing nervousness.

The incredible result of the application of this very short sighted policy is that in addition to the fact that Greece started out with a serious competitiveness issue with its most competitive EuroArea peers, like Germany.....

it has even hadits virtual currency revalued against the EuroArea average since entering the IMF sponsored programme, which is the exact opposite of what we need to see.

Export Lethargy Feeds The Industrial Output Slump

As a result we are seeing no evidence of a Germany-type resurgence in export activity.

And in fact even though the trade deficit has reduced somewhat, it still remains a trade deficit.

Given the fact that domestic demand is falling, while exports stagnate, Greece's industrial sector is still in a sharp and continuing contraction.

A contraction which continued and even accelerated slightly in October, according to the most recent PMI reading.

Construction activity is in "freefall", as can be seen from the drop in cement output.

and the decline will surely continue, as new building permits continue to fall.

And private construction activity continues to drop.

The net result of the economic contraction and a credit crunch is, of course, that while other consumer prices rise, house prices are now falling, giving us just one more reason why Greeks are starting to feel a lot less wealthy than they used to feel. Evidently, to kick start the economy again the fall in land and property prices needs to be brought to a halt. This is where the traditional devaluation strategy helped a lot, since you could stop the fall in nominal prices at a stroke, but the Greeks are helpless in this case, and it is rather alarming to find that there is no discussion of this key issue at the policy level, and just talk about how structural reforms will put everything right.

Employment Falls And Unemployment Surges

The man and woman power is there to rebuild the economy, as ageing hasn't yet reached the point where the labour force will start to shrink. Indeed at this point it is still rising.

But, of course, employment is now falling.

And thus, logically, unemployment is rising, and is currently something over 12%.

And With The Fall In Employment Revenue Comes Under Pressure

And with the rise in unemployment, there is a fall in incomes, and thus income tax revenue is falling, putting yet more pressure on the deficit.

At the same time, and despite a 5% increase in VAT rates, returns on the tax are also not rising as hoped.

A Contraction Which Feeds On Itself?

The Greek fiscal deficit is now falling, but after the huge upward revision in the 2009 figure, getting it down towards this years 9.4% target is a more or less Herculean task, which will involve far more fiscal effort than was previously anticipated, and with the fiscal effort more economic contraction. In addition, the finance ministry recently reported that while Greece's central-government deficit narrowed by 30% in the first 10 months of this year, this still fell short of the targeted narrowing of 32% due to lower than anticipated revenue returns.

Finance ministry data show that the Greek central government took in 41.0 billion euros in revenue in the first 10 months of 2010, just 3.7% more than it did in the same period of 2009. The deficit-reduction plan hammered out with the EU and the IMF in May called for 13.7% growth in such revenues for 2010 as a whole. This implies that to meet the target, Greece must receive 14.1 euros billion in November and December, which is highly improbable given that to date this year the Greek government has only once had monthly revenue above €5 billion, and that was in January.

On the spending side things have gone better, and targets are being met. Indeed over the summer the Greek government put forward a revised plan that compensates for the lower revenue with deeper spending cuts. But even meeting the lowered target of €52.7 billion would require a 30% jump over last year's revenue for the last two months of the year, and this is well nigh impossible.

As a result of the revenue shortfalls and the revision in the 2009 deficit, Greece still looks to be well short of the 7.8% of GDP deficit originally aimed for. Current estimates are for a shortfall this year of something like 9.4% of GDP. In order to try to soothe market fears in this unsettled environment the Greek government last week unveiled a further austerity plan for 2011 involving an addition 5 billion euros in cuts, with the objective of cutting public deficit to 7.4% of GDP by the end of next year. Apart from the fiscal effort involved the new budget will almost certainly involve a stronger economic contraction than previously anticipated - and indeed the Greek government have already revised their forecast to 3% from the previous expectation of a 2.6% shrinkage.

The problem is, that Greece is in danger of a counterproductive downward spiral here, since the revenue shortfall is at least partially the result of the existing budget austerity, which has simply helped to squeeze an already weak economy. The expected sharp contractions in GDP this year and next, will weighing heavily on revenue from income and sales taxes. Cuts to public-sector paychecks that went into affect this summer, for instance, have certainly helped contribute to a fall of about 10% in retail sales in August and September, and continuing unemployment rising above 12% will only add to the banking sectors bad debt problems.

You Need To Attack The Competitiveness Issue, And Not Just The Fiscal Deficit One

In my opinion the IMF are making a fundamental mistake in relying almost exclusively on structural reforms. "It has to come through structural reforms," Mr. Thomsen said, adding that he expected those reforms to be discussed at the next visit by the delegation early next year. "It cannot come through higher tax rates, that's not good for the economy, and it cannot come from more wage cuts because that is not fair."

The are right that more taxes and less salaries without corresponding price reductions don't solve the problem, but Greece needs to do something radical (like a sharp internal devaluation) to restore competitiveness rapidly. Pushing the issues out to 2020 is no solution, and it is hard to imagine Greek civil society will accept the levels of unemployment and social dislocation that are being produced for such a lengthy period of time.

Estimates of the future path of Greek debt vary a lot, and their is considerable uncertainty involved in any estimate. The IMF currently forecast that the debt will peak at just under 145% of GDP in 2013, but I think we can regard that as an estimate at the lower end of the range.

Despite the fact that George Papandreou's government has been widely praised for enforcing draconian austerity measures, the country still has the largest debt-to-GDP ratio in the EU, which involves a debt mountain of something like 330 billion euros - only 110 billion of which will be funded by the EU-IMF rescue programme. That is to say, private sector bondholders will still have something like (at least) 220 billion euros of exposure to Greek debt come 2013.

Greece's whopping current account deficit has reduced to some extent since the 2008 15% of GDP high, but the level is still quite large.

More importantly the IMF do not forsee Greece running a current account surplus at least before 2015. Indeed they imagine that Greece will still have a current account deficit of 4% of GDP come 2015. Which means that far from paying down their external debt, Greek indebtedness (absent restructuring) will continue to rise over the whole period. According to Greek central bank data, the country had a net external investment position of 199 billion euros in 2009, or put another way, net external debt was something like 110% of GDP.

At the end of last week, risk premiums on 10-year Greek bonds over their German equivalents were still timidly nosing above 1,000 basis points, a level many consider to be the market signal that default is likely. And this despite the International Monetary Fund having announced the same day that the Greek reform programme is “broadly on track”.

And then there is the return to the financial markets issue. Finance Minister George Papaconstantinou has repeatedly said the country would return to bond markets when the time was right sometime in 2011. This looks increasingly like wishful thinking, especially since the 2009 deficit revision by Eurostat, while the less than anticipated revenue performance means that Greece has already missed its first fiscal consolidation target. Such a lapse may convince inspectors from the EU and the IMF, but it is unlikely to cut too much ice with ultra conservative fixed income market participants.

And, as Nick Skrekas points out in the Wall Street Journal, the numbers simply don’t add up. Greece has to raise €84 billion to repay interest and principle over the next three years, even assuming the force of the economic contraction doesn't mean even more missed deficit targets . Add to that an additional €70 billion for each of 2014 and 2015 in repayment of EU-IMF loans, and the calculation equals an unavoidable default, which is what the markets are signalling with there 1,000 to the sky is the limit spread on Greek 10 year bonds over bunds.

Even in the pre-crisis days, Greece couldn’t realistically raise more than about €50 billion a year from markets that trusted it. And market participants know the ‘troika’ is being unrealistic in its expectations. Lack of conviction in the bond markets that Greece can survive without a default is creating a vicious cycle that keeps prospective borrowing costs elevated and thus makes eventual repayment even more unlikely. And round and round and round and round we go.

In this sense the troika’s earlier inflexibility over the repayment postponement issue has been entirely self-defeating. The delay in letting the markets know that extension was a possibility is rumored to have been in part due to the German government's worries about what the reaction inside Germany would be to the news. Evidently borrowers are going to be able to kick the can a lot harder and a lot further down the road than previously imagined. Indeed only today Ireland is seemingly to get money over a nine year term, which makes it hard to see how exactly the European Financial Stability Facility can be wound up in 2013 as previously planned - indeed the way things are shaping up it looks like 2013 could be the year when it really gets going.

Which, as John Dizzard notes in the Financial Times, would seem to create a new potential moral hazard problem, which is that if the funds in the pot are going to be limited, and if potential costs going forward are likely to be high, then we could see a rush to get in (before the funds are all used) with few in any hurry at all to leave. Giving Spain the prospect of 350 billion euros (or thereabouts) over seven and a half years mights seem very tempting, but it is unlikely that those in Rome would be happy to pay rather than join the queue standing next to the soup pot.

So, what this all boils down to is, that along with the EU and IMF we can be in no doubt: the reform programme evidently is on track. The only issue which seems to divide everyone - and especially those office-bound Fund employees from their more financially savvy market-participant peers - concerns the exact name of the station towards which the train in question is heading.

An Unusual But Interesting Argument Which May Help To Understand Why QE2 Is Now Almost Inevitable

2010-10-16T13:54:00.000-07:00

For reasons which aren't worth going into now, I'm reading through a recent report by Deutsche Bank Global Markets Research entitled "From The Golden To The Grey Age" this afternoon. The report (all 100 pages of it, many thanks to researchers Jim Reid and Nick Burns who produced the thing) looks at the extent to which a variety of macro indicators - like GDP growth, inflation rate, equity yields, etc - may have been influenced by demographic forces over the last 100 years or so. It is certainly one of the most systematic reports of its kind I have seen, and well worth losing a Saturday afternoon to read.

But in the middle, there is an argument which caught my eye, and I thought it worth reproducing. Basically the starting point is this chart, which if you haven't seen by now (or something like it) I'm not sure where exactly you've been during the last 2 or 3 years.

Obviously, just the most cursory of glances at the thing should lead even the most untrained of eyes to get the point that what is going on around us is not some passing phenomenon, and that there are deep structural factors at work.

As our Deutsche Bank researchers put it:

As can be seen (from the above chart) there was a step change in the US economy’s indebtedness from the early 1980s onwards and then an additional one in the late 1990s/early 2000s. A similar picture is apparent across most of the Western World.

Basically from the early 1980s to the onset of the Global Financial Crisis the economy added on more debt every year and business cycles were extended as a result. Indeed the Fed and Central Banks around the world were afforded the luxury of operating in a secular falling inflation regime (globalisation) that allowed them to cut rates, further allowing the accumulation of debt, every time the economy may have naturally been rolling over into a normal recession consistent with those seen through history. This debt accumulation undoubtedly helped smooth the business cycle and contributed to the period being known as the ‘Great Moderation’. This period came to a spectacular end with the onset of the crisis and it is possible that going forward we will revert to seeing business/credit cycles more like they were prior to the ‘Great Moderation’.

Now here comes the clever part. Our researchers then go on to take a look at the the average and median length of the 33 business cycles the US economy has seen since 1854. For the overall period they found the average cycle from peak to peak (or trough to trough) lasted 56 months (or 4.7 years). However, the averages are boosted by an occasional elongated "superbusiness cycle", and thus the median length is a much smaller 44 months (3.7 years). As they comment, such numbers must look very strange to those who have only ever analysed business cycles over the last 25-30 years. Within these 33 cycles the contraction period lasted 18 months on average or 14 months in terms of median length. This equated to the economy being in recession 31% or 32% of the time depending on whether you look at the averages or the median numbers. Taking just the period before the “Great Moderation” the average US cycle lasted 5 months less at 51 months (or 4.3 years) with the median at 42 months (3.5 years). Over this period the US economy was in recession 35% and 36% of the time respectively depending on whether you look at averages or the median.

Now we used to think that all of that was behind us, but then we used to think that the "Great Moderation" had gotten things under control, and not simply temporarily extended the cycle length by facilitating long-term-unsustainable levels of indebtedness. So in fact, given that, as they say some sort of cycle or other has been with us since at least biblical time, what we might now expect are more "normal" cycles (in historical terms), which put a little better means shorter ones with more frequent recessions.

"Given all we know about the ‘debt supercycle’, it is likely that the onset of the Global Financial Crisis ended the “Great Moderation” period. Unless we find a way of continually adding more debt at an aggregate level in the Developed World it is likely that we will see much more macro volatility and more frequent business cycles going forward. Given the fact that Developed World Government balance sheets are under pressure, and given that interest rates around the Western World are close to zero, the post-crisis ability to fine tune the business cycle is extremely limited. We may need to put an immense amount of faith in the experimental force of Quantitative Easing to deliver economic stability. This will be an experiment with little empirical evidence as to how it will turn out. For now the base case must be that we revert more towards business cycles more consistent with the long-term historical data".

So then our authors do their calculations concerning the average length of US cycles since 1854 in order to make a rough estimate of when the next few US downturns will start, as illustrated in the following chart.

Now, without dwelling on the gory details, if we look at the spread between the upside, median, and downside cases, we could pretty rapidly come to the conclusion that the next US recession has a high probability of starting sometime between next summer, and the summer of 2012 - which, as you will appreciate, isn't that far away. I am also pretty damn sure that Ben Bernanke and his colleagues over at the Federal Reserve appreciate this point only too well, and hence their imminent decision on more easing, since a recession hitting the US anytime from next summer will really come like a jug of very icy water on that very fragile US labour market, not to mention the ugly way in which it might interact with the US political cycle.

I think the mistake many analysts are making at this point is basing themselves on some sort of assumption like, "if the recession was deep and long, then surely the recovery should be just as pronounced and equally long", but, as the DeutscheBank authors bring to our attention, business cycles just don't work like that.

Now, why I think this is an interesting argument is that the starting point for looking at the recovery is rather different from the norm, in that instead of peering assiduously at the latest leading indicator reading, they do a structural thought experiment, and work backwards from the result. Now, one thing I'm sure Ben Bernanke isn't is stupid, so it does just occur to me that either he, or someone on is team, is well able to carry out a similar kind of reasoning process.

Watch Out, Here Comes The QE2

In fact, it would be an understatement to say that the forthcoming QE2 launch is causing a great deal of excitement in the financial markets. As the news reverberates around the world, it seems more like people are getting themselves ready for some kind of "second coming". Right in the front line of course are the Europeans and the Japanese, and the yen hit yet another 15 year high (this time of 81.11 to the dollar) during the week, while the euro was up at 1.4122 at one point. Greeks, where are you! Can't you engineer another crisis? We need help from someone or we will all capsize in the backwash created by this great ocean liner as it passes.

But joking aside, a weaker USD is going to be both the natural and the intended consequence of the coming bout of additional QE by the Fed, and it will have a strong collateral effect on the already weaked and export dependent economies of the EuroArea and Japan.

With this prospect as the background, it should not come as a surprise that talk of currency wars and competitive devaluations is rising by the day. Japan only last week threatened "resolute action" against China and South Korea, Thailand has placed a 15% tax on bond purchases by non resident investors, and central banks from Brazil to India are either intervening to try and keep their currency from rising too fast, or threatening to do so.

And the seriousness of the situation should not be underestimated. Many have expressed disappointment that the recent IMF meeting couldn't reach agreement, and hope the forthcoming G20 can do so. But really what kind of agreement can there be at this point, if the real problem is the existence of the ongoing imbalances, and the inability or unwillingness of the Japan's, Germany's and China's of this world to run deficits to add some demand to the global pool. Push to shove time has come, I fear, and if this reading is right then it is no exaggeration to say that a protracted and rigourously implemented round of QE2 in the United States could put so much pressure on the euro that the common currency would be put in danger of shattering under the pressure. Japan is already heading back into recession, as the yen is pushed to ever higher levels, and Germany, where the economy has been slowing since its June high, could easily follow Japan into recession as the fourth quarter advances.

Indeed, I think we can begin to discern the initial impact of the QE2 induced surge in the value of the euro in the August goods trade data. The EuroArea 16 have been running a small external trade surplus in recent months, and to some extent the surplus has bolstered the region's growth. It is this surplus that is now threatened by the arrival of the QE2. The first flashing red light should have been the news that German exports were down for the second month running in August, but now we learn from Eurostat that the Euro Area ran a trade deficit during the month.

"The first estimate for the euro area1 (EA16) trade balance with the rest of the world in August 2010 gave a 4.3 bn euro deficit, compared with -2.8 bn in August 2009. The July 20102 balance was +6.2 bn, compared with +11.9 bn in July 2009. In August 2010 compared with July 2010, seasonally adjusted exports rose by 1.0% and imports by 1.8%".

Basically the eurozone countries had been managing to run a timid trade surplus (see chart below, which is a three month moving average to try and iron out some of the seasonal fluctuation) and this had been underpinning growth to some extent. Now this surplus is disappearing, and with it, in all probability, the growth. Maybe we won't get a fully fledged "double dip" in the short term, but surely we will see a renewed recession (and deepening pain) on the periphery and at the very least a marked slowdown in the core.

In fact the current situation is extraordinarily preoccupying. We are now in the fourth year of the present crisis (however you choose to term it, the second great depression, the very long recession, or whatever) and there seems to be no sustainable solution in sight. The underlying problems which gave birth to the crisis are excessive debt (both private and public) and large global imbalances between lender and borrower countries, and neither of these issues has so far been resolved, nor are there proposals on the table which look capable of resolving them.

And unemployment in the United States (which is currently at 9.6%, and may reach 10% by the end of the year) is causing enormous problems for the Obama administration. The US labour market and welfare system are simply not designed to run with these levels of unemployment for any length of time. In Japan the unemployment rate is 5.1%, and in Germany it is under 8%. So people in Washington, not unreasonably ask themselves why the US should shoulder so much extra unemployment and run a current account deficit just to maintain the Bretton Woods system and the reserve currency status of the US Dollar.

My feeling is that the US administration have decided to reduce the unemployment rate, and close the current account deficit, and that the only way to achieve this is to force the value of the dollar down. That way it will be US factories rather than German or Japanese ones that are humming to the sound of the new orders which come in from all that flourishing emerging market demand.

I think it is as simple and as difficult as that.

The problems created by the way the crisis has been addressed now exist on a number of levels. In emerging economies like Brazil, India, Turkey and Thailand, ultra low interest rates in the developed world are creating large inward fund flows which are making the implementation of domestic monetary policy extremely difficult, and creating sizeable distortions in their economies.

At the same time, a number of developed economies like Spain, the United States, the United Kingdom became completely distorted during the years preceding the crisis. Their private sectors got heavily into debt, their industrial sectors became too small, and basically the only sustainable way out for them is to run current account surpluses to burn down some of the accumulated external debt. Traditionally the solution to this kind of problem would be to induce a devaluation in the respective currencies to restore competitiveness, but in the midst of an effectively global crisis doing this is very difficult, and only serves to produce all sorts of tensions. As Krugman once said, "to which planet are we all going to export".

At the same time, two of the world's largest economies - Germany and Japan - have very old populations, which effectively means (to cut a long story short) they suffer from weak domestic demand, and need (need, not feel like) to generate significant export surpluses to get GDP growth and meet their commitments to their elderly population. The very existence of these surpluses also produces tensions, and demands for them to be reduced. But this is just not possible for them, and Japan is the clearest case. For several years Japan benefited from having near zero interest rates and becoming the centre of the so-called global "carry trade", which drove down the currency to puzzling low levels, and made exporting much easier. Large Japanese companies were even expanding domestic production and building new factories in Japan during this period (a development which had Brad Setser scratching his head at the time, trying to work out how the yen could have become so cheap).

Then the crisis broke out, the Federal Reserve took interest rates near to zero, and the United States became the centre of the carry trade. The result is that every time the Fed threatens to do more Quantitative Easing the yen hits new 15 year highs, even while the dollar continues its decline, with the result that Toyota are having a change of heart, and are now thinking of closing a plant in Japan to move it to Mexico. The present situation is just not sustainable for Japan, which is basically being driven back into what could turn out to be quite a deep recession.

Unfortunately I think there is no obvious and simple solution to these problems. As we saw in the 1930s, once you fall into a debt trap, it can take quite a long time to come out again. You need sustained GDP growth and moderate inflation to reduce the burden of the debt, and at the present time in the developed world we are likely to get neither. In the longer term, the only way to handle the presence of some large economies which structurally need surpluses is to find others who are capable of running deficits, but this is a complex problem, since as we have seen in the US case, if the deficit is too large, and runs for too long, the end result is very undesireable. Basically the key has to lie in reducing the wealth imbalance which exists between the developed and the developing world, but this is likely to prove to be a rather painful adjustment process for citizens in the planet's richer countries, so policy makers are somewhat relectuntant to accept its inevitability.

Basically, the structural difficulty we face is that all four major currencies need to lose value - the yen, the US dollar, the pound sterling and the euro - and of course this basically is impossible without a major restructuring of what has become known as Bretton Woods II. The currencies which need to rise are basically the yuan, the rupee, the real, the Turkish lira etc. But any such collective revaluation to be sustainable will need to be tied to a major expansion in the productive capacity of the economies which lie behind those currencies.

In fact, the failure to find solutions is increasingly leading to calls for protectionism and protectionist measures. The steady disintegration of consensus into what some are calling a "currency war" is, as I said above, another sign of this pressure. On one level, the move to protectionism would be the worst of all worlds, so I really hope we will not see this, but if collective solutions are not found, then I think we need to understand that national politicians will come under unabating pressure from their citizens to take just these kind of measures. The likely consequence of them succumbing to this pressure, which I hope we will avoid, would be another deep recession, possibly significantly deeper than the one we have just experienced. And, not least of the worries, the future of the euro is in the balance at the present time.

The structural imbalances which we see at the global level, between say China and the United States, also exist inside the eurozone, between Germany and the economies on the periphery (Ireland, Portugal, Spain, Italy, Greece). These latter countries failed to take advantage of the opportunities offered by the common currency to carry out the kinds of structural reform needed to raise their long run growth potential, and instead they simply used to cheap money available to get themselves hopelessly in debt. At the same time the crisis has revealed significant weaknesses in the institutional structures which lie behind the monetary union, weaknesses which go way beyond the ability of some members to fail to play by the rules when it comes to their fiscal deficits. Steps are now being taken in a night-and-day non-stop effort to try to put the necessary mechanisms in place, but it is a race against the clock, and it is not at all guaranteed that the attempt will be succesful, especially if the volume of liquidity about to hit the global financial system drives the euro onwards and upwards beyond supportable limits.

And Then There Were None

2010-09-27T03:16:00.000-07:00

According to Spanish Prime Minister José Luis Rodríguez Zapatero speaking in an interview with the Wall Street Journal last Tuesday the European sovereign debt crisis is over. "I believe that the debt crisis affecting Spain, and the euro zone in general, has passed," Mr. Zapatero said.

This is excellent news, but it comes with just one proviso, and that is that despite all such reassurances most financial market participants seem to be far from convinced that he is right. True Spain recently raised nearly €4bn in a successful government bond sale, with some observers suggesting the sale constituted but one more sign that what is still the eurozone’s fourth-largest economy had finally broken free from the group of “peripheral” European economies who have severe economic problems and whose debt is viewed by investors as especially risky.

In fact Spain managed to sell €2.7bn of 10-year bonds and almost €1.3bn of 30-year bonds while at the same time bringing yields down noticeably from their earlier highs - to 4.144 percent in the case of the 10-year issue ( from 4.864 percent in June), and to 5.077 percent for the 30 year issue (from 5.908 percent in June). But, at the same time, in the background the extra yield that investors demand to hold Spanish 10-year bonds over German bunds has been steadily creeping back up again, and as of last Friday (24 September) it stood at 183 basis points, below the 220 level being asked in June but still more than double what it was at this point last year.

Yet, despite all those nice words we hear from him, one of the things that is worrying investors right now is the real depth of Mr Zapatero’s commitment to reducing the deficit as planned, especially after he unexpectedly stated on August 10 that in his opinion some of the planned infrastructure spending cuts could be reversed, while on September 10 he reiterated the point, saying that lower borrowing costs may enable the government to "ease up" on some of the projected spending cuts. In fact the extra yield offered on Spanish debt has risen 33 basis points over the period since he started to mention the possibility.

On top of which all the short term indicators we have been seeing suggest that the Spanish economy started to contract again in the third quarter.

Spreads Rising Across The Periphery

Of course it isn't only Spanish bond yields which have been sneaking back up of late. Greek 10-year bonds as compared with equivalent German bunds still offer around 950 basis points (or 9.5 percent) of additional yield, only around 20 points below the all time record they hit on May 7, at the height of the Sovereign Debt Crisis

Indeed spreads on government bonds all along Europe's periphery have been rising steadily back towards (and even in some cases beyond) their May levels in recent weeks. Most notably the last week has seen both the Irish and Portuguese government 10-year bond yields surge to euro era records levels, in a way which could lead us to ask whether, rather than Spain snuggling back into the main group the big picture story at this point might not be that it is Irish and Portuguese sovereign debt that is being prised apart from the rest.

So rather than being over, what the debt crisis now may be entering is a new stage, where one sovereign bond after another is being chisled out and sent off to join their Greek counterpart in the isolation ward. Actually, in this sense the present European Sovereign Debt situation does rather resemble the plot of the well known Agatha Christie detective novel "And Then There Were None". As told by M. Christie a group of ten people, all of whom have in one way or another been previously complicit in an earlier death, are somehow tricked into travelling together for what was intended to be a short stay on a secluded island. Once there, and even though the guests are apparently the only people on the island, they are - somehow, and one after another - systematically murdered. So, in a way which may eventually come to foreshadow scenes from the forthcoming meetings of the European Financial Stability Facility management board, each morning one guest less shows up for breakfast. One by one, and little by little, each participant becomes mysteriously overcome by a seemingly inexplicable bout of some fatal variant of what could be termed "systemic instability syndrome".

As I say, Irish and Portuguese yield spreads are significantly wider than they were May 7, the last trading day before Greece finally agreed to go for their €110 billion bailout package and the European Central Bank announced the initiation of its ongoing program of purchasing EuroArea government bonds in the secondary markets.

And despite holding what was considered to be a "succesful" bond auction at the start of last week Irish 10-year bond yields, shot up`once more during the remainder of the week, hitting a new record high of 6.34 per cent (see Bloomberg chart below), while yield spreads over benchmark 10 year German Bunds spiked to 416bp, euro era another record. At the same time Ireland 5 year CDS shot up to 461 bps, which meant the cost of insuring Irish debt was $461,000 for $10m of debt annually over five years.

At the same time yields on Portuguese 10-year bonds over comparable German bonds hit a record of near 4.25 percentage points Friday, while the Portuguese debt agency paid a euro era record of 6.24 percent to holders of its 10-year bonds and 4.69 per cent to holders of the four year-bonds in its own bond auction this week. In last equivalent auction, Portugal had paid 5.32 percent on 10-year bonds and 3.62 percent on four-year bonds. Portugal’s budget gap widened in the first eight months of the year, indicating the government may struggle to rein in the euro-region’s fourth-largest deficit as its borrowing costs surged to a record.

Portugal and Ireland "Decoupling"?

In each case the issue is different, since in the Irish case it was a sharp and unexpected contraction in the economy which became the major concern while in Portugal's case it was an apparent inability to reach the political agreement necessary to get the budget deficit under control.

Data out during the week for second-quarter gross domestic product showed the Irish economy has never really left recession, since GDP contracted by 1.2% compared to the first three months of the year, following a downwardly revised 2.2% expansion in the first quarter. Irish GDP has now contracted on a quarterly basis for 9 out of the past 10 quarters, and there is no evident end in sight.

In addition Ireland’s central bank governor Patrick Honohan saw fit to give a rather ill-timed press conference (unless he objective really was to force the country's government into the arms of the EFSF) where he urged the government to implement even deeper fiscal cuts to restore balance to the budget in what seems at this point to be a virtually unrealisable bid to regain investor confidence. All of which left many observers wondering just what the country can do in the present situation, since the budget is evidently deteriorating due to the severity of the economic contraction, and further cuts in spending by anyone (households, companies, government) are only likely to feed the contraction even more, in their turn making even more cuts necessary.

Obviously Ireland is rapidly approaching a situation where it cannot move the situation forward based on its own resources. This feeling is only added to by the persistent rumours that subordinated bond holders to Anglo Irish bank may well not get re-imbursed in full. These rumours have found some confirmation in a report which appeared in the Irish Examiner suggesting that the Irish Finance Minister Brian Lenihan had given a strong hint that the riskiest lenders to nationalized Anglo Irish Bank may not get all their money back.

Mr Lenihan apparently explained to the paper that the bank guarantee program which will be extended once it runs out at the end of September may only cover deposits and not subordinated debt. And if the interpretation put on events by the FTs John Dizard's is correct Mr Lenihan's delay in clarifying the situation is due to the fact that the Irish government is awaiting an EU Commission ruling on exactly this issue. His most recent official statement on the topic was that the Aglo Irish wind-up plan “is being prepared for submission to the [European] Commission for approval”.

At the same time the EU’s Competition Commissioner, Joaquin Almunia, issued a statement that “a number of important aspects need to be clarified, and a new notification received, before the Commission is in a position to finalise its assessment and to take a decision”. Which Dizard interprets as meaning that while Anglo Irish might propose a buy-back of its subordinated bonds, and that buy-back might be included in an Irish government proposal, Brussels might, in the end, not approve the plan. Since this would effectively the first time in the current crisis that a significant group of investors did not have their losses underwritten (apart, of course, from the rather unfortunate Lehman incident), decision makers may be rather apprehensive, since no one really knows how the financial markets would react. Yet speculation some such decision will be taken remains rife, as witnessed by the decision by Moody's rating agency to downgrade Allied Irish ratings. Moody's cut Anglo Irish's senior bonds by three notches to Baa3, the last level before junk, but the markets' main focus was on the deep, six-notch cut in the bank's subordinated debt, to Caa1, which indicates that bondholders will be forced to pay for some of the expected bailout.

Deficit Worries In Portugal

In the Portuguese case it is the budget deficit issue which is unsettling the markets, with the spread widening sharply following the revelation that far from the deficit being reduced is was actually increasing. According to the latest data from the Finance Ministry the central government’s shortfall during the first eight months of the year rose to 9.19 billion euros from 8.74 billion euros over the equivalent period in 2009. Previously the 2010 deficit had been almost exactly tracking the 2009 one (see chart from Societe Generale below).

Portugal’s borrowing costs surged to record levels on the news, and while the spread subsequently eased back to 388 basis points, the level is still close to the zone in which Greek bonds were trading in April just before the EU offered the country emergency loans to avoid default (see Greek 10 year spread chart below).

What this means is that this year's overall public deficit could well come in at around 9 percent of gross domestic product unless there is a radical change in policy during the last few months of the year.

According to its commitments to the EU Stability Programme, the Portuguese government should be aiming to reduce the overall deficit to 7.3 percent of GDP in 2010 from last year’s 9.3 percent. The government has pledged to reach the target, with Finance Minister Fernando Teixeira dos Santos saying that the country “can’t afford” not to, but so far there is little evidence that it will be able to do so, and especially with all the political bickering that is now going on in the background.

In all these cases, including the Greek and Spanish ones, this issue is not simply one of stimulus versus austerity (always a false polarity when it comes to the situation on the Euro periphery). The real issue is how to restore growth to highly-indebted and structurally-distorted economies, since without growth the debt to GDP ratios will not come down, and the burden of the debt will not be reduced.

So more borrowing is not what these countries need right now (other than to aid short term liquidity). What the countries involved all need is more exports and larger industrial sectors, and no one seems to be very clear how they are to achieve them. Simply running a double digit deficit to generate less that 1% (in the best of cases) GDP growth is not exactly a "wise" use of resources. Evidently using deficit spending to cushion programmes which would lead to a surge in exports would make sense, but in no case is this really being done, and all the emphasis is simply going on what may turn out to be a rather fruitless and self-defeating programme of achieving fiscal rectitude.

The result is that the peripheral countries are one by one being steadily "decoupled", with Portugal and Ireland now moving up towards Greece, as the following two charts from Citi Research clearly show.

For quite a long time the Irish and Portuguese spreads simply moved in harmony with the Greek ones, widening as the Greek spread surged upwards. But now it is Greek debt which can be adversly affected by sentiment over the situation in Ireland or Portugal, and not the other way round, and meanwhile the other two countries slowly but surely are moving on up there to join their Greek counterparts as the second of the two charts (which show the recent relative movements in Greek and Irish spreads) seems to demonstrate.

Vigourous Action Needed

Naturally the ongoing deterioration in the situation requires bold and far reaching action from the Commission and the ECB. Obviously we should expect to see renewed activity on the part of the ECB, buying an increasing number of eurozone periphery government bonds. Their activity on this front has been increasing of late, but weekly bond purchases are still well below 1 billion euros a week level seen at the height of the crisis in May and June. Evidently we will see calls for more of these purchases in the days and weeks to come, but what is striking at the present time is just how ineffective they have been in containing the damage.

The ECB’s bond buying program is effectively the second pillar in the EU crisis containment mechanism established in May. The other one is the Luxembourg-based 440 billion-euro European Financial Stability Facility, headed by former European Commission official Klaus Regling. Mr Regling has also been actively campaigning to calm markets in recent days. "It would be preferable if we didn't even have to intervene," he told the German magazine Der Spiegel in an interview, "In fact, I believe that's the most likely scenario." His hope then is that the very existence of his organization will bring calm to investors and deter speculators. "If that's the case, we'll close up shop here on June 30, 2013," he said.

Morgan Stanley’s Chief Global Economist, Joachim Fels remains pretty unconvinced by all of this. “Strains,” he wrote in a recent research report, have now reached a point where "one or several governments" may soon have to resort to the rescue mechanism. "Neither the European sovereign debt crisis nor the banking sector crisis has been resolved and both continue to mutually reinforce each other," he said, adding that the EU's stress tests for banks had manifestly failed to restore the necessary confidence. Fels's conjecture didn't need that long to get some confirmation, since according to the German newspaper Handelsblatt the ECB was last week actively considering recommending that Ireland avail itself of the fund. The Central Bank declined to comment on the story, and simply pointed out that any decision on the matter was a question for national governments, which is formally correct (and obvious) but doesn't mean that they wouldn't in fact have recommend such a move if asked.

So, like former US Treasury Secretary Hank Paulson before them, Europe’s leaders, having armed their bazooka may soon need to fire it. Indeed Mr Regling’s optimism that his organization may quietly disappear from the scene is not generally shared by investors, who as we are seeing seem to be continuously pricing in an ever greater likelihood of intervention.

Meantime, according to a report in the Financial Times over the weekend, Europe's leaders are once more at odds among themselves about just how much carrot and how much stick the various national governments need to get their economies back into line. Predictably it is Paris talking about carrots, and Berlin who is talking about sticks.

But all this talk of what to do about those countries who in the future fail to stick to the new set of rules which are apparently being prepared monumentally misses the point: what we need are some policies which help the most affected economies get out of the mess they have found themselves in following the way the monetary and fiscal policy rules were implemented last time round.

According to one popular analogy currently circulating , the EuroArea countries could be likened to a group of 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One of the climbers - Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding him dangling there, however uncomfortable it may be for them, but they cannot quite manage to pull their colleague back up again. So, as the day advances, others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge, getting nearer and nearer to the abysss with each passing moment. And just behind Ireland comes Portugal, while some way further back Spain lies Spain, busily consoling itself that it is in no way as badly off as the others who have already lost there footing. But if Spain cannot hold out, and all four finally go over, each dragged down by the weight of those who preceded them, then this will leave some 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario. In the event that this is finally what happens, Mr Reglin will certainly find that the quiet life has come to an end for him, and that he has plenty of work to do, as will Mr Trichet’s successor at the ECB. In the meantime all the rest of us can do is wait and hope, firm in the knowledge that having come this far, we can only go forward, since there is no easy way back down to the point from which we started. But for heavens sake, the only thing we don't need while we sit here biting our nails is to be told by someone who manifestly has no idea what he is talking about that the danger has already past, even as we slide, inch by inch, onwards and downwards towards the chasm that gapes beneath.

Much Ado About (Some Of) The Wrong Things

2010-05-18T00:31:00.000-07:00

German Finance Minister Wolfgang Schaeuble told reporters in Brussels yesterday (Monday) that getting their deficits down was "the only task that everyone has to fulfill for himself and for the common good." Meanwhile, over in New York, Paul Krugman was busy writing on his blog that "the most startling and frustrating thing about the debate over the fate of the euro is the way almost everyone avoids confronting the core issue" - which is, according to Krugman, that "wages in Greece/Spain/Portugal/Latvia/Estonia etc. need to fall something like 20-30 percent relative to wages in Germany". So at one extreme the Eurozone's problems are seen as being almost exclusively fiscal ones, while at the other the principal problem is thought to be one of restoring lost competitiveness.

The difference in perceptions couldn't be clearer at this point, now could it?

And if all of this is causing so much confusion among reasonably well informed economic observers, then what chance is the layperson likely to have? As it happens, reading through this piece by PIMCO's Mohamed El-Erian this morning a number of thoughts started to come together in my head. Essentially what we have on our hands are a number of distinct (yet inter-related) problems, but few studies seem to go to the trouble to differentiate these analytically, and the end result is often a hotch-potch, which given the seriousness of the European situation is an outcome which is a long long way from being satisfactory.

One point that is often not stressed hard enough and long enough is that the backdrop to this whole debt issue is the underlying problem of rapidly rising elderly-dependency ratios (and increasing population median ages) across the entire developed-economy world. Normally this implies the imminent arrival of a wave of heavily underaccounted-for-liabilities which will simply increase the pressure on the underlying structural (rather than cyclical) deficits in the worst affected economies. The strange thing is that this development had in principle been long foreseen, and indeed formed part of the underlying raison d'être for drawing the 3% deficit/60% debt Maastricht line-in-the-sand. The other part was, of course, an attempt to stop spendthrift governments being spendthrift. As is now abundantly clear, in neither case can the Maastricht package be said to have worked, but the unfortunate historical accident is that we have come to realise this in the midst of the worst global economic crisis in over half a century (indeed arguably the second worst one ever, and - disturbingly - it is still far from being over).

So one part of the sovereign debt concerns which are currently so preoccupying the financial markets is associated with the containability of state debt in the context of ageing societies, and this issue is further complicated by the fact that different developed societies are ageing at different rates. This underlying uneveness is leading some people to draw some surprising conclusions. For example, according to a Financial Times/Harris opinion poll published this morning, the French turn out to be the most nervous of developed economy citizens when it comes to thinking about the sustainability of their country’s public finances.

Some 53 per cent of those polled in France thought it was likely that their government would be unable to meet its financial commitments within 10 years, while only 27 per cent thought this outcome was unlikely. Americans were only slightly less worried, with 46 per cent saying default was likely, against 33 per cent who saw it as unlikely. Curiously, only a third of the British people polled thought a government default was likely in the next 10 years, and I say curiously since on many counts the UK economic position is far more critical than the French one is. In fact, I am inclined to think that the British here are being reasonably realistic, while the French and the Americans are not, and I say this for one simple reason: all these countries have had substantial immigration in recent years, while the fertility levels in each case are quite near population replacement level. And this means that their population pyramids are much more stable, and if what is worrying you is rising elderly dependency ratios, then this is important. Let's put it this way, if you assume (a big assumption I know) that underlying GDP growth rates are similar, and that the level of pension entitlement is the same, then the more rapidly the elderly dependency ratio rises the greater the pressure on deficits and accumulated debt.

On the other hand, the Spanish respondents were remarkably more positive about their situation, with only about 35 per cent of Spaniards questioned saying they considered default to be a likely eventuality over the next decade. Which is strange, not because I have any special insight into whether or not Spain will default, but Spain's problems are clearly worse than any of the other three aforementioned countries (in part, as Krugman stresses because they lack some key economic policy tools which could help them correct the distortions in their economy) and, even more to the point, Spain's citizens are showing very little appetite at this point for making the changes which will be needed to stave off the worst case scenario.

Without reform in the labour market, and in the health and pension systems, France's finances are just as capable as going careering off a cliff as anyone else's, but the French do have a little more time, and this, at the end of the day, could be critical. Also the French (like the Swedes) have done their homework in one department - the demographic one - so their population pyramid is inherently much more stable than the Spanish one. Indeed the Spanish government clearly indicated last week just how little they understand the importance of this question, since rather than facing up to the wrath of the Spanish pensioners (who of course vote) by cutting back on pension payments, they took the easy route (since babies don't vote, and those who never get to be born even less so) and slashed the so called "baby cheque" (which may well not be the best of pro natality policy tools, but still). Basically cutting the baby cheque instead of cutting back on pensions has to be the next best thing to slitting your own throat, just to see what happens. Societies need to invest in their future, not in their past, and having children is an investment, indeed in the age of the predominance of human capital it is one of the most important ones there is.

Basically this whole area (of the impact of ageing populations on GDP growth performance and with this the consequent debt dynamics) remains largely underexplored by most mainstream analysts, but for now I will simply state that those "doctors" who wish to offer cures for our collective ills yet fail to mention the underlying dynamics of the demographic transition all our societies are passing through (even in a footnote) have missed one very important dimension of the overall picture, and their analyses and remedies are likely to be correspondingly deficient as a result. The musings of Mohamed El-Erian, interesting as they are, would fall into this category, since I fear he is missing the biggest part of the big picture.

Secondly, there is the issue of the financial rescue which has been carried out during the crisis itself. Something strange seems to have happened to the discourse over the last three years, since a problem which originated in the financial sector has now metamorphised into a fiscal crisis for almost all modern democratic states. Indeed, such is the sense of panic being generated out there on this issue that I am already starting to see articles from investor circles asking whether or not democracy is compatible with fiscal rectitude. This is rather putting the cart before the horse, I feel.

So having identified an underlying structural issue with government spending in the previous (demographic) argument, we should not fail to notice the fact that another significant part of rising state indebtedness comes from having recently bailed out a significant chunk of the private sector. Look at Latvia for example, and the Parex bank bailout, as the extreme case, since government debt to GDP was something like 12% before the crisis, while it is now heading up to near 80%, or Ireland, where debt was around 35% of GDP before the crisis but will probably rise above 70% this year.

In fact, a rather weird circle has been created. The private sector (possibly as a result of the absence of adequate public vigilance) got itself into a huge mess of its own making. Governments all over the globe (understandably and correctly) rushed in to put the fire out, and in the process transferred the problem over to their own balance sheets. But what is most interesting to note about what happened next is how, given that the crisis itself means there are few positive investment outlets in the first world, the money generated by the bailouts is increasingly being used to encircle those very governments who initially made them. Basically a massive moral hazard conundrum has been created, as markets leverage a discourse which pressures governments for fiscal rectitude (which is contractionary - given the depth of the crisis - as far as aggregate demand is concerned), in the process creating the need for yet more bailouts, and so on (the possibility of ultimate Greek default being perhaps the clearest example here).

Actually, while the initial "fire prevention" intervention was evidently necessary, people may have been mislead into thinking that action, in and of itself, would do the trick (see Bernanke's speech on Milton Friedman's 90th birthday - with its this time we got it right theme - also see note at the foot of this post) due to a slightly faulty diagnosis of what happened during the great crash. There was, of course, a bank run: but this was by no means the whole picture, and in any event doesn't explain why the whole global economic system took so long to recover, even back then in the 1930s.

So something decisive needs to be done to break the circle which currently binds us, although at this point I am not exactly sure what. If we could agree that Mohamed El-Erian's most striking insight is that: "Industrial countries are running out of balance sheets that can be levered safely in order to minimize the disruptive impact of past excesses. ... The balance sheets that are left -which reside essentially in central banks - are not made (and, I would argue, should not be forced) to assume permanent ownership of dubious assets." then the logic would seem to be that the dubious assets need to be put back where they belong - on the balance sheets of the private sector in general (including households) and the likes of AIG, Goldman Sachs, UBS, and naturally PIMCO.

But we should be clear: any such move to do this would also be significantly growth "unfriendly" across the first world.

And thirdly, and certainly not least importantly, as Paul Krugman is constantly pointing out, here in Europe we have an additional complicating factor: the euro experiment. Whatever the pros and cons of all the various arguments here, one thing seems evident: under the existing set-up the 16 economies are not converging. Exactly why this is would take us into areas which lie far beyond the objectives of this short post, but I would say that, personally, I feel the different demographic trajectories of the countries concerned must form part of the picture. As Angela Merkel is stressing, even in the best of cases (the euro holds) the bailouts which are being prepared can only buy time in which to carry out the much needed adjustments, which in countries like Spain/Portugal/Ireland are as much to do with restoring competitiveness to an extremely distorted private sector as they are to do with applying fiscal correction measures.

As far as I can see, measures like collectively financing state debt via EU bonds and bilateral loans - plus operating some variant of Quantitative Easing at the ECB (if this can all credibly be made to stick, and the vicious circle meltdown mentioned in the second point be avoided) - could temporarily stabilise the patient while the much needed surgical intervention is carried out. But my guess is that one by-product of doing things this way would be that a lot of the toxic stuff would then work its way onto the ECB balance sheet. Thus, instead of recapitalising Spanish Cajas, what we would then be collectively into would be recapitalising the central bank, which would be just another form of fiscal sharing through the back door (with the result that, following a good Brussels tradition, what you can't explain to people directly and from centre stage, you explain to them in footnotes and in the small print). The latest data from the ECB (see this useful post from FT Alphaville), suggest that the bank is not only busy buying peripheral bonds, it is also buying private paper from countries like Spain and Portugal (although there is no breakdown available on this point).

The measures which need to be applied on Europe's periphery are all more or less obvious at the micro level - labour market reform, pension reform, reform of the public administration - but (and assuming we have at most three years to see all this though before the respective populations get very, very restless), on the macro economic side it is very doubtful such measures will have the impact which is expected for them in terms of restoring competitiveness and growth, and fiscal order can only be restored by restoring competitiveness and growth.

Given this I can see only two plausible alternatives:

a) Either the peripheral economies undertake a sizeable internal devaluation (say 20%, but this is just a rule of thumb estimate). The snag here is that at the present time most EU policymakers remain unconvinced that we need a shift of this magnitude. Yet there is surprisingly little detailed study of how the economies concerned are going to get back to growth without this price correction. Indeed the EU Commission itself has strongly pointed out that the rates of domestic private consumption growth being assumed for these economies by the respective national governments in their Stability Programme estimates are highly optimistic. What would be nice would be for someone to set up a small model to try to examine just how much ongoing growth in the combined goods and services trade surplus countries like Spain now need to achieve to get positive growth in headline GDP under a variety of different assumptions, including low or negative inflation, stagnant domestic consumption and reduced fiscal spending.

This should enable people to calculate just how much of a drop in unit costs (from a combination of productivity growth and price adjustment) you need to have to get the kind of surplus you need given the relevant elasticities (etc). In particular one of the problems I see in basing too much hope on using productivity improvements to do the heavy lifting in the correction is that while you can surely get significant efficiencies at the micro level (though not by a long way enough to do the whole job), you can in fact only achieve the result in the short term by slowing a recovery in the labour market (since you will be going for more output with less people), which means aggregate productivity (say GDP per capita as a proxy) doesn't improve that much, given that there is a huge fiscal burden and continuing stress on the financial sector as a result of all those long term unemployed. Alternatively we have another possibility;

b) Germany (and possibly one or two other smaller economies) temporarily leaves the eurozone and revalues.

Now, since option (a) looks very, very difficult to implement (especially since virtually no one apart from people like me and Krugman apparently wants to even hear of it),to which problem we could add the fact that German politicians are having increasing difficulties convincing their citizens that the "qualitative transformation" of the ECB is what is really in their best interests, then on a purely pragmatic level (b) may well end up being what happens in the end (and we had better just hope any eventual German exit is only temporary).

Having Germany temporarily separate from the Eurozone would, in fact, have a number of evident advantages. The first of these would be that citizens in the South would not need to see their wages slashed, while those in Germany would not be asked to pay for bailouts via their tax bill, or lead to blame Greeks or Spaniards for having their hospitals closed or their pensions reduced: ie it would all be politically much easier to handle at this point.

Evidentally German banks would have to swallow a write-down, as loans paid back in Euros would not be worth the same in (new)marks, but 70% of something (say) is better than zero or 20%, and the big plus would be that as the Euro devalued sharply the peripheral economies could rapidly return to growth, and government finances could be quickly turned round as exports grew, tourists returned, and (in addition) many of those coastal properties that currently stand empty could be sold. At the end of the day, what would be left would be a private sector, and not a public sector, problem, and it was (in part) the private sector who got us all into this mess (wasn't it?).

Indeed this solution does to some extent coincide with what could be termed the new economic reality, since economic growth in emerging markets mean that these are fast becoming key trading targets for German industry, as consumption in Southern and Eastern Europe looks to be increasingly "maxed out". In fact, according to the recent March trade report from the German Federal Statistics Office, the rate of interannual growth in exports to ex-EU "third" countries (34.7%, as compared with 15.1% for the euro area) was significant, while the volume of trade (34.2 billion euros as opposed to 35.2 billion euros for the Euro Area) is roughly comparable, and indeed at this rate countries outside the EU will soon replace the Eurozone group as destinations for German exports.

I say I hope this move (if undertaken) would be temporary, since I think in the mid term the German economy is neither so strong, nor the peripheral countries so weak, as many commentators assume. But being out of the zone would give the Germans the opportunity to see this for themselves.

The important point to emphasise, I feel, is what we now need is an orderly and credible solution to our problems. Simply standing back and watching things deteriorate, and keeping our fingers crossed that what won't work will, is not going to produce an orderly outcome. Au contraire! Even those precious exports we are winning as a result of the falling Euro are being put in doubt, try these headlines from Bloomberg: Mexico’s Peso Falls Third Day on European Fiscal Deficits, Yuan Appreciation Unlikely This Year Due to Europe Debt Crisis, Emerging-Market Stocks Drop Most in Six Days, Russian Stocks Slide Most in Week on Oil, Europe Debt Concern. And this is just a quick selection.

The problem is that any gain to exports outside the EU can be offset by falling risk sentiment as the currency slide continues, and markets which were previously being funded lose the ability to attract money. What we need are some serious measures which can turn the tide, and restore confidence that we are applying measures which will work.

Actually, the argument I am presenting here was first put to me by a young Barcelona IT engineer - David González - and you can find his argument in this blog post (below the Spanish introduction). As David says:

In conclusion, at the moment the EMU lacks the necessary economic long term policies to become a stable monetary zone. Obviously, we lack the free currency exchange rate needed in any free trade zone, which would work as an automatic stabilizer between different countries. But we also don’t have enough automatic stabilizers (only the exception of cohesion funds) needed in any monetary zone. First we need to recover the balance, and then we have to make sure it is a stable balance implementing measures that keep it. Otherwise the EU construction process will fail, and the hopes it has bring to so many people and countries will be forgotten. The implications this failure would have for democracy and peace in Europe should not be underestimated.

Or as Krugman puts it: "If the euro isn’t workable without highly flexible nominal wages, well, it isn’t workable". It's a sad conclusion, but that would seem to be where we are at this point. Basically, it is obvious that any road forward is now fraught with difficulty, but a situation where none other than the head of Deutsche Bank is saying that in all probability Greece will not be able to pay, and where an ECB which badly needs to operate a policy of Quantitative Easing but is at desperate pains to try to show that it isn't, is evidently not sustainable for long. Money has been put on offer, and the financial markets are now chafing at the bit to try to force it up and onto the table as quickly as possible. July promises to be another sweltering month here in Spain. Maybe it's time for a rethink.

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Note: At the end of his "On Milton Friedman's Ninetieth Birthday" speech Ben Bernanke arrived at what now looks like a rather hasty conclusion: - "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again". In fact, what is at issue here is a question of causality, whether the real economy problems are ultimately caused by the absence of a "stable monetary background", or whether in fact, the demand shock unleashed by the unwinding of a highly leveraged economic boom may not be the main factor in preventing the recovery of a "stable monetary background", as we have already seen in the Japanese case. The critical question facing all developed economies in addressing their fiscal sustainability problems is where the aggregate demand is going to come from to make the adjustment both viable and socially palatable.

What A Difference A Day Made!

2010-05-02T02:40:00.000-07:00

According to a once famous statement by the British Prime Minister Harold Wilson, a week is often a long time in politics. But when it comes to financial market crises we seem to follow a pattern more reminiscent of a line from the Dinah Washington version of an old María Méndez Grever song: "What a difference a day made". The day in this case was last Wednesday, at least for those of us here in Spain, since it was on Wednesday that the ratings agency Standard & Poor's downgraded Spanish Sovereign debt to AA from AA+. As a result the cost of insuring such debt using credit default swaps (CDS) surged at one point to a record 211 basis points according to CMA DataVision prices. Contracts on Greece and Portugal also rose sharply, with Greece climbing 42 basis points to hit 865.5, while Portugal jumped 20 to 406.

Standard & Poor's justified their Spain downward revision by referring to their medium-term macroeconomic projections. In particular the agency cited heavy private sector indebtedness (of around 178% of GDP), an inflexible labor market (they expect unemployment to remain around 21% throughout 2010, but then continue at a very high level for half a decade or so), the country's fairly low export capacity (Spain's exports only amount to around 25% of GDP) and the general lack of external price competitiveness. All these factors they feel are likely to mean that Spain will have low growth between at least now and 2016, a factor which will make the combined burden of private and public indebtedness much harder to service.

And despite the fact that Spanish Deputy Finance Minister Jose Manuel Campa stepped forward to say he was “surprised” by the move, arguing they are based on overly pessimistic growth forecasts, the fact is it is very hard to disagree with the S&P conclusions, as investors across the globe well understand. Even the EU Commission recently responded to Spain’s Stability Programme by stating that the growth forecast it contained was far too optimistic, and the IMF are even more pessimistic than the Commission.

In fact, it now seems that the present Spanish government seems to be becoming more and more isolated from Spain's financial and corporate establishment with every passing day. As Victor Mallet points out in today's Financial Times, "it cannot be often that academic economists use pictures of Omaha Beach, site of the bloodiest fighting in the 1944 Normandy D-Day landings, to illustrate their conclusions about one of the world’s medium-sized industrial economies", but this is precisely what the prestigous Barcelona-based Esade business school's latest economic bulletin did in their “H-Hour for the Spanish economy” editorial. “The diagnosis is very serious,” they said. “This is a highly indebted country with a damaged income-generating mechanism.”

Now even if one does not entirely go along with the whole analysis they offer of the roots and remedies for Spain's malaise, there can be no doubt that they now take the situation very seriously, even if one could lament that they did not begin to do so starting in August 2007, when the wholesale money markets first closed their doors to the increasingly toxic products that were being issued from within the Spanish banking system. The warning signs were already there, and were plain to see, although, unfortunately few inside Spain were able to do so. As a result, nearly three critical years have been lost, dithering around, large quantities of public money have been wasted, and what was a private sector external indebtedness problem has now been transformed, little by little, into a fiscal crisis of the state.

If the Spanish economy is really to be put straight, and not simply go straigh back and recidivise (after whoever it is who will do the "bailing out" finally does it), then surely one major priority during the coming national soul-searching process must be for public opinion leaders to find the ability and the courage to speak openly and clearly about the Spanish economy's "inner secrets", and the strength of character needed to publicly recognise problems in order to be seen to address them in a proactive and not a reactive fashion - to be out there in front of the curve, and not constantly trailing behind it. Put another way, it's high time Spain's bank and financial analyst community finally came out of the closet.

And if that all important international investor confidence is to be once more regained then it is important that those in the Economy Ministry are seen to be aware of the problems they face, and not simply reduced to the role of "marketing department" for a government which finds itself in ever deeper difficulty, caught between the rock of its own voters, and the hard place of the international financial markets. If you don't like having rating agency downgrades, then do something to avoid them before they inevitably come. But what was it Mr Zapatero was saying only yesterday, oh yes, he personally can see "signs" the Spain's economy Spain is at long last "improving", that the "worst is now behind us", or as Miguel-Anxo Murado so ironically puts it in the Guardian's Comment Is Free: "all repeat after me, "Spain is not Greece"". I'm not sure who it is the Spanish Prime Minister currently has interpreting the signs for him - it is certainly not Perdro Solbes, or David Vergara, or Jordi Sevilla, or indeed Carlos Solchaga - but it seems far more likely to me to be one of Spain's renowned Gypsy palm-readers than any reputable and internationally recognised macro economist.

In fact, as I have often stressed (and as Paul Krugman makes plain yet again here) Spain's problem is not essentially a fiscal one. Spain's problem is one of very high levels of corporate and household debt, and how Spain's banking system is going to support these during the long economic downturn and the ultra-high unemployment the country now faces, especially as a growing number of unemployed steadily lose their entitlement to unemployment benefit. The problem is not only that unemployment is currently running at 20%, but that benefits only last two years (plus an emergency six month flat rate 426 euro monthly payment extension), while many forecasts are now showing unemployment in the 16% to 20% range in 2013 or 2014. Just how are all these people going to continue to pay all those mortgages?

So it is not simply that "public sector borrowing is aggravating external debt and leading Spain towards high-risk territory". This is happening, as Spain's most high profile and most strategic export increasingly becomes government and bank paper, but this is the aggravating factor, and not the root cause. The principal reason why Spanish debt is steadily moving into high risk territory is the continuing state of denial to be found among the Spanish decision making elite, and the absence of any credible plan that is up to the magnitude of the challenge ahead. Confidence has now become the main problem, but not the confidence of those consumers who rationally decide to keep their money in the bank (to earn those very attractive 4 percent interest rates those banks who now anticipate having difficulty funding themselves in the wholesale money markets are offering) rather than going out and spending it.

The real issue is to be found in the confidence (or lack of it) those who Spain and its banks owe money to that the country (as a whole and not just the government) is going to be able to pay it all back. And in this context the sea change in mentality that Victor Mallet describes - assuming it is maintained - will be crucial. Those of us with rather longer memories - ones that stretch back to January for example - may wonder whether, once the immediate pressure is off, all that new found national resolve may not simply drift back into the mists from which it emerged, as has happened only too often in the past. Maybe the simplest and quickest way to help everyone feel comfortable that this was not going to happen would be to call in the IMF now, not becuase a bailout loan is needed yet, but as David Cameron is suggesting in the UK case, to carry out a "no holes barred" policy audit, so that everything which should be transparent actually is.

Who Really Likes Having A Dose Of Ebola

Of course the problems which became all too apparent on Wednesday went well beyond Spain. Along with the CDS prices, bond spreads widened all across the European periphery - with Spanish, Greek, Portuguese, Italian, and Irish yields all widening in tandem. Yields on Greece's two-year bonds briefly even hit an incredible 21%, following Standard & Poor's downgrade of the country's sovereign debt to junk status the day before.

All of this and more finally forced the EU’s hand, and officials had to go rushing to the microphone to reassure investors that Greece would soon be able to access an aid package, with German Chancellor Angela Merkel going so far as to state that talks about providing aid should now be accelerated.

Then the numbers started to be filtered out, and evidently they were much larger than many had been expecting. According to press reports IMF chief Dominique Strauss-Kahn told German policymakers that Greece might need EUR120-130bn over three years, a number which the German press quickly calculated would mean that the German contribution might then go up to EUR25bn.

Certainly, at the point of writing we still don’t know what the exact number will be - and it is not even sure they have decided yet - but the reality is that once the EUR120-130bn number is out there from an authoritative source, it will be hard not to hit it, if not exceed it.

Then followed the announcement that IMF staff have reached an agreement with the Greek authorities on a 3-year program that will include draconian fiscal cuts (of the order of 10pc of GDP) and a series of structural measures aimed at driving nominal wages lower, reforming the pension system and building better institutions. Thus, the message this weekend to investors is: stop worrying about Greece for the next three years; you can continue to speculate in the secondary market, but the Greek government will be fine. And debt restructuring with the private sector now seems to be off the table for, at least for as long as the Greek government stick with the conditions – which will obviously be the aspect to watch carefully going forward. And even if there is an eventual default, the main counterparty will be other European governments (and the taxpayers who back them) and not private bondholders.

On the other hand, Europe’s institutions have, at a stroke, opened themselves up to a large slice of what is known as “moral hazard”, since the implicit message is : what we are doing for Greece we'll do for any other Euro-zone country, if needed. So from this moment on, we are all in up to our necks, if not beyond.

This "historic moment" point-of-no-return dimension did not escaped the notice of Dominique Strauss-Kahn either, since following his meeting with German politicians he was at pains to stress the potential contagion affect lack of backing Greece to the hilt would have had on the euro and the rest of Europe in the days to come. “I don't want to hide behind a rosy picture. It's not easy,” he said. All this “ can also have consequences far away. We have to face a difficult situation. We are confident we can fix it... But if we don't fix it in Greece, it may have a lot of consequences on the EU.”

Highly respected US economist and Harvard University Professor Martin Feldstein went even further, saying that in his opinion Greece will eventually default on its bonds and he feared other euro-area nations may follow, most probably Portugal. “Greece is going to default despite all the talk, despite the liquidity package,” he said. Portugal's name is mentioned frequently these days, since although the government deficit and debt levels are lower in Portugal than in Greece and the Portuguese government has much more fiscal credibility than its Greek counterpart, when you add private sector debt to the public part the number is not far short of 300% of GDP, and in fact the underlying problems are very similar to those which are to be found in Greece.

But it isn’t only in the South the the EU has to worry, since probems in the East continue to fester. The Hungarian forint had a fairly hard time of it over the past few days, and had a two-day intraday loss 3.6 percent on Tuesday and Wednesday, its biggest such fall since March last year. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. The drop followed revelations from Hungary’s incoming Prime Minister Viktor Orban that the country’s underlying fiscal deficit had in fact been rather higher than the previous government had acknowledged. So contagion may now be also moving Eastwards, meaning that EU institutions may now increasingly face a battle on two fronts, since the wobbling won’t simply stop with Hungary, there is Latvia, Bulgaria and Romania to also think about (just to name the first three that come to mind).

As Angel Gurria, OECD Secretary General, said this week: “This is like Ebola. When you realise you have it you have to cut your leg off in order to survive...... it is contaminating all the spreads and distorting all the risk assessment measures. It is also threatening the stability of the entire financial system.”

The Greek Tragedy Continues

2010-04-23T08:54:00.000-07:00

The future of the Eurozone is decidedly hanging in the balance at the moment. As I said earlier in the week, the problem isn’t a simple question economics anymore: everything now is all about credibility, about who does what, and when, and how everyone else reacts. As the crisis trundles on and on, news that Greek bond spreads have hit ever higher post European Monetary Union records has become such a regular event that the process now seems almost a monotonous one. However, what happened on what we could now call this week’s Greek “Black Thursday” certainly marked a new, and more worrying milestone in the ever evolving crisis. The news this morning that Greece has demanded the activation of the EU-IMF loan - news which apparently took even the EU Commission itself by surprise it seems - only adds to the general sense of confusion that abounds.

The problem we are presented with is not only that Greek 10-year bond yields reached 8.83 per cent, their highest levels since 1998, or that the cost of insuring Greek government debt against default hit a record high of 616 basis points. The really disturbing development was that spreads on government bonds all around Europe’s periphery – including countries like Hungary and Bulgaria - widened sharply, raising heightened concerns that Greek contagion may move from being a mere possibility to becoming a reality. And the cost of protecting peripheral eurozone borrowers against default also hit record levels, with Spain and Portugal touching record highs for their Credit Default Swap prices.

The surge in Greek bonds followed news that Eurostat, the European Union’s statistical service, had revised its estimate of the country’s 2009 deficit to 13.6 per cent of gross domestic product from 12.7 per cent, and the announcement that Moody’s Ratings Agency had downgraded Greek sovereging debt to A3 from A2.

Markets are obviously nervous at the moment, and understandably so, with two issues in the forefront of their minds. In the first place the real level of commitment of core Europe, and especially Germany, to supporting the periphery through several years of difficult and painful structural adjustment is far from clear. On the other, the ability of political leaders in Greece and other affected countries to carry their citizens with them through the sacrifices which will be required to maintain the monetary system intact continues to remain in doubt.

German voters are notably uneasy about lending money to Greece, and a sizeable majority of them are against any form of aid. Reticence on the part of Angela Merkel’s coalition partner also makes obtaining parliamentary backing for the loan difficult, and the FDP senior spokesman on financial questions, Frank Schaeffler, stated bluntly this week that either Greece needed to intensify its austerity plan or it should leave the Euro.

Most observers, however, consider a Greek withdrawal to be only a remote possibility, given that any return to the Drachma would make the country’s debts even less payable. In fact the threat to the integrity of the currency union comes from an altogether different quarter. What is in now increasingly in doubt is the ability of Germany’s political leadership to carry voters with them should either Greece decide to default while continuing with Euro membership, or should other member countries be forced to apply for loans.

At the same time, some sort of Greek default is now no longer simply a theoretical possibility among many others, indeed talk of the inevitability of some form of debt restructuring (albeit voluntary) grows with every passing day. Erik Nielsen European Economist with Goldman Sachs said this week he is expecting Greece to offer some sort of “voluntary debt-restructuring” to creditors over coming months, while JP Morgan issued a research note saying that while such restructuring may not be imminent, the move would make sense given that Greece could be seen as “the sovereign analogue of a ‘bad’ company with a bad capital structure”.

Restructuring is simply a polite word for default, with the difference that it is normally carried out by agreement. The most likely form of restructuring in the present context would be debt rescheduling, whereby short and medium-term debt is converted into a long-term version, as happened with the so-called “Brady bonds” devised by the US Treasury to resolve the debt difficulties of a number of Latin American countries in the late 1980s.

One indication that the ground may be being prepared for some kind of restructuring can be found in the decision reported by German Deputy Finance Minister Joerg that any aid to Greece would come in the form of pooled loans from the euro-zone countries and not through the purchase of Greek bonds. Plans to purchase bonds are “off the table,” he said. This procedure implies that government loans would be strongly guaranteed, while private bond holders would really pay the price for the Greek “rescue”.

At the same time voices are now being raised asking whether it would not be a better idea for Germany, rather than financing more and more loans, simply to put its losses down to experience and go back to the Deutsche mark? According to Joaquin Fels, Chief Global Economist at Morgan Stanley, the Greek rescue measures could “set a bad precedent for other euro- area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time,” in this case “countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union.”

Evidently such statements can be read as bargaining postures, attempts to get politicians and voters in the South of Europe to focus their minds on the problem in hand, but they can also be read as warnings of what could happen if they do not. At the present time the situation is extraordinarily confused. Greek Prime Minister George Papandreou's formal request for financial financial support seems to have taken almost everyone completely by surprise although it shouldn't have, since as I reported in my earlier post the Greek Finance Minister George Papaconstantinou had previously warned that his country could call on loan backup from the EU and the IMF even while talks with the 20 strong EU, ECB and IMF mission were continuing. Actual details of the level of financial support which will be offered remain scant at this point. According to G20 sources who spoke to Reuters, the Greek government have only asked at this point for a first tranche downpayment, to give them working capital to keep going while the talks continue (think of the JP Morgan distressed company talks with the receiver analogy). What is quite striking, however, is how the government let things come to this pass before striking the decisive agreement - evidently they could not hold out till after the German regional elections, and that is another worrying sign. When all is said and done, one thing is obvious, the forthcoming loan will clearly have some kind of super-senior status (which means it would be payable before ALL other creditors - German voters would settle for nothing less), and this implies that it is likely to be existing bondholders, and not EU national governments, who are going to be invited invited to pay for the Greek bailout. How they will react to this realisation is what remains to be seen in the days and weeks to come.

Do I See Movement In The Greek Trenches?

2010-04-20T06:38:00.000-07:00

This isn't about economics anymore, this is now about who does what, and when, and how everyone else reacts.

Certainly the news that Greek bonds hit another post-EMU record high yesterday can hardly be said to have come as a surprise. 10-year bond yields reached 7.76 per cent at one point and closed up 26 basis points on the day. This morning Greece comfortably sold 1.5 billion euros worth of 3 month Treasury Bills - in the end they sold 1.95 billion euros of them - but the yield on the bonds more than doubled to 3.65 percent, from 1.67 percent for a sale of similar debt on January 19. And the the extra yield investors demand to hold Greek 10-year bonds instead of German bunds, the euro-region’s benchmark government securities, rose again today - to as much as 472 basis points - the most since Bloomberg records began in 1998. The average spread over the past 10 years has been 61 basis points. Greek two-year notes also fell, pushing the yield 23 basis points higher to 7.51 percent.

On the other hand, Bundesbank President Axel Weber was out there yesterday telling a group of German lawmakers that Greece was going to need more, not less money.

Greece may require financial assistance of as much as €80 billion ($107.92 billion) to escape its debt crisis and avoid default, Bundesbank President Axel Weber told a group of German lawmakers Monday, according to a person familiar with the matter.

The estimate, considerably more than the €45 billion that European countries and the International Monetary Fund are currently prepared to extend Greece this year if it needs a bailout, suggests that a rescue of the country may come in several stages and reach beyond 2010.

Why, I ask myself, is a conservative, and normally discreet, figure like Axel Weber out there stressing precisely this point at this moment in time, when German voters are notably nervous about any sort of aid to Greece, reticence on the part of Angela Merkel's coalition partner makes a parliamentary debate on a loan difficult, and voices are even being raised about whether it would not be a better idea for Germany simply to put the losses down to experience and go back to the Deutsche mark?

Germany might consider exiting Europe’s current monetary union to create a smaller bloc as the Greek crisis threatens to turn the euro area into a region of “fiscal profligacy,” Morgan Stanley said.

Greek rescue measures “set a bad precedent for other euro- area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time,” said Joachim Fels, co-chief global economist at Morgan Stanley in London, in an April 14 note. “If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union.”

All these statements can be read as bargaining postures, attempts to get people in the South of Europe to focus their minds on the problem in hand, but they can also be read as warnings of what could happen if they do not.

Certainly, nothing at this point is very clear. Especially, as the FT reminds us this morning, when we live in a world where the unthinkable has finally become thinkable. So we could now ask ourselves whether the financial markets are not in fact, and before our very eyes, gearing themselves up for an event which many had not previously been factored into the realms of the possible: Greek debt restructuring.

Even as Greek bail-out discussions continue – talks between representatives of the European Commission, European Central Bank and IMF were delayed on Monday by the volcanic ash cloud – market watchers are starting to question whether, in the long term, Greece can avoid a restructuring of its debts or even an outright default.

“Investors and analysts are now running the numbers to see what a haircut to Greek bonds would be,” says Steven Major, global head of fixed income research at HSBC. “One way to do this is to compare restructurings for emerging market sovereigns. Based on the defaults over the last 12 years the average long-term recovery rate is close to 70 per cent. Ultra-long Greek bonds currently trade at a price below this.”

The Financial Times also reports that the IMF is likely to raise the question of debt restructuring at their forcoming meetings with the Greek finance ministry - you know, the ones that have been delayed by the symbolic intervention of all that volcanic ash. According to the FT source it is not likely to be a detailed discussion “just a pointed reminder of the debt forecast”.

The IMF has already told the finance ministry informally that Greece’s debt will reach 150 per cent of GDP by 2014, according to this person. Greece’s debt to GDP level – 113 per cent in 2009 – is already the highest in the eurozone. The IMF calculates that Greece will need to find €120bn ($162bn) over the next three years.

Of course, the term "debt restructuring" does sound a lot better than default, and the expression does cover a wide range of possible outcomes, running from unilaterally changing the terms of the bonds one the one hand, to voluntary renegotiation to ease refinancing pressure at the other.

One proposal which has been advanced (most recently by Wolfgang Munchau) is for recourse to some form of Brady bond:

Restructuring is a form of default, except that it is by agreement. It could imply a haircut – an agreed reduction in the value of the outstanding cashflows for bond holders. The Brady bonds of the late 1980s, named after Nicholas Brady, a former US Treasury secretary, worked on a similar principle. An alternative to restructuring would be a debt rescheduling, whereby short and medium-term debt is converted into long-term debt. This would push the significant debt rollover costs to well beyond the adjustment period.

Brady bonds were initially issued to ease the debt difficulties of a number of Latin American countries in the late 1980s (and they are modeled on the earlier Japanese par bonds - you can read more about them in wikipedia here). The essential idea in the Greek case would be that current debt instruments would need to be swapped for some longer term bond with a lower than market rate coupon (or implied interest rate).

Of course, as Munchau points out, in order to get the existing bondholders to trade their debt on a voluntary basis, they would have to be put under some sort of pressure:

One way to force the debate would be to attach super-senior status to the EU loan to Greece. I understand this is still an unresolved issue. Super-senior means this loan would be repaid before existing debt. Should Greece ever get into a liquidity squeeze, bondholders would be put in a back seat. In such a situation, they might prefer rescheduling.

Which makes this little detail about the form of the EU loan rather more interesting than it might seem at first sight:

Any aid to Greece would come in the form of pooled loans from the euro-zone countries and not the purchase of Greek bonds, German Deputy Finance Minister Joerg Asmussen said Tuesday.

He also said that Greece will be an issue at the meetings of finance ministers and central bankers from the Group of Seven leading industrial nations and the Group of 20 industrial and developing nations this weekend in Washington.

"Of course, Greece will be an issue," Asmussen told reporters Wednesday. He also said that "if financial aid for Greece will be given, then the pursued path will be to provide pooled loans." Germany would provide its share of such loans through the state-owned KfW Banking Group and the loans would be guaranteed by the government.

Plans to purchase bonds "is off the table," he said. The advantage of providing pooled loans is that there can be stricter conditions to paying out such loans, such as demanding the implementation of fiscal reforms.

So we could imagine that the forthcoming loan would have super-senior status (German voters would settle for nothing less), and, if this interpretation is correct, it will be existing bondholders, and not the EU governments, who will be being invited to "bail Greece out". Well, maybe we won't have to wait too much longer to find out, since the Greek Finance Minister George Papaconstantinou stated today that the country could call on loan backup from the EU and the IMF by as early as next month depending on loan conditions and the progress of talks with the EU, ECB and IMF joint mission, which is composed of around 20 people according to reports. Plenty to talk about, and plenty of people to do the talking. Too many, perhaps?

Angela Calling

2010-04-11T05:02:00.000-07:00

Angela Merkel is a Chemist. In her doctoral thesis - entitled "Untersuchung des Mechanismus von Zerfallsreaktionen mit einfachem Bindungsbruch und Berechnung ihrer Geschwindigkeitskonstanten auf der Grundlage quantenchemischer und statistischer Methoden" - she demonstrated herself to be a thoroughgoing expert when it comes to analysing the speed of disintegration of chemical compounds once the bonds which hold them together are weakened. Unfortunately she is now having to apply all this acquired expertise and know-how in a determined attempt to avoid the break up and falling apart, not of a highly complex chemical substance, but of an even more complex economic and political one, and the bonds which are the focus of all her attention right now are not chemical, but financial and social.

The problems we in Europe all now face together ("wir teilen ein gemeinsames schicksal" in M. Trichet's words) have not arrived just "suddenly one springtime" as it were, indeed they come from afar. Right from the very begining it has been no easy matter for German society to achieve the consensus necessary to accept the idea of participating in a common currency, the Bundesbank has long maintained its by now well-known reservations, while not a few have been the voices expressing the view that having so many diverse countries all sharing the same monetary unit would inevitably create a structure which was too unwieldy to be manageable, and too weak to hold together when the real storm weather came. What was needed, it was argued, was a two, not a one, speed Europe.

Unfortunately, all these simmering issues have once more resurfaced during the last week, over the tricky question of what to do about Greek financing needs, and Germany's economic and political leadership now seem to be locked in an intense debate about exactly which path to take. Meanwhile Greek bond spreads simply work their way onwards and upwards, while capital flight from Greek bank deposits has forced the banks themselves to go rushing to the government for a further 18.000 million euros in funding just to keep them alive.

The current issue came to a head last Monday afternoon, following a brief report on the Financial Times website stating that progress with the decision on any Greek rescue plan was effectively deadlocked due to the inability of the Germany to agree with her other European partners the precise rate of interest to be charged on any loan to be provided. Ironically it is this single issue which is currently bringing European decision making to a dead halt, and creating a level of uncertainty and debate of such intensity that, if it is not resolved decisively, could bring the very future of the Euro into question. And it is not a trivial matter, since the rate charged will become a precedent, which other, larger, countries can refer to later.

Essentially the problem is this. According to the US economists Carmen Reinhardt a Ken Rogoff (in a widely quoted paper Growth In A Time Of Debt) a potential tipping point exists once government debt breaches the 100% of GDP level in the aftermath of a financial crisis. After this point the impact of additional state spending is, paradoxically, to effectively reduce growth (given the weight of interest repayments, and the additional risk price charged for lending, and the impact of more government debt on investor confidence) and indeed far from helping a country to recover, further borrowing may mean the economy actually shrinks rather than grows.

Let's take an example. Imagine Greece has debt at the 100% of GDP level (in fact it is somewhat over 115%), and the price investors charge for buying the bonds is around 6% (or more or less 3% more than the German government has to pay to sell equivalemt debt). Now let's also imagine that Greece has zero inflation and zero growth (they are in the midst of a massive correction which will last some years, so these are reasonable, and indeed possibly even optimistic assumptions). Then Greece will need to produce what is know as a "primary surplus" (or difference between current spending and current income) of around 6% just to stand still, and not see its level of gross indebtedness increase. But Greece, in 2009, had a primary deficit of some 7% of GDP.That is to say, simply to not get more in debt Greece has to withdraw something like 13% of GDP in demand from the economy, and this is massive, which is why all the experts anticipate a sharp contraction in the Greek economy over the next 3 or 4 years, and why rather than looking to domestic demand the Greeks will need to look to exports for support (The US economist Charles Calomiris has an excellent detailed explanation of all this here, while Peter Boone and Simon Johnson dig even deeper here) .

Which is where the European Union comes in. Basically, if Greece has to pay such a high interest rate differential to support such a large debt there is every likelihood she will not be able to continue to finance herself, and default will become inevitable. You can only demand so much effort from the reformed alchoholic before they are driven back to drinking in frustration. On the other hand the EU could help by making the interest rates charged cheaper, but unfortunately there is a 1993 decision of the German constitutional court which makes it effectively illegal for the German government to participate in such a subsidised loan. The IMF can help, they are reportedly willing to make a loan of up to 10 billion euros at very favourable rates, but there are limits to how far they can go, since they cannot justify favouring comparatively rich Europeans when they deny such funding to poorer countries in the third world.

And the quantity Greece actually needs is massive. Initial reports spoke of a total loan of around 25 billion, but this is surely not enough. At least 50 billion will be needed, and some estimates put the number much higher (see Peter Boone and Simon Johnson again). And remember, we are not talking about fancy theories here, all of this is all simple arithmetic: either Greece gets a large, cheap loan, or she will default. They will have no alternative. So European decision making is gridlocked, while on Thursday Greece's 10 year bond interest rate differential hit record post-EMU highs of 4,63%, and the ineterest being charged was not 6% but near to 8% at one point.

Naturally, if Greece were to do the "honourable thing", and leave the Eurozone and default, "all would be light". But they won't, and there is no good reason why they should do so. Now, enter Professor Starbatty of Tübingen University. He has another proposal. Not Greece, but Germany should leave the Eurozone, and go back to the Mark. And before you start to laugh, you should bear in mind that he is very serious in his proposal, and many Germans agree with him. Indeed so seriously does Angela Merkel take the possibility that any cheap loan to Germany will encourage supporters of Professor Starbatty to go to the Constitutional Court and ask for a ruling that German participation in the common currency is illegal that she has frozen the whole Greek bailout process.

And it is not clear, at this stage what the view of the Bundesbank is. According to German press reports, accepted by the bank itself, the Bank is currently considering an internal report on the rescue loan proposal which states "This agreement of the heads of government, which according to our knowledge has been reached without any consultations from central banks, implies risks to stability that should not be underestimated," (my emphasis).

And before anyone complains that the Germans are too dependent on exports to the South of Europe to do anything which makes selling these more difficult, please consider that domestic demand growth in all four Southern European members of the Eurozone is expected to be extremely weak over the next decade, while growth in emerging markets like India, China, Brazil and Indonesia is predicted to be massive. The markets are moving, so why not move with them?

Of course, none of this means that the Eurozone, like one of those chemical compounds Angela used to study, is about to fly apart. But we should not underestimate the stresses the currency union faces at this point. As former IMF chief economist Ken Rogoff pointed out in the Financial Times this week, "if investors gather with enough sustained force, and if the central bank lacks sufficient resilience and resources, they can blow out a fixed exchange rate regime that might otherwise have lasted quite a while longer." What the countries in the South of Europe need to give the Germans right now are not arguments about how they would be foolish for them to leave, but arguments about what they themselves are prepared to do to make it more attractive for them to stay. The German giving machine is all done, and the Germans themselves are now more than tired of being continually told they need to pay, pay and pay again for events that now took place over half a century ago. Calling, Berlin, calling Berlin, hello, hello, is anybody there?

From A Greek Debt Crisis To A Eurozone Structural One?

2010-03-26T03:41:00.000-07:00

When we look back five years from now, will we see this week as marking a turning point in the short, but far from uneventful, ten year history of Europe’s common currency? Certainly recent comments by the deputy governor of the People's Bank of China have made evident what was already implicit: the dependence of EU sovereign debt on sentiment in global markets, especially in Asia and the Americas. Simon Derrick, chief currency strategist at Bank of New York Mellon even went so far as to say the trauma of recent days might well signal the point that we stop talking about a “Greek debt crisis” and start talking about a “Eurozone structural crisis” . And while Herman Van Rompuy, president of the European Council, was telling us on the one hand that the eurozone will never let Greece fail, Jane Foley, research director at Forex.com busied herself explaining, on the other, that any involvement of the International Monetary Fund in helping Greece to stabilise its fiscal position only heightens the risk that the country might one day end up leaving the eurozone. So just where are we at this point?

Basically it is important to recognise that the current crisis has placed the spotlight on the severe institutional weaknesses which lie underpin the common currency, and it is just these weaknesses which are leading so many commentators to now ask themselves whether it might not have been easier to implement political union in Europe before embarking on such an ambitious monetary experiment.

These weaknesses became even more clear on Thursday when Jean Claude Trichet went very public in making clear that he personally is totally opposed to IMF participation in any Greece "rescue". “If the IMF or any other authority exercises any responsibility instead of the eurogroup, instead of the governments, this would clearly be very, very bad,” he said on France’s Public Senat television. And this on the same day as Angela Merkel and Nicolas Sarkozy were publicly celebrating the triumph of the "Franco-German" entente. Clearly there are still many rivers left to cross before we can say we have reached the other side in this particular structural crisis.

Basically the issues facing Greece are now not primarily fiscal ones. The issue is how to get growth back into the economy fast enough to stop deflation and the economic contraction taking away all the good work acheived through fiscal cutbacks, and how to finance Greek borrowing at a rate of interest which stops the level of indebtedness spiralling upwards out of control.

The Economist magazine have done their own calculation on this, and they estimate that a loan of €75 billion rather than the currently rumoured €25 billion will be needed and that the country is likely to need five years (rather than three) to get its deficit down below 3% of GDP. They also assume that Greek GDP will be 5% below its current level by 2014. Obviously the output you get in these sort of calculations rather depend on the expectations you put in, but these are not unrealistic expectations.

As I explain in this post on the debt snowball problem, only two things really matter at this stage, the rate of change in nominal Greek GDP (that is non price adjusted) and the rate of interest charged on the sovereign debt. As regards nominal GDP, the Economist assume a 5% contraction in 2010. This may seem rather steep, but it does include an anticipated fall in prices as well as a drop in GDP. My own calculations suggest a drop in real GDP of about two percent, rather than the somewhat higher numbers others are talking about. I suggest this number is more realistic given the degree to which the trade deficit is likely to correct, and the net trade impact on headline GDP numbers.

As far as prices goes, I think a one percent fall in the CPI is a reasonable guess at this stage. If you look at the chart below you will see that interannual Greek inflation is still well above the EU 16 average, but prices have now been falling since November, and even though we shouldn't neglect the impact of tax and public sector tariff increases, prices will almost certainly be down in December 2010 over January. The big difficulty is estimating by how much.

One of the key issues facing Greece at the moment, with large parts of its outsanding debt needing to be refinanced, is just what rate of interest (or extra spread) will have to be paid on any loan (I deal with this question in this post). This is almost a key question, since it can become a "life or death" issue in determining whether or not the country will be forced into default. But here both the EU and the IMF have a problem, since if the Euro Group countries make a loan at a level near to the the current price charged for German debt (which is what should happen if we argue Greek debt carries no additional risk since we are all guaranteeing it), then other countries who are currently paying more (Spain, Ireland, Portugal, Austria etc) may ask why they also could not have such favourable treatment. On the other hand, asking the IMF to make a cheaper loan causes problems, since it could be seen as subsidising Europe in sorting out its problems, and this might not be easily understood in Emerging Economies where there are evidently many more needy cases than Greece's to think about.

The bottom line is that there is no easy answer here, and Europe is struggling to convince the rest of the world that it has both the will and the instruments to effectively tackle the problem of maintaining a single currency in a diverse group of countries. Herman Van Rompuy said on Friday there was no danger of Portugal being sucked into the same sort of debt whirlpool as Greece, and that Portugal would not be the next country to be sent over to Washington in search of a helping technical hand from the IMF. Which raises the question: if it won't be Portugal, who will it be?

Why Not Unravel The IMF Too While We're At It?

2010-03-24T05:56:00.000-07:00

If you're really good at making a pigs ear of things, why not join the EU? Of course, this is not meant as a piece of solid advice, rather it is a cry of frustration at being impotently forced to watch so many things done so badly, each in turn, and one after the other. Southern Europe's problem is essentially a competitiveness problem, and not a fiscal one, and if many states have been having growing difficulty with their negative fiscal balances, this is a symptom of the problem, and not its cause. Even in the worst of cases - countries like Greece and Portugal - the rising recourse to fiscal outlays has been a response to lack of "healthy" growth, and the root cause of this continuing difficulty in generating real growth has been the underlying lack of competitiveness, and the inability to export your way out of trouble once the burden of debt starts to rise, so simply pruning the fiscal side isn't going to cure the problem, and by now that simple point should be obvious, I would have thought.

Naturally a lot of financial markets attention has been focusing recently on whether or not the Euro is about to unravel. Even the ever-so-prudent Ralph Atkins winds up his mamoth "Defiant Berlin" review with a quote from Jörg Krämer, chief economist at Commerzbank in Frankfurt who says the next few years may see the eurozone becoming more of a “transfer union”, one in which better performing countries have to help out weaker members. “That" - he argues - "could mean Germany says, ‘we are no longer willing to support the weaker parts of the EU’, while the Greeks say that they are not prepared to have policy dictated by the Germans," Thus: “The risk cannot be totally excluded of a eurozone break-up within 10 to 15 years – and this is a consequence of widening eurozone divergences.” To which Atkins adds "If that risk rose, Europe would be facing a very different ballgame". You bet it would!

To some extent I cannot help feeling that a congenital inability to take bite-the-bullet type decisions is resulting in an ongoing process of passing the buck ever onwards and upwards. The latest exemple here is the issue of IMF involvement in the Greek adjustment process. Now, as with any issue, there are good reasons and there are bad reasons why IMF involvemnet might be considered desireable. Among the good reasons are the vast experience and technical expertise of the fund, or the fact that representatives of the IMF might find it easier to say "no", given that the underlying sovereignty issues are not exactly identical when posed in terms of the IMF as they are in terms of the EU.

But among the bad reasons would be the idea that the IMF could fund any eventual Greek loan more cheaply. As far as I can see, a lot of the EU interest in having an IMF loan to Greece stems from the need to make the rate of interest applied cheap enough to bring the spread down. This is an important concern, since it is not obvious why a country which is making its best effort to put things straight should need to be paying an exorbitant charge for the money it borrows while it does this. Earlier this week European Central Bank President Jean-Claude Trichet spoke out strongly against offering the kind of low-interest loans for which the Greek government has been pressing - “There shouldn’t be any subsidy element, no concessionary element” in any eventual loan to Greece, he told members of the Economic and Monetary Affairs Committee of the European Parliament. And maybe this is the only reasonable position the ECB can take (given its Charter), but evidently the Eurogroup of countries are not bound by the same constraints and they themselves could do this (via recourse to Group-backed EuroGroup bonds, or whatever), which raises the obvious question: why don't they?

Well, one of the reasons lying behind all the reluctance we are currently seeing may not be the issue of the German constitution, or even the question of changes to the Lisbon Treaty, or any of the major issues of principal which arise and would require lengthy and onerous debate. Maybe the question is a much more simple one: perhaps Europe's leaders are simply worried that if they make a cheap loan to Greece, then Spain, Portugal, Ireland, Italy, Austria, Slovenia and Slovakia may all soon argue they also need one.

My view is that this is an issue where the EU itself needs to bite the bullet, and make large changes, ones which lead, as Wolfgang Munchau has been arguing, to much closer political union. If we need the IMF in Greece, and I think we do, it is for its proven capacity to implement programmes, and its extensive technical resources, NOT for the money.

Indeed the Indian economist Subroto Roy just raised a very important issue in this regard on my Facebook. If IMF funds are used to bailout Greece, wouldn't that be a bit like the poor pampering the rich. Shouldn't IMF money be being used for other things? Shouldn't the IMF have other priorities? Evidently stabilising Europe is important, but shouldn't the EU be doing that (and not just as a matter of pride, as a matter of international solidarity)? As Roy asks, what happens if...

"the US, Britain, ANZ and everyone else in the IMF who is not in the Eurozone.... (decide to)... legitimately ask why the effective subsidy of Greece by its Eurozone partners should be transferred to the rest of the world ... (after all) .... the Europeans have enough clout in the IMF to, say, insist some of their own IMF-directed resources be directed towards Greece specifically, which would spell the unravelling of the IMF if it became a general habit."

Exactly.

On a slightly different, but somewhat related topic, I basically agree with a lot of what Martin Wolf wrote in his Excessive Virtue piece in the FT yesterday. As Martin points out, in saying "nein" to those who suggest that its economy should become a little less competitive what the German government is effectively saying is that the eurozone must become some kind of greater Germany - a huge export machine which generates a massive surplus with the rest of the world, a surplus which enables all those highly indebted member countries to pay down their debts. But, as Wolf argues, this policy would have profoundly negative implications for the entire world economy.

He cites the German secretary of state Ulrich Wilhelm, who, in a letter to the FT, argues that:

“The key to correcting imbalances in the eurozone and restoring fiscal stability lies in raising the competitiveness of Europe as a whole. The more countries with current account deficits are able to increase their competitiveness, the easier they will find it to decrease their public and foreign trade deficits. A less stability-oriented policy in Germany would damage the eurozone as a whole.”

This worries Wolf, who argues that Mr Wilhelm is inviting everybody to join a zero-sum world of beggar-my-neighbour policies in which every country tries to grab market share from the rest (strange how all of this sounds very similar to the way things wound up back in the 1930's, now isn't it?). As he suggests, at a time of generalised global weakness, this is a self-defeating recommendation for both the eurozone and the world. If we take a look at Japanese exports, which after an initial surge, are basically now near enough to being stationary, it is obvious that deficient aggregate demand in Europe is now part of the problem:

And obviously with all the fiscal pruning and "good housekeeping" we are now about to see, this problem is set to get worse, not better. Being well apprised of the problem Wolf then goes on to put forward an alternative:

"An alternative solution might be to help the world absorb larger export surpluses from the eurozone, the US, Japan and the UK. True, no sustainable exit from the present quagmire can be envisaged without increased net capital flows into emerging countries. It also seems evident that this is where the world’s surplus savings ought to end up. But it is going to take time and much reform to make this happen."

Really, I entirely agree, but a quantum leap in thinking is necessary here. If the books are to balance - and if we want growth and pensions in the OECD then they have to - what we need to do is help cheaper finance reach those countries with capacities to grow and absorb others exports, while the EU takes on in-house responsibility for sorting out the financing (but not necessarily the disciplining) of its own members. That is, if cheap loans need to be provided to anybody it is to those in need in the Emerging Countries, and not to Europeans who have happily spent their own way into difficulty.

In fact, in my New Year questions to Paul Krugman I raised some sort of similar point, but unfortunately his response was not exactly positive.

E.H.: One of the standard pieces of economic observation about countries recovering from financial crises is that their recoveries are export driven. This has now almost attained the status of a stylised fact. But as you starkly ask, at a time when the financial crisis is generalised across all developed economies - whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them - to which new planet are we all going to export? Maybe we don’t need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies. Do you think there is room for some sort of New Marshall Plan initiative, to generate a win-win dynamic for all of us?

P.K.: Um, no. Not realistically as a political matter. We’ll be lucky if we can get the surplus developing countries to spend on themselves. My guess is that our best hope for recovery lies in environmental investment: taking on climate change could, in terms of the macroeconomic impact, be the functional equivalent of a major new technology.

So the solution to our problems is not politically realistic. And meantime we keep trying to play around with policies which simply won't work. It is now pretty clear to me at least just how so much valuable time was lost back in the 1930s, thrashing around playing with solutions which didn't, and wouldn't, work. As Krugman himself likes to say, "history has a habit of repeating itself, the first time as tragedy, and the second time as yet another tragedy".

Waiting For Something To Turn Up: Europe's Looming Pensions-based Sovereign Debt Crisis

2010-03-16T03:26:00.000-07:00

As Irwin Stelzer argued in a recent opinion article in the Wall Street Journal, Spain’s Prime Minister José Luis Rodríguez Zapatero seems to be an admirer of Charles Dickens's character Mr. Micawber. When asked what he plans to do about Spain’s 11.4% fiscal deficit, first he promises to extend the retirement age, only to later tell us the measure may not be necessary. Then he promises a public-sector wage freeze, only to have his Economy Minister, Elena Salgado, say he really doesn't mean exactly what he seems to say. And in any event, we shouldn’t worry too much, since given that Spain is a serious country, somehow or other the fiscal deficit will be cut to 3% by 2013, even though most serious analysts consider the economic growth numbers on which the budget plans are based to have their origins more in the dreams of an Alice long lost in Wonderland than in any kind of sobre analysis of real possibilities. "We do have a plan," deputy prime minister, Maria Teresa Fernandez de la Vega assures us, but to many that plan now seems to be little better than hoping, like the proverbial Mr. Micawber, that "something will turn up."

The lastest to draw attention, to the problematic nature of this "wait and see" approach - and to the gaping hole which is now yawning in Spain’s national balance sheet - is the credit ratings agency Fitch, who only last week warned that many Western governments now face unsustainable debt dynamics following measures taken to address the financial crisis.

The agency singled out Britain, France and Spain as being in special and urgent need of outlining plans to strengthen their public finances if they don’t want to risk losing their current highly prized AAA ranking.

This strong and direct warning was issued by Brian Coulton, Head of Global Economics at Fitch, who said "High-grade sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010 to underpin confidence in the sustainability of public finances over the medium-term and their commitment to low and stable inflation. The UK, Spain and France in particular must outline more credible fiscal consolidation programmes over the coming year given the pace of fiscal deterioration and the budgetary challenges they face in stabilising public debt."

Yet, while criticising Portugal's gradual approach to fiscal consolidation as a matter of "concern" Fitch senior director Paul Rawkins also argued that the Spanish govenment had acted swiftly in announcing plans to consolidate public finances. Nonetheless he did still warn that the economic risks facing Spain remain very high, especially since the pace of decline in tax revenues is dramatic enough to be preoccupying, while continuing “labour market inflexibilities could well prolong the economic adjustment”.

The current problem facing Spain (and other similarly affected countries) has its roots in two quite distinct sources. In the first place measures taken to counteract the impact of the financial crisis have been inadequate and have simply produced large short term deficits. However to this short term liquidity and adjustment problem must now be added the further dimension of longer term impacts on public finances which have their origins lie in ageing populations, and the effect on economic growth of having older and smaller working-age populations.

Regarding the first, as Willem Buiter, now chief economist at Citi has pointed out, more than 40 per cent of global GDP is currently being produced in countries (overwhelmingly advanced economies) running fiscal deficits of 10 per cent of GDP or more. Over most of the last 30 years, this level fluctuated in the 0-5 per cent range and was dominated by debt form emerging economies. So the crisis marks a watershed, from which there will likely be no turning back, and in many ways could not have come at a worse moment for those countries who still have to undertake substantial pension reform to put their nation finances on a solid footing when faced with the unprecedented ageing which lies ahead.

Indeed, to take the Greek case, while the short term fiscal deficit has been the focus of most of the press attention, the longer term problem associated with the funding of Greek pensions far outweighs issues associated with the falsifying of national accounts in the early years of this century. A recent report by the European Commission found that Greek spending on pensions and health care for its ageing population, if left unchecked, would soar from just over 20 percent of GDP today to around 37 percent of G.D.P. by 2060. And Greece is simply an early warning indicator of troubles to yet to come, in larger countries like Germany, France, Spain and Italy who have all relied for decades on pay as you go type state-financed pension schemes. Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because fiscal issues associated with the downturn have suddenly pushed at least part of these previously hidden costs up to the surface.

In fact, unfunded pension liabilities far outweigh the high levels of official sovereign debt. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to something like 875 percent of its gross domestic product. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent. Other countries have obscured their total obligations as well. In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Of course, these numbers are arguable, and may well be in the excessively high range, but the fact still remains: outstanding and unfunded liabilities are huge, and would have been difficult to honour even without the present crisis. As it is, we are now in danger of spending the seedcorn which could have been harvested later on down the road.

Public opinion has yet to assimilate the seriousness of the issues involved here. As Pimco Chief Executive Mohamed El-Erian said in a recent FT Opinion article, the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. With time, this issue will prove to be highly consequential. The latest Fitch report is simply another warning shot. The sooner we all recognise the, the greater the probability of our being able to stay ahead of the disruptions this adjustment to reality will cause. It is time to stop simply waiting around to see what is going to turn up, since if we do continue like this we won’t like what we eventually find.

Serious Problems Emerge For The F-UK-De Group Of Countries

2010-03-15T13:44:00.000-07:00

Well, I for one can't help thinking that it's now well time we all stopped getting carried away with the use of so many acronyms. Not only may one man's meat easily prove to be another's poison, it may even be that for some the entire meal will be so distasteful as to prove totally indigestable. And so it is with the latest set of proposals to appear on that diagnostic lab bench which has been hastily erected in the search for that magic "cure all" for the eurozone's many ills.

Daniel Gros, in a well meaning, but I feel fatally flawed, move to get us all away from talking about some of the members of our own community as if they were PIGS, has decided to tell us that they are not pigs at all, they are merely GIPSYs. Of course, depending on which way you look at it, such forms of reference could be taken as a compliment ("you sure do eat like a pig"), or not, but stopping to think for a moment about the kind of controversy which has been provoked by the arrival of large numbers of Roma in Italy, perhaps telling the countries which lie on Europe's periphery that the best way to conceptualise them is as a bunch of "gitanos" is not the best way to get reasoned debate going. Nor is it necessarily the best way to do this to tell the members of core Europe that they as things stand they are essentially F-UK-De. But there it is. That's just how things are these days.

A Fiscal Adjustment Alone Won't Work

Now, taking us back a bit nearer to that harsh and horrid reality, Daniel does in fact, in his ill-named Working Paper "Adjustment Difficulties in the GIPSY Club", actually get to the heart of some very important matters, and really I thoroughly recommend everyone to read it from start to finish. The core of Daniel's argument is, I feel, the extraordinarly obvious point that the kind of fiscal adjustment currently being proposed for some of the peripheral countries is going to have one, and only one immediate consequence: these countries are going to be sent off to the outer darkness of very, very (see his numbers) sharp GDP contractions, and these contractions run the risk of preciptating pre-Argentina 2000 type situations in one after another of the countries involved, since the contractions in nominal GDP are so large that they effectively take away with the one hand what was given (in the form of sacrfice) with the other, and will lead to a seemingly endless spiral of increases in the debt-to-GDP ratios, which will in turn lead to ever deeper short-term fiscal cuts, and ever stronger contractions, etc, etc.

As Daniel argues, the only way to restore competitiveness, and avoid the dreaded Argentine spiral is to carry out some form of internal devaluation:

"What can Greece do to escape the ‘Argentine’ vicious circle of higher risk premia and a worsening economic outlook? The only way to minimise the cost of the external and fiscal adjustments that are required to... make the situation sustainable is to make Greece more competitive and thus stimulate exports."

"This can be achieved only by an across-the-board reduction of wages (or rather labour costs) in the private sector of between 10 and 20%. Cuts in wages of this order of magnitude will encounter fierce popular resistance. They could come about either at the end of an extremely painful process when unemployment has reached peaks never seen before or they could come much earlier as the result of an overarching national agreement in which the government, opposition parties and the social partners agree on what is needed in the light of present circumstances. Greece thus needs a concerted effort at the national level not just a government that pushes austerity measures through Parliament."

So Why Are The Other F-UK-De?

The problem is, conceptualising this situation as one group of fiscally derilict countries having to be controlled by another group of upright and competitive ones does not give us a complete picture of the mess we are all in, as Gideon Rachman eloquently argues in his Dr Schäuble's Torture Chamber post:

Behind the careful bureaucratic language, Schauble makes some amazing claims and proposals. Here are just a few.

“All eurozone members must return to adherence to the stability and growth pact as rapidly as possible.” This is just hypocrisy. I was living in Brussels when the pact was gutted the first time - because Germany and France were unable to keep within the 3% deficit limit.

Schauble also seems keen to resurrect the main feature that made the stability and growth pact lack credibility in the first place: the notion that countries that are running out of money need to be shocked back onto the path of virtue and prudence by being fined - a move that would obviously worsen their financial plight.

Basically, as Rachman argues, we all need to calm down a bit here, and get things rather more in persective. In the first place the Eurozone's economies - as I keep arguing day in and day out - are all roped together via the system of current account deficits and surpluses.

This is a point France’s finance minister Christine Lagarde draws attention to in an interview in this morning's Financial Times. As M. Lagarde says:

“[Could] those with surpluses do a little something? It takes two to tango,” she said in an interview with the Financial Times. “It cannot just be about enforcing deficit principles.”

“Clearly Germany has done an awfully good job in the last 10 years or so, improving competitiveness, putting very high pressure on its labour costs. When you look at unit labour costs to Germany, they have done a tremendous job in that respect. I’m not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence.”

Well, let's leave aside today the issue of whether or not convergence is a realitistic (or even a possible) objective for Europe's economies given the large demographic mis-matches between countries, but still, Lagarde is on to something. What we don't have is a situation where on the one hand we have everything for the best in the best of all possible worlds, while on the other we have a group of slouchers and forgers. This kind of thing makes for nice headlines, but it is far from corresponding to reality.

Another reason the F-UK-De group are in trouble if the GIPSYs wander off to the outer darkness, is that they will have issues to resolve in their banking systems, as the chart below reveals. German banks may have little exposure to Greek debt, but their exposure to Spain and Ireland is enormous.

In fact, the massive exposure of German and French banks to Portugal, Ireland, Greece and Spain offers part of the explanation as to why Europe’s biggest economies have been steadily moving to rescue their southern neighbors in recent days, according to a recent report from Societe General entitled “Shotgun Greek Wedding.” According to the report banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the four countries collectively referred to as the "PIGS".

“The exposure is enormous,” said Klaus Baader, co-chief European economist at Societe Generale in London. “The crisis in Greece isn’t Greece’s problem alone but a concrete problem for Europe’s whole banking sector. That explains the interest of finance ministers in stabilizing the situation.”

Defining Moment?

Gideon Rachman admitted that this one felt like a significant moment to him, and I am inclined to agree. We have two proposals on the table, and neither of them will work. In the first place simply treating the problem on Europe's perifery as an essentially fiscal one will not return these countries to competitiveness, and will simply precipitate GDP contractions, and deflationary spirals, that will lead inexorably towards failure, defualt, and possibly exit from the Eurozone (which, in fact, Herr Schläuble seems to feel would be an acceptable outcome to all this).

On the other hand, A Germany (or a Japan) which is not able to maintain a substantial external surplus (which is the only way a country with their kind of demographic profile can attain headline GDP growth, since internal demand is long gone as a "driver") since without a surplus and without GDP growth the implicit liabilities of ageing populations (via health and pension commitments) will become unpayable, leading to default (or a huge slashing of public welfare commitments) in these countries too.

Wolfgang Munchau also seems to think it is decision time. As he argues in his Op-ed in today's FT, "Shrink the eurozone, or create a fiscal union". I know which side I am on. As Joaquín Almunia once argued, people would need to be crazy to leave the Eurozone. So let's get on with it, and go climb that hill which lies out there in front of us.

Just What Is The Real Level Of Government Debt In Europe?

2010-02-14T05:34:00.000-08:00

“If you don’t fully understand an instrument, don’t buy it.”

To the above advice from Emilio Botín, Executive Chairman of Spain’s Grupo Santander, I would simply add one small rider: Don’t sell it either, especially if you are a national government trying to structure your country’s debt.

In a fascinating article in today's New York Times, journalists Louise Story, Landon Thomas and Nelson Schwartz begin to recount the mirky story of just how the major US investment banks have been able to earn considerable sums of money effectively helping European governments to disguise their growing mountain of public debt.

Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

In fact, concerns about what it is exactly Goldman Sachs have been up to in Greece are not new, and the Financial Times have been pusuing this story for some time, in particular in connection with the investment bank's ill fated attempt to persuade the Chinese to buy Greek government debt (and here, and here). Nor is the fact that the Greek government resorted to sophistocated financial instruments to cover its tracks exactly breaking news, since I (among others) have been writing about this topic since the middle of January - Does Anyone Really Know The Size Of The Greek 2009 Deficit? - following the arrival in my inbox of a leaked copy of the report the Greek Finance Minister sent to the EU Commission detailing the issues.

What is new in today's report from the NYT team is the extent to which they identify the problem as a much more general one, involving more banks and more countries, since "Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere". I very strongly suggest that our NYT stalwarts take a long hard look at what has been going on in Spain, and especially at the Autonomous Community level.

So the question naturally arises, just how much in debt are our governments, really? As the NYT team point out, Eurostat has long been grappling with this matter, and as far back as 2002 they found themselves forced to change their accounting rules, in order to try to enforce the disclosure of many off-balance sheet entities that had previously escaped detection by the EU, since up to that point the transactions involved had been classified as asset "sales", often of public buildings and the like. Following advice paid for from the best of investment banks many European governments simply responded to the rule change by reformulating their suspect deals as loans rather than outright sales. As we say in Spain "hecha la ley, hecha la trampa" (or in English, when you close one loophole you open another). According to the NYT authors:

"As recently as 2008, Eurostat.... reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”"

So just what is all the fuss about. Well, in plain and simple terms it is about an accounting item known as "receivables". Now, according to the Wikipedia entry:

"Accounts receivable (A/R) is one of a series of accounting transactions dealing with the billing of a customers for goods and services received by the customers. In most business entities this is typically done by generating an invoice and mailing or electronically delivering it to the customer, who in turn must pay it within an established timeframe called credit or payment terms."

However, as we can learn from another Wikpedia entry, often the use of "accounts receivable" constitutes a form of factoring, and this is where the problems Eurostat are concerned about actually start:

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.

But how does all this work in practice? Well, the World Wide Web is a wonderful thing, since you have so much information near to hand, at just the twitch of a fingertip. Here is a useful description of what are known as PPI/PFI schemes, from UK building contractor John Laing:

A Public Private Partnership (PPP) is an umbrella term for Government schemes involving the private business sector in public sector projects.

The Private Finance Initiative (PFI) is a form of PPP developed by the Government in which the public and private sectors join to design, build or refurbish, finance and operate (DBFO) new or improved facilities and services to the general public. Under the most common form of PFI, a private sector provider like John Laing will, through a Special Purpose Company (SPC), hold a DBFO contract for facilities such as hospitals, schools, and roads according to specifications provided by public sector departments. Over a typical period of 25-30 years, the private sector provider is paid an agreed monthly (or unitary) fee by the relevant public body (such as a Local Council or a Health Trust) for the use of the asset(s), which at that time is owned by the PFI provider. This and other income enables the repayment of the senior debt over the concession length. (Senior debt is the major source of funding, typically 90% of the required capital, provided by banks or bond finance). Asset ownership usually returns to the public body at the end of the concession. In this manner, improvements to public services can be made without upfront public sector funds; and while under contract, the risks associated with such huge capital commitments are shared between parties, allocated appropriately to those best able to manage each one.

And for those still in the dark, Wikipedia just one more time comes to the rescue:

The private finance initiative (PFI) is a method to provide financial support for "public-private partnerships" (PPPs) between the public and private sectors. Developed initially by the Australian and United Kingdom governments, PFI has now also been adopted (under various guises) in Canada, the Czech Republic, Finland, France, India, Ireland, Israel, Japan, Malaysia, the Netherlands, Norway, Portugal, Singapore, and the United States (amongst others) as part of a wider program for privatization and deregulation driven by corporations, national governments, and international bodies such as the World Trade Organization, International Monetary Fund, and World Bank.

PFI contracts are currently off-balance-sheet, meaning that they do not show up as part of the national debt as measured by government statistics such as the Public Sector Borrowing Requirement (PSBR). The technical reason for this is that the government authority taking out the PFI contract pays a single charge (the 'Unitary Charge') for both the initial capital spend and the on-going maintenance and operation costs. This means that the entire contract is classed as revenue spending rather than capital spending. As a result neither the capital spend nor the long-term revenue obligation appears on the government's balance sheet. Were the total PFI liability to be shown on the UK balance sheet it would greatly increase the UK national debt.

And here are two more examples of what is involved which were brought to light by a quick Google. First of all, the case of Italian health payments. Now according to analysts Patrizio Messina and Alessia Denaro, in this report I found online from Financial Consultants Orrick:

In the last years many structured finance transactions (either securitisation transactions or asset finance transactions) have been structured in relation to the so called healthcare receivables.The reasons are several. On one side, the providers of healthcare goods and services usually are not paid in time by the relevant healthcare authorities and therefore, in order to gain liquidity, usually assign their receivables toward the healthcare authorities. On the other side, due to the recent legislation that provides for very high interest rates on late payments, the debtors as well as banks and other investors have had the same and opposite interest on carrying out different kind of transactions. In this brief article we will analyse, after a quick description of the Italian healthcare system, some of the different structures that have been used in relation to transactions concerning healthcare receivables and, in particular, we will focus on transactions concerning the so called “raw receivables”, which are lately increasing in the Italian market practice, by analysing the legal means through which it is possible to ascertain/recover such receivables.

This system thus has two advantages (apart from the fact that it effectively hides debt). In the first place the healthcare providers gain liquidity in order to continue to run hospitals, pay doctors, etc, while those who effectively intermediate the transaction earn very high interest rates for their efforts, interest payments which have to be deducted from next years health care provision, and so on.

As the Orrick report points out, Italy’s national healthcare service (servizio sanitarionazionale, “nhs”) is regulated by the legislative decree of December 30, 1992, no. 502 (“decree 502/92”).The reform introduced by decree 502/92, as amended from time to time, provides for a three-tier system for the healthcare service, as outlined below: State level The central government provides a national legislation limited to very general features of the NHS and decides the funds to be allocated to the single regions according to specific criteria (density of population, etc.) for the NHS.

As the Orrick analysts note: "the Healthcare Authorities usually pay the relevant Providers with a certain delay".

Usually, when healthcare funds are allocated, in the national provisional budget, the central government underestimates the amount of healthcare expenditure. Since the central government does not provide regions with enough funds, regions are not able to provide enough funds to Healthcare Authorities, and payments to the Providers are delayed. Since the Providers need liquidity, they usually assign their receivables toward the Healthcare Authorities. To deal with all the above issues, Italian market practice has been developing an alternative system of financing through securitisation and asset finance transactions of Healthcare Receivables.

As the analysts finally conclude:

Despite of the risks concerning the judicial proceedings, Italian market players are still very interested on carrying on securitisation transaction on this kind of asset, principally because Legislative Decree no. 231/02 provides for very high interest rates on late payments (equal to the interest rate applied by ECB plus 7%) - my emphasis

Another technique Eurostat have identified as a means of concealing debt relates to the recording of military equipment expenditure, as described in this report I found dating from 2006. At the time Eurostat were worried about the growing provision of military equipment under leasing agreements. Basically they decided that such provision was debt accumulable.

Eurostat has decided that leases of military equipment organised by the private sector should be considered as financial leases, and not as operating leases. This supposes recording an acquisition of equipment by the government and the incurrence of a government liability to the lessor. Thus there is an impact on government deficit and debt at the time that the equipment is put at the disposal of the military authorities, and not at the time of payments on the lease. Those payments are then assimilated as debt servicing, with a part recorded as interest and the remainder as a financial transaction.

However, a loophole was found in the case of long term equipment purchases:

Military equipment contracts often involve the gradual delivery over many years of a number of the same or similar pieces of equipment, such as aircraft or armoured vehicles, or including significant service components, such as training. Moreover, in the case of complex systems, it is frequently the case that some completion tasks need to be performed for the equipment to be operational at full potential capacity. Some military programmes are based on the combination of several kinds of equipment that may be completed in different periods, so that the expenditure may be spread over several fiscal years before the system, globally considered, becomes fully operational.

In cases of long-term contracts where deliveries of identical items are staged over a long period of time, or where payments cover the provision of both goods and services, government expenditure should be recorded at the time of the actual delivery of each independent part of the equipment, or of the provision of service.

Payment for such items are only to be classifed as debt at the time of registering the actual delivery, which may explain why, if my information is correct, the Greek military as of last December were still officially "testing" two submarines which had been provided by German contractors, since final delivery had still to be formally registered, and the debt accounted.

A lot of information about the kind of things which were going on before the 2006 rule change can be found in this online presentation from Europlace Financial Forum. Here are some examples of private/public sector cooperation in Italy.

And here's a chart showing a list of advantages and possible applications:

Now, at the end of the day, you may ask "what is wrong with all of this"? Well quite simply, like Residential Mortgage Backed Securities these are instruments that work while they work, and cause a lot of additional headaches when they don't. I can think of three reasons why debt aquired in this way in the past may now be problematic.

a) they assume a certain level of headline GDP growth to furnish revenue growth to the public agencies committed to making the payments. Following the crisis these previous levels of assumed growth are now unlikely to be realised.
b) they assume growing workforces and working age populations, but both these, as we know, are now likely to start declining in many European countries.
c) they assume unchanging dependency ratios between active and dependent populations, but these assumptions, as we also already know, are no longer valid, as our population pyramids steadily invert.

Given all this, a very real danger exists that what were previously considered as obscure securitisation instruments, so obscure that few politicians really understood their implications, and few citizens actually knew of their existence, can suddenly find themselves converted into little better than a glorified Ponzi scheme.

And if you want one very concrete example of how unsustainable debt accumulation can lead to problems, you could try reading this report in the Spanish newspaper La Verdad (Spanish, but Google translate if you are interested), where they recount the problems being faced by many Spanish local authorities who are now running out of money, in this case it the village of San Javier they have until the 24 February to pay a debt of 350,000 euros, or the electricity will simply be cut off! The article also details how many other municipalities are having increasing difficulty in paying their employees. And this is just in one region (Murcia), but the problem is much more general, as Spain's heavily overindebted local authorities and autonomous communities steadily grind to a halt.

Few Surprises As Greece's Economic Contraction Accelerates

2010-02-12T10:16:00.001-08:00

Well, I may say there were no surprises, but in fact the Greek economy contracted more than many observers expected in the fourth quarter, while downward revisions to the rest of 2009 converted the present recession into the country's worst since 1987. Evidently the latest numbers offer the first warning that all may not be as simple as it looks on paper for the Greek government's plan to set their finances straight. As far as I am concerned the latest numbers simply confirm what should already have been abundantly evident - correcting the fiscal deficit without straightening out the rest of the economic distortions is going to make economic growth something which is very hard to come by.

Accelerating Contraction

According to the Greek National Statistics Office gross domestic product contracted by 0.8 percent in the fourth quarter, significantly more than the 0.5 percent drop forecast in a Reuters survey of economists. The data clearly reveal that Greece's downturn actually picked up speed from a revised 0.5 percent in the third quarter, casting doubt over government estimates of a return to growth in the second part of this year, and raising yet more issues about the evolution of the debt to GDP ratio.

On a year-on-year basis, the economy shrank 2.6 percent in the fourth quarter following a revised fall of 2.5 percent in the third. The sweeping data revision showed Greek GDP contracted by 2 percent in 2009 as a whole, considerably more than the government's earlier 1.2 percent estimate, making for the worst annual performance in nearly 30 years.

The latest batch of data changes only serve to further undermine the government's already badly dented statistical credibility, even if the Greeks are far from being alone in carrying out this type of revision. But it is the scale of the revisions which is so striking in the Greek case - GDP shrank, for example, by a quarter-on-quarter 1 percent in the first quarter of last year: twice the earlier estimate, and the sharpest quarterly contraction since 2005. In the second quarter, GDP fell 0.3 percent, compared with an earlier estimate of a 0.1 percent, while third-quarter GDP shrank 0.5 percent revised from the earlier estimate of 0.4 percent. Rather than leaving the impression that government GDP figures are "doctored" what the revisions suggest is that the government actually has little real idea of what is going on in the economy at any given moment in time, a conclusion I personally find even more disturbing.

The revisions will also push up the figure for Greece’s budget deficit last year, possibly by 0.1 percent, leaving the current "final, final figure" standing at something like 12.8 percent while the debt to GDP ratio may increase 1.2 percentage points to 114.6 percent. But then the Greek Finance Ministry have just amended the 2009 fiscal cash execution data they provide on their website, and have added close to 6 billion Euro to the December expenditure number, making for a final total of 11.8 billion Euro for the month.

This number takes the full-year deficit to 37.9 billionn - up from the 29.4 billion Euro previously reported, with the implication that there will be a further substantial increase in the 2009 central government budget deficit. To date no explanation has been offered for the revision, although a good guess would be it is associated with the payment hospital supply arrears, in which case the general government deficit may well have been proportionately reduced. As I pointed out in this post, even after all the glare of public scrutiny considerable uncertainty still surrounds the 2009 deficit number, and the latest revision is just one more stunning example of the kind of payments changes which one can find made without further explanation. As I say, the biggest doubt here isn't the sincerity of the numbers, but the ability of the government itself to control what actually happens.

Little Relief In Sight

While the current pace of GDP contraction may slow somewhat there is little actual hope for a real and sustainable return to growth in the Greek economy in the forseeable future, and especially as the impact of the fiscal correction starts to bite. Unsurprisingly Greek industrial output continued its fall in December, and was down 2% from November.

And the January PMI suggested that the contraction in industrial output continues and may even be accelerating.

Commenting on the Greece Manufacturing PMI survey data, Gemma Wallace, economist at Markit said:

“The onset of the new year brought little hope of a near-term recovery in Greek manufacturing. Accelerating contractions in new orders, output and employment caused the headline PMI to sink to an eight-month low. Meanwhile, firms were struggling to cover rising costs, as strong competition and unfavourable demand conditions rendered them unable to raise charges.

Domestic demand also shows few signs of life, and retail sales are falling steadily.

As are new car sales.

While Greece has not had the kind of private credit boom that countries like Spain and Ireland have seen (in terms of the levels of indebtedness) credit was increasing at an annual rate of over 20% before the crisis hit, and this boom in borrowing has now clearly run out of steam.

But in fact there was no bubble in house prices in Greece.

And private construction activity (housebuilding) has been falling since 2003.

Nonethless a very substantial current account deficit was created, as the competitiveness of domestic manufacturing industry wilted.

This deficit has been reducing, but both goods and services exports have been falling, so there would seem to be little likelihood at this point of a tourism-driven economic expansion.

Europe's Tough Love May Be More Substantial Than It Seems At First Sight

Rumours still abound regarding the possibility of an eventual EU bailout package. The central scenario still remains the same, namely that money will be made available eventually, as and when needed (probably by end of March), even if the precise mechanism to be used is not yet clear. Speculation continues that the IMF may well play some sort of role, although, again, at this point in time it is far from clear what precise form their participation might take. US economist Jeffery Frankey this week added his name to the long list of those who have now come out in favour of a role for the fund (I have long had my name on the venerable list), and makes at least one novel argument: that core Europe, far from expressing their reservations about a hypothetical IMF role, should in fact be only too happy to welcome one.

Europeans worry that if Greece were put into default, troubles in Portugal and Spain would appear as quickly as heads on a hydra. Perhaps it is glib for an American, on the other side of the Atlantic, to discount the financial strains that Greece is placing on Europe — including Mediterranean contagion, loss of prestige of European institutions, and depreciation of the euro. But in fact it is the northern Europeans who should be most eager for the IMF to come in. They should be the most worried about what they are going to say to Portugal, Spain, Italy and Ireland, if instead they have just bailed out Greece.

Meanwhile the IMF itself continues to wait courteously on the sidelines, limiting itself to stating, as IMF First Deputy Managing Director John Lipsky put it this weekend, that the Fund "is willing to support Greece as thought appropriate by the Greek authorities".

And judging by the latest statements by Greek Prime Minister George Papandreou, thinking is something the Greek administration will be doing a lot of in the coming days, especially after the recent demonstration of "tough love" (lots of words but little tangible support) from their European counterparts. Papandreou reportedly criticised the European Union's response to the country's financial crisis as "timid and too slow" in a televised cabinet meeting in Athens on Friday. He also asserted that the EU lacked coordination, and had effectively undermined Greece's credibility. Speaking on his return from Brussels, Mr Papandreou said that while Greece had received a statement of support, delays and conflicting statements over the past few months had actually served to make matters worse. "But in the battle against the impressions and the psychology of the market, it [the EU response] was at the very least timid, " the BBC report him as saying.

Basically Papandreou's comments are completely out of place, even if they are intended for domestic consumption. It was always unrealistic for Europe's political leaders to agree to more than general guidelines for how a rescue plan might take place at last week's meeting. A firm commitment was virtually impossible, partly because some of the possible solutions - bilateral lending, for example - would very likely have to be approved by the relevant national parliaments, if support was to go anywhere beyond small token sums.

An important list of outstanding issues still need to be decided, including (1) the size of any eventual loan or guarantee; (2) the extent of burden sharing between the other Eurogroup countries (Germany and France are expected to be the heavyweights but others will surely participate as well); (3) the terms of the loan (whether it is only to be short term - 6 months has been mentioned); and (4) the precise terms of conditionality (conditions are expected to be tough, and include specific commitments on what to do if programme execution falls short of estimated objectives.)

Given the complexity of all this, and the amount of fine tuning still to be carried out, it is hardly suprising that nothing substantial was announced, and especially given the fact that the Eurogroup are entering into what effectively consitutes new institutional terrain, while France and Germany, for example, may be very reticent to get too far involved with their Southern neighbours at the cost of loosening ties with - say - the UK and Sweden, which is why Frankel may have a very solid point.

The Planned Correction Simply Is Just Not Doable As Things Stand

Nothing is going to change the fact that if Greece really does tighten fiscal policy by 3 or 4 percentage points of GDP over the next four years, growth is going to be almost non-existent. This is going to be a long hard slog and providing a temporary bridging loan to guarantee Greece’s solvency this year will not avoid the fact that the same will be needed next year, the year after and the year after that.
Societe Generale, The Economic News

As is by now very well known Greece has one of the highest government debt levels as percentage of GDP among the OECD countries. The government’s gross debt burden is expected to rise sharply to 135% in 2012, based on the latest EU Commission projections - up from 99% in 2008. This rise is driven by ongoing fiscal deficits, which hit a minimum of 12.7% in 2009, as a result of the unexpectedly large size of Greece's economic downturn. The deficit is expected to continue to be large in 2011 - as a result of the continuing shortfall in tax revenues. On the government’s own estimates the budget deficit is expected to remain significantly above the EU budget deficit ceiling of 3% until 2012. Thus the Greek government will have substantial borrowing requirements through 2012, with something like €45.2billion gross issuance being needed in 2010 (in addition to the recently issued €8billionn of 5-year GGB’s) and a further €45 billion or so in 2011.

Greece’s Stability and Growth Programme (SGP), which was submitted to the EC on January 14, 2010, is ambitious both in terms of magnitude and given Greece’s track record in fiscal consolidation. The plan aims for a reduction in the fiscal deficit of 10.7 percentage points of GDP over four years, from 12.7% of GDP in 2009, to 2% of GDP in 2013. This magnitude of fiscal consolidation is unprecedented in Europe and raises questions regarding the credibility of the plan - in light of Greece’s poor track record in fiscal consolidation that failed in the past due to lack of political commitment. The plan also assumes a GDP growth rate well in excess of EC and IMF forecasts. According to Dan Lustig (lead analyst in Mitsubishi UFJ's Greece team) who prepared the above chart the plan’s implementation will be "very challenging, given Greece’s large public sector, weak economic growth prospects and the potential for social upheaval, due to the necessity for significant public sector expenditure cuts".

Appendix - A Hard Package To Implement

The main guidelines of the new tax bill and the key themes regarding the Government’s income policy to be introduced into the Parliament for voting in the upcoming days were recently released by the Finance Ministry. These include:

Tax Measures

The upper tax rate of 40% will be applied on annual incomes above €60,000. This will replace the existing €75,000 threshold. The new tax scale implies tax cuts to annual incomes below €40,000 and increases for incomes above this sum. The government have created 6 new
tax brackets for incomes between €12,000 and €60,000, and tax levels will range from 18% to
38%. The progressive character of the tax scale is basically aimed at transferring tax burdens to higher income groups, while alleviating tax burdens from low income categories. Incomes ranging from €12,000 to €16,000 are to be taxed at 18% as compared with the current 24% tax rate on incomes ranging from €12,000 to €30,000. Since around 95% of individual tax records show incomes below €30,000 this implies that low income groups should be less affected by the changes in the tax scale, although it is important to bear in mind that there is probably widespread underreporting of income.

Interestingly the €12,000 tax-free income bracket includes a provision that tax payers need to submit receipts for goods and services in order to qualify. This measure has the objective of helping the tax service crosscheck data and encourages individuals to demand VAT denominated invoices for purchases.

There will be:

- an increase in the fuel tax rate which aims to boost revenues by €934 million in 2010.
- an annual tax rate increase on real estate held by offshore firms (rising to 10% vs. the current 3%).
- A Tremonti type tax amnesty whereby undeclared bank accounts deposits outside Greece can be repatriated at a 5% tax rate for 6 months after the bill is put into effect so long as the money is transferred into 1-year term deposits.
- the introduction of a new progressive tax scale on large real estate holdings valued
above €400,000
- VAT will be applied to a wider category of transactions, and electronic cash registers will be obligatory in an increased number of designated activities (including gas stations, kiosk, taxis, and street markets). Such measures are expected to significantly boost VAT revenues, since many professional activities (like lawyers and doctors) were previously largely exempted from the 19% VAT system.

Regarding the income policy (which will be retroactive and applied to 2010 incomes for employees in the public sector in the widest sense of this term):

- civil servants’ wages will be frozen in 2010, although seniority pay increases will be applied as usual.

- there will be a 10% cut in civil servants’ allowances. Contrary to earlier announcements, the cut in allowances in public sector will not be proportional to the employee’s income (i.e. greater cut for high income groups and lower cut for lower income employees). According to press reports, the decision to apply a uniform 10% cut in allowances across the board was due to the legal impediments to doing it any other way. Nevertheless, the allowance cut, as well as the wage freeze measure, are the key instruments for the government effectively lowering the wage bill of the budget in 2010, in its effort to control government spending.
- As a consequence, the gross monthly income of public sector employees will decline by as much as 5.5%.
- The upper limit for overtime payment is reduced by 30%. - State sector pensioners will get an increase of 1.5%, in line with government’s inflation forecast for 2010 of 1.4%. Pensioners earning more than EUR 2,000 on a monthly basis will get no increase.
- There will be a hiring freeze for the public sector for 2010 (partially excluding the health, education and security sectors), and an application of the rule of 1 replacement for every 5 people who leave from 2011 onwards. Furthermore, a widespread re-allocation of civil servants will be instigated, along with the consolidation of much public enterprise, in order to increase the effectiveness of public administration.

Most of the measures announced were included in the Stability & Growth Programme and are consistent with the government’s earlier announcements.

The Labour Ministry has also announced that it is planning to raise the retirement age as part of changes aimed at amend and support the state-run pension system. The Minister highlighted that unless a reform is implemented the pension system will face serious funding problems by 2015. The proposals which will be sent to the committee of experts and social partners charged with drafting the pension reform bill include the following:

- Increase by 2 years of the effective average retirement age to 63 years of age by 2015.
- Abolishing all incentives to early retirement.
- Encouraging workers to stay on the job longer,
- Separating the health-care and pension systems, with the former being incorporated
into the National Health System.
- Harmonisation of the male and female retirement age in the public sector, in line with
EU directives.
- The establishment of an independent entity overseen by the Central bank to manage social-
security fund reserves.

Greece Gets The Green Light, But Will It All Work?

2010-02-05T00:35:00.000-08:00

Well, as reported over the weekend on this blog, the EU Commission did in fact demand "more sacrifices" from the Greek people, and in the end Prime Minister Papandreou had to make a last minute TV appearance to explain to his incredulous listeners that the time had come "to take brave decisions here in Greece just as other countries in Europe have also taken....We all have a debt and duty towards our homeland to work together at this difficult time to protect our economy." I thought that that time had come last November, but evidently I was precipitate in my judgement, but now it has finally arrived, although I ould note that hope does spring eternal, and that even now not everyone is 100% convinced.

When Adreas Papandreou said Greece needed the same brave decisions others have taken I presume he was in fact referring to Latvia, Hungary and Romania.

More than the measures themselves, what is interesting about the Brussels acceptance speech were the series of measures put in place to monitor and control Greek economic policy. As the Financial Times put it, the EU puts Athens under close scrutiny.

"The European Commission, the guardian of Europe’s fiscal rules, struck out into uncharted territory by placing Greece’s economic and budgetary policies under closer surveillance than has yet been applied to a eurozone country."

In fact the European Commission has put Athens on an unprecedentedly short leash, since there is to be a mid-March interim progress report, a further one in mid-May, and quarterly updates thereafter. In addition, an infringement procedure was also launched against Athens for "failing in its duty to report reliable budgetary statistics".

The Commission recommendations will now be forwarded to EU finance ministers for possible approval on 15-16 February. If endorsed, it will be the first time that a eurozone member country will be put under such strict surveillance.

And the agreed measures are obviously far from being the end of the road, since the EU executive only conditionally approved Greece's three-year fiscal plan and warned further cuts in public sector wages would be required (that dreaded internal devaluation) if, as many economists believe, the measures so far announced prove to be insufficient to generate the economic growth which will be needed to meet the steep deficit-reduction targets. Thus the die is cast, and Greece will not, as I recommended, be going to the IMF. Such a move is now seen as superflous, since the EU Commission is steadily transforming itself into a local "mini-version" of the Fund in order to try to handle the cases of those countries who show continuing reluctance in implementing those much needed deep structural reforms. I only hope the Commission have the will to follow this through with all the determination that is needed, since if Greece do now finally go to the IMF for help it will surely now be as an ex-member of the Eurogroup.

Not that this weeks session was entirely accident free. Retiring Economy Commissioner Joaquin Almunia gave yet another example of how clumsy he can at times be, by declaring that "En esos países (Greece, Portugal and Spain), observamos una pérdida constante de competitividad desde que son miembros de la zona euro" (a "continuous" loss of competitiveness), which appeared in the English language press as: "Almunia Says South Europe Has ‘Permanent’ Competitiveness Loss". It isn't clear to me from this distance whether he was speaking in English and his core message got "lost in translation", or whether he thought the speech out in Spanish, and the faux pas is down to his advisers. Either way the damage was done, causing even more problems than needed - according to data from CMA datavision, Credit Default Swaps were up on Spanish Sovereign Debt to 151 bps, or up 18.24 on the day. Portugal CDS also rose sharply on the day - 28.47 bps to 195.80.

As Deutsche Bank's Jim Reid said after the announcement:

Clearly aggressive fiscal tightening can look plausible on paper but the reality is that the path will be full of potential roadblocks. Future strike action will be sign of how prepared the general population is to take the hard medicine. The jury must still be out on this and the market will look to exploit any set backs. However in the short-term the market does seem to have lined up an alternative target.

So the jury still is very much out on just how viable the GDP targets being offered by the Greek government really are. George Papaconstantinou, Greece’s finance minister, may have told the Financial Times that he expected a return to economic growth from the middle of this year - boosted, he said, by strength in the shipping and tourism industries and the “hidden power of consumers” in the shadow economy. But saying this is one thing, and achieving it is another. Growth across Europe will at best be modest this year - let's say between 0.5% to 1% of GDP at the most optimistic - with labour markets week everywhere, so I think it is rather unrealistic to expect a tourist boom going much beyond the one we saw (or didn't see) last year, and the same goes for shipping, which is a sector where surplus capacity still abounds. As for those affluent Greek consumers he is talking about, we have to hope they all dig deep into their wallets, and that each and every one of them now insists on a VAT valid invoice!

But so far there is not much sign of this, and retail sales are actually falling steadily (see chart below). In fact I seriously doubt we are going to see much support from internal consumption at this point. Greece is all about exports now, but where are they going to come from? And how is the country going to get a trade surplus big enough to achieve the sort of economic growth they are talking about without a much stronger internal devaluation?

Industrial output has been falling for some time.

And the latest January PMI only served to underline how Greece was becoming detached from the recovery elsewhere.

Commenting on the Greece Manufacturing PMI survey data, Gemma Wallace, economist at Markit said:

“The onset of the new year brought little hope of a near-term recovery in Greek manufacturing. Accelerating contractions in new orders, output and employment caused the headline PMI to sink to an eight-month low. Meanwhile, firms were struggling to cover rising costs, as strong competition and unfavourable demand conditions rendered them unable to raise charges.

Eurozone unemployment hit 10% for the first time in December, underlining the extent to which the timid economic recovery has yet to translate into job creation. Spain's jobless rate rose to nearly 20%, and Ireland, which like Spain has also been hard hit by a housing downturn, saw its jobless rate climb to 13.3% from 13%. As is normal Eurostat didn't have data on the jobless rate in Greece, where, as Market Watch point out, statistics are notoriously hard to come by. The lastest - EU comparable - number we have is for October, but at this point such a data point is the next best thing to useless. A similar situation exists in the construction sector, we have no clear idea of what is happening since the Greek statistics office simply to not supply comparable data to Eurostat.

Meanwhile the drama in the bond markets looks set to trundle on:

Greece's acute problem is the need to raise financing to allow it to roll over maturing debt in April and May, while preserving sufficient cash to fund current expenditure. We estimate an additional funding need of at least €30bn by May. The concentration of maturing debt is unusual, but even if this immediate source of stress can be overcome, the funding profile for coming years remains demanding. The next three months will have a heavy bearing on the profile that is followed, but whatever happens, Greece and other peripheral euro area countries will still suffer from a chronic need to improve productivity, raise national savings and cut government borrowing.
Christel Aranda-Hassel, Director, European Economics, Credit Suisse.

An all the doubt continue as to whether, with the fiscal retrenchment process and the competitiveness correct Greece can manage to achieve the debt to GDP reductions promised in their Stability Programme. As Credit Suisse's Giovanni Zanni puts it, previously

Nominal GDP growth was systematically higher than the average rate of interest paid on the government’s debt. The implication was that the government could run significant fiscal deficits and still reduce the debt-to- GDP ratio. It did not exploit that advantage significantly, however, and the Greek government’s debt ratio fell only slightly over the period. Things have changed drastically since last year. Nominal growth fell to 0% in 2009. Although it should recover from 2009 lows, we think it will remain subdued relative to the recent past. Even if Greek sovereign credit spreads versus Germany fall back somewhat from the peaks reached last week, it seems extremely unlikely that the favourable dynamics of the past will reappear anytime soon. As such, there are few options open to the government other than to move the primary balance into surplus – a surplus that is sufficient to first stabilise the debt-to-GDP ratio and then push it downwards.

This primary surplus seems a very, very long way off at this point. And Greek bonds fell again yesterday, pushing the premium investors demand to hold 10-year securities instead of German bunds up by 12 basis points to its highest level in a week. The move followed news that Greece’s biggest union had approved a mass strike while tax collectors began a 48-hour walkout. The Greek 10-year yield jumped 8 basis points to 6.76 percent as of 11:45 a.m. in London. The difference in yield, or spread, with benchmark German bunds was at 365 basis points. It widened to 396 basis points on Jan. 28, the most since before the euro’s debut in 1999.

And Citicorp warns that investors may well continue to cut their holdings of Greek bonds amid skepticism the government can overcome public hostility to budget cuts.

“Although Greece has secured the expected backing from the EU for its latest austerity program, we expect markets to remain very fearful of the potential for the fiscal consolidation process to slide or to be derailed by public dissent,” according to Steve Mansell, director of interest-rate strategy at Citigroup in London. Investors, he said, may be “more prone to lighten exposure on any significant spread tightening moves”.

And it isn't only the bank analysts who are not convinced. According to this article in Le Monde IMF head Dominique Strauss Kahn and his close associate Jean Pisani-Ferry, director of the Brussles based think tank Bruegel also have their doubts:

Celui-ci estime que l'UE n'a ni la vocation, ni les équipes, ni les techniques pour analyser les carences d'un pays et préconiser des remèdes. L'Union n'a pas l'habitude d'affronter l'impopularité des thérapies de choc et pourrait céder aux manifestations de rue. Le FMI peut jouer de sa réputation de dureté pour aider le gouvernement grec à imposer les sacrifices inévitables.

Which in plain English says that they thing the EU Commission has neither the vocation, nor the teams, nor the technical experience to take on a job of this size, and while it is vital that the necessary structures and policy tools are developed, in the meantime the clock is ticking away, and the infection is spreading to the Sovereign Debt of other countries - even as far away as Japan. Basically M. Strauss Kahn seems to feel that the EU Commission is assuming an unnecessarily high risk, and that the Greek dossier should really have been sent to the IMF as a matter of some urgency. I cannot but agree.

Greek Bailout News (1)

2010-01-30T12:30:00.000-08:00

"British or German taxpayers cannot finance the failures of others," German Economy Minister Rainer Bruederle said at the World Economic Forum in Davos, Switzerland, according to the Associated Press. "Solidarity also means everybody adheres to common rules."

France is not working with Germany or other countries on a support package for Greece which is managing to handle its problems on its own, a French government source said on Thursday. "I am not aware of a support plan. There is not a plan. We're not discussing one (with Germany or others)," the source told Reuters. "They are managing themselves. They are finding financing support on the market. There is no plan for a support plan. We are not working on one. Le Monde newspaper said earlier that euro zone countries were studying ways of helping Greece resolve its budget problems."

The above statements have been widely interpreted in the international press as a "no" from Germany and France to any EU bailout of Greece. But is this interpretation justified? Before going further, I think it should be pointed out that the whole argument depends on what you consider a bailout to be. If you take the view that a bailout involves a restructuring of Greek Sovereign Debt, with the EU itself offering to pay a part, then this is clearly not on the cards, at least at this point, and let's take things a day at a time. But if you consider the "bailout" which is under consideration at the present time to be simply a loan, which in some way shape or form (yet to be determined) would be guaranteed by the EU institutionally, and would thus be available at a cheaper rate of interest than the one the markets are currently charging, then it is hard to see how British or German taxpayers would be having to finance anything, except in the unikely event that Greece were unable to repay (as Moody's point out, Greece's problems are longer term, not short term), and remember, even Latvia and Hungary are likely to repay the loans already made to them, and their underlying economic situation (and competitiveness problem) is a lot worse than that of Greece. So basically the German economy minister is making a speech which generates good headlines, and political enthusiasm, but like Jüergen Starks before him, has little real significance in terms of the options which are really on the table.

On the other hand, statements like the following:

European officials on Friday sought to quell rumors of a pending bailout for Greece, insisting that the financially troubled nation could still manage to avoid a debt crisis on its own. The effort to allay market speculation came as investor confidence in Greek bonds fell this week to levels not seen in a decade, amid concern over the government's ability to close its gaping budget deficit and maintain financial stability.

Can simply be seen as officials doing the job they are paid to do, that is talk down the market pressure. Obviously, if the spread on Greek bonds could be talked back down, then there would be no need for anyone else to make a loan, but at this point in time, and especially following the ill fated proposal of Finance Minister Papconstantinou to mount a fund raising roadshow including a visit to China, this possibility looks very unlikely. After all, why should the Chinese banks risk their money buying bonds the German taxpayer is unwilling to buy? As Yu Yongding, a former adviser to the Chinese central bank said, it just isn't interesting to buy a “large chunk” of Greek government debt in order to help rescue the country simply because their securities "are more risky than U.S. Treasuries". “Let European governments and the European Central Bank rescue Greece", he said. Over to you Herr Bruederle.

And despite the fact that Joaquin Almunia strenuously denied in Davos that any kind of plan "B" existed, really they would be fools not to have a plan "B", and the people involved obviously aren't fools, ergo....

A top European Union official said on Friday there was no risk that Greece would default or leave the euro zone and the country's finance minister said he was not aware of any bailout talks. "No, Greece will not default. Please. In the euro area, the default does not exist because with a single currency the possibility to get funding in your own currency is much bigger," Monetary Affairs Commissioner Joaquin Almunia told Bloomberg TV. "There is no bailout problems."

Asked if its problems could force Greece out of the euro zone, Almunia said: "no chance. Because it is crazy to try to solve the problems the Greek economy has outside the euro zone," he said. Almunia said euro zone ministers had prepared fiscal recommendations for Greece and other countries, to be discussed at a regular meeting at European Commission level next week, but denied there was any special EU plan to rescue Greece. "It is a normal analytical document that is written every month," he said. "We have no plan B. Plan A is on the table. It is fiscal adjustment."

EU Commission "Ups the Ante"

So now lets turn to Plan A, and to that normal analytical document Señor Almunia refers to, which is due to be discussed by the Commission on Wednesday. Fortunately, the Greek web portal Ta Enea have seen the document, and Reuters have provided us with a convenient English language version of what they saw. What the Ta Enea report makes clear, is that the reason Greek Prime Minister Papandreou has not asked the EU for a "bailout loan" is connected to the conditions which would be attached to that loan. According to the reports, the EU Commission plan to go a lot further than simply providing short term funding on the cheap:

The European Union will tell Greece next week to take extra measures by May 15 to shore up its finances and cut a spiralling deficit, Greek newspaper Ta Nea said Saturday, citing a draft of the recommendations. The European Commission's recommendations, due to be made public on February 3, include cutting nominal wages in the public sector and setting a ceiling for high pensions, Ta Nea said.

Under the headline "Urgent measures to be taken by 15 May 2010," the EU document will tell Greece to "cut average nominal wages, including in central government, local governments, state agencies and other public institutions." The EU will also urge Greece to introduce advance tax payments for the self-employed and possibly a tax on luxury goods, according to the document, excerpts of which were printed by Ta Nea. Most other recommendations, as reported in the paper, are already part of the Greek plan.

Reports also mention putting a complete freeze on public sector hiring, and a system of monthly reports to the Commission along the lines of the Latvian programme. What this effectively amounts to is enforcing the implementation of an internal devaluation process along the lines of the ones adopted in Ireland and Latvia, as outlined in the most recent technical report to the commission (see here), in order to restore competitiveness to the economy and make Greek debt sustainable in the long run. It also amounts to an effective surrendering of part of Greece's national sovereignty to the EU Commission, and this is the part that virtually everyone is doubtless baulking at.

IMF Waiting On the Sidelines

Obviously, the EU Commission is not the only institution who could furbish the bailout loan, the IMF would serve just as well, and Marek Belka, Director of the IMF's European Office, has already made it very plain they are ready willing and able to help. And only last Friday John Lipsky, the first deputy managing director of the IMF, said the Fund "stands ready" to help Greece with its debt crisis. According to Lipsky's statement, the fund is in "ongoing contact" with the Greek authorities following a "scoping mission" to assess the possibilities.

"The IMF stands ready to support Greece in any way we can," Mr Lipsky said. "It is a matter for the Greek authorities to decide, in collaboration with the European Union, but we are here to help if we are wanted."

In fact, I personally favour the IMF alternative, given the time scale involved, and the likely programme implementation difficulties, and according to Edmund Conway, economics editor of the UK Daily Telegraph, this view is now shared by many "highly respected" economists:

I understand that in many of the conversations Mr Papandreou had [last week in Davos] with very senior, respected economists this week, he was directly advised to go to the IMF, which would be the 'cleanest solution'..... But an IMF intervention would have potentially to be channelled through European authorities, since Greece is a member of the euro.

But the EU Commission seems to have very strong reservations about going for the IMF route, which is why the "bitter pill" of the EU bailout loan may well need to be swallowed. My fear here is that EU reservations may mean that history sadly repeats itself, the first time in Latvia and then in Greece, as queasiness about taking on board the full implications of what is involved in correcting competitiveness distortions leads to policy-making delays and mistakes of the kind which in Latvia have produced a resession which is far deeper and longer than was actually needed, but which in Greece could easily lead to very serious problems for the entire Eurozone further on down the line.

Yet the door is certainly not closed on an IMF solution, and George Papaconstantinou did meet with IMF Managing Director Dominique Strauss-Kahn on Friday on the sidelines of the WEF in Davos. The possibility of IMF intervention was left open by IMF Managing Director Dominique Strauss-Kahn in an interview with broadcaster France 24 this weekend, although he certainly seemed to suggest that EU support was more likely. "We at the IMF are ready to intervene if asked, but that's not necessarily required," Strauss-Kahn said. "The European authorities, both in Brussels and the central bank, are looking at it and I think they'll handle it properly" ...."solidarity" within the countries sharing the euro could "fix the problem,", he said without elaborating.... "It's the first test of this kind for the euro zone,".

Contagion Danger Concentrating Minds

Perhaps the strongest argument to support the idea of imminent EU support is the level of contagion risk being experienced. Concerns that Athens may not be able to service its debt have put growing pressure on the euro, and even if some would welcome this as an aid to German export competitiveness, the attendent credibility issues hardly make the situation a desireable one. There are also growing worries that the Greek debt crisis could spill over to other weak members of the Eurogroup, such as Spain, Portugal, Ireland and Italy. The German daily Sueddeutsche Zeitung last week quoted an EU draft memorandum as saying the situation in Greece was creating a "big challenge and in the long term risky," and could force other euro-zone countries to pay higher risk premiums on their bonds. The spread between Portuguese and German 10-year government debt rose to 120.5 basis points on Friday - up from 114.9 the day before, and the spread on equivalent Spanish bonds is hovering round the 100 basis points mark. Basically, as one European leader after another stresses, it is hardly desireable to let Greece's problems lead other states to have to pay more to finance their borrowing.

Where's The Moral Hazard?

Finally, there has been considerable discussion about the dangers of moral hazard in the Greek case. If the EU offer a bailout loan, this will encourage other countries to seek something similar, so the argument goes.

"Moral hazard considerations suggest that the ECB will never openly support a bailout, but we doubt that Greece will be left on its own if the situation were to become critical," UniCredit analysts said. They referred to the danger that a rescue could reinforce ill-considered fiscal practices that have caused serious problems for Greece and others.

But if we look at the realities of the present situation, then it is clear that what is being offered to Greece in return for a possible loan is clearly not enticing, and indeed it may well be that countries would rather not accept the carrot in order to avoid the stick.

But there are other versions of moral hazard at work here. The FT's Martin Wolf put his finger on one of them:

At the same time, a bail-out by the eurozone as a whole would create a monstrous moral hazard for politicians. It would only be possible if the eurozone subsequently exercised a degree of direct control over the fiscal decisions of member states. It would, in short, be the fastest route to the political union that many initially believed was a necessary condition for success.

Indeed, the very creation of a monetary union in the absence of a political will for unification could be seen as having been the biggest moral hazard risk taken on board, and no matter how many clauses you put in Treaties beforehand, this risk cannot be avoided when push comes to shove.

But there is a third, and more dangerous version of moral hazard in play here, and this arises from the fact that the EU Commission may itself fail to adequately identify and diagnose the roots of the problem, with the result that the correction measures prove to be inadequate, sending Greek debt snowballing off into default. At this point, if the Greek leaders had been simply "following orders", then a more substantive form of bailout would become inevitable, and Herr Bruederle's fears that the German taxpayer may end up having to foot part of the bill would be realised. With this in mind, I really suggest that Commission members and Finance Ministers think very carefully about what they are doing before signing and sealing any definitive agreement with Greece. On the other hand, if the nettle is cleanly grasped, and the necessary changes are introduced both in Greece and in the EU's institutional structure, then maybe the most important and most enduring outcome of the current economic crisis will be a Europe which is more unified and effective than ever it was before.

And It's A Bailout.....

2010-01-28T15:10:00.000-08:00

Well, it's not fully official yet, and all the fine print certainly isn't written and signed, but the will is now clearly there, and where there's a will, there's a way, especially when you have the global financial markets breathing down your necks. The first one out of the box was the Economist's Charlemagne, earlier this afternoon.

In Brussels policy circles, the question asked about a bailout of Greece used to be: are European Union governments willing to do this? Now, I can report, the question among top EU officials has changed to: how do we do this?

Twice in the past 48 hours I have heard very senior figures - both speaking on deep background - ponder the political mechanics of how large sums in external aid could be delivered to Greece before it defaults on its debts: a crisis that would have nasty knock-on effects for the 16 countries that share the single currency. One figure said yesterday that heads of government could not wait "forever" to take decision. That means a decision in the next few months, at most.

By sundown the story had gotten a bit more traction, with the FT running an article under the header "EU signals last-resort backing for Greece".

The European Union made clear on Thursday it would not abandon Greece and let Athens’ mounting debt crisis jeopardise the eurozone, even as Germany and France played down suggestions they had already formulated an emergency rescue plan.

“It’s quite clear that economic policies are not just a matter of national concern but European concern,” José Manuel Barroso, European Commission president, told reporters in Brussels. According to high-level EU officials, Greece would in the last resort receive emergency support in an operation involving eurozone governments and the Commission but not the International Monetary Fund.

And by sundown the New York Times were running the story:

France, Germany and other European countries have begun discussing privately how they can come to the aid of fellow euro-zone member Greece, as doubts intensify over the country’s ability to get its budget under control.

Despite public attempts to discourage such expectations, discussions are under way, although the shape or scale of a possible bailout package has yet to be determined, according to officials in several capitals, all speaking on condition of anonymity.

“Greece failing is not an option and lots of people think that we will have to intervene at some stage,” said a euro-zone finance official, who was not permitted to speak publicly because of the sensitivity of the matter. “It doesn’t have to happen, and we hope it won’t, but it would be better than seeing a default.”

Of course, we haven't gotten to the actual bail out yet. Timing will depend very much on what happens in the financial markets over the next few days. The spreads on Greek bonds widened strongly again today - reaching a record 4.1 percentage points over German bunds, while Credit- default swaps on Greece jumped 28 basis points to 402, according to CMA DataVision prices. As the Economist puts it in another piece:

The bond market’s skittishness puts more pressure on the Greek government to come up with a credible plan for fiscal retrenchment. A pledge to follow Ireland’s example in making substantial cuts to public-sector wages may now be necessary to ensure Greece can fund itself at reasonable cost. Having raised €8 billion this week the Greeks probably have enough money to see them through until May, when a chunk of their long-term borrowing falls due. The danger now is that market sentiment spirals out of control. If that happens, only the most radical measures, or a euro-zone bail-out, will turn things around.

The bail-out will now surely come, but first it would be better to have the EU Finance Ministers meeting on February 9 and 10, and the national leaders summit on 11 February. The key now will be to see the conditions imposed, and whether they are realistic enough to bring about a return to economic growth and debt sustainability over a reasonable horizon.

Basically all these reports today only confirm the contents of my January 21 piece - The EU Is Reportedly Exploring Making a Loan To Greece - contents which were based on a report in European Voice, a report which, despite all the denials at the time, now seems to have been accurate. The decision also means that the Commission remains adamant not to let Greece go to the IMF. In this case, I do really hope they know what they are at, since failure in the Greek case would immediately expose Portugal, and more importantly Spain to massive market pressure.

Finally, having started this piece with a quote from Charlemagne, I will close it with another one. This time, though, there is a difference, in that in this extract it he who is citing me, rather than I who am citing him:

The bloggers over at A Fistful of Euros offer a view of the Spiegel leak that puts the report neatly in context:

"there would seem to be an underlying transition going on here, one which in EU terms is quite rapid. The EU’s own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject - the issue of Eurozone imbalances"

Rumours, Rumours, But No Greek Bond Sales To China

2010-01-28T13:52:00.000-08:00

Well there certainly is a lot happening out there at the moment. And Monday's successful bond sale which left the Greek government triumphally proclaiming they could comfortably meet their 2010 borrowing program now seems to belong to a lifetime ago. The sale raised 8 billion euros over a 5-year syndicated bond which attracted total bids of EUR25 billion, well above the EUR 3 billion to EUR5 billion initially targeted by the government, who immediately declared a major victory.

That was before yesterday, and the Financial Times announcement that Athens was wooing Beijing to buy up to €25bn of government bonds in a deal being negotiated using Goldman Sachs as intermediary. China had not agreed to such a purchase, according to the FT at the time. In the wake of this announcement - as the FT put it - "Greece’s debt crisis returned to financial markets with a vengeance as agitated investors demanded the highest premiums to buy its government bonds since the launch of European monetary union over a decade ago".

In fact, the yield spread between 10-year Greek bonds and benchmark German Bunds widened dramatically, and were up by almost 0.7 percentage points at one stage, as a general panic set in among sellers who were rattled by doubts about Greece’s ability to refinance its debt - or their willingness to make the reforms which would make their debt sustainable in the longer term. If they were so keen to make all the necessary changes, why were they talking to the Chinese, and not the ECB and the EU Commission, who can, of course, easily guarantee funding for such a small quantity of money?

But the biggest impetus to the debacle actually came not from the FT announcement itself, but from the Greek government's clumsy attempts to deny they had asked for help from Goldman Sachs in order to sell government debt to China. In the end Greek 10-year bond yields closed at 6.70 per cent, up 0.48 percentage points up on the day. In fact, the lid was virtually sealed on the Greek fate by statements reported in Bloomberg from Yu Yongding, a former adviser to the Chinese central bank, who is quoted as saying that China shouldn’t buy a “large chunk” of Greek government debt to help rescue the country because their securities "are more risky than U.S. Treasuries". “Let European governments and the European Central Bank rescue Greece", he said. Exactly. This is the point.

The Greek finance ministry reacted by coming out with an attempt to deny that any such negotiations were taking place: "The Finance Ministry categorically denies that there is any deal to sell Greek bonds to China.......The Finance Ministry has not mandated Goldman Sachs to negotiate any deal with China." Fine, but wording here is important. Evidently there is no deal, and Goldman Sachs were given no "mandate" - but that doesn't mean they weren't in Beijing, negotiating on Greece's behalf. In fact, as the FT notes, this issue has a relatively long historyand goes back to at least last autumn:

Greece’s attempt to attract Chinese investors to buy a slice of its sovereign debt took shape last November at a lunch attended by George Papandreou, the prime minister, and Gary Cohn, chief operating officer of Goldman Sachs, the US investment bank. Faced by a soaring budget deficit and record public debt, the newly installed socialist government was eager for ideas about how to finance this year’s €55bn ($77.5bn, £48bn) borrowing requirement, the FT has learnt.

Goldman was keen to promote a Greek bond sale to the Chinese government and the State Administration of Foreign Exchange, which manages the country’s foreign exchange reserves – increasing at a rate of $50bn (€35bn, £31bn) monthly in recent months.

Goldman Sachs has close involvement with the struggling Greek government. The investment bank – along with Deutsche Bank – last month organised the government’s first roadshow to London, led by George Papaconstantinou, the finance minister. It was also one of four foreign banks – the others were Deutsche Bank, Credit Suisse and Morgan Stanley – that arranged Monday’s successful bond offering, along with two Greek banks.

The Greek press has long been rife with speculation about possible Chinese investments in the country, and some of the earliest stories go back to 2008, when Chinese port operator Cosco Pacific signed a 3.4 billion euro deal to run and upgrade facilities at Piraeus Port, which is Greece's biggest, although none of the deals mentioned ever fully materialised, since the Chinese have been unable to operationalise their Piraeus asset following a dockworkers strike last October which lead all concerned to have second thoughts.

This time the rumour mill had it that the Greek government were willing to cede some control over one of their strategic assets - National Bank of Greece - in return for the funding. Analysts in Athens saw the government’s appointment of Vassilis Constantacopoulos, a senior Greek shipowner, as a non-executive director of NBG earlier this month as a signal that a deal with a Chinese investor might be in the offing. Mr Constantacopoulos’s shipping company charters container vessels to China’s Cosco shipping and ports group, and it was he who facilitated the above mentioned €4bn concession for Cosco to operate a container terminal at Piraeus port.

The Greek Prime Minister George Papandreou has vigourously denied all these reports - although again, watch the wording. Speaking at Davos today he said that recent media reports that China would buy up to E25 billion worth of Greek sovereign bonds are "wrong," and that Greece has "not asked for money anywhere else." He added: "We are in a jittery time" in which "rumors can create problems." Greece's Finance Minister George Papaconstantinou also reiterated the same points: "We have not talked to China and no investment bank has a mandate from us to talk to China," he said in an interview with The Wall Street Journal.

But it is strange to here Mr Papconstantinou saying this, since if we go back just to last Tuesday - the day before the current rumpus broke out - Mr Papaconstantinou gave an earlier interview to the Wall Street Journal, but this time the Greek Finance Minister was there to detail a diversified global borrowing plan to plug government fiscal gaps - including, he mentioed, aspirations to raise up to $10 billion from Chinese and other Asian investors.

Papaconstantinou will lead a delegation next month to the U.S. and Asia to market Greek debt valued at at least $1.5 billion to $2 billion denominated in euros, dollars and possibly yen. But Greek officials hope that the bond tour, which will include stops in Beijing, Shanghai and Hong Kong, could bring in five times that amount if Chinese investors are attracted to the deal. "There is a lot of liquidity in China. There are big funds in China. This is why China is going to be part of the road show," he said, adding that if Chinese investors are to get involved the bond size has to be "significant... possibly $5 billion to $10 billion." A person familiar with the situation has told Dow Jones that Greece is trying to place as much as EUR20 billion to EUR25 billion overall with Chinese investors.

Indeed the Greek government have not gone so far as to deny the roadshow ever exitsed, but Reuters today do report that they have backtracked somewhat, since while they had previously announced they were going to stage the roadshow sometime in the near future, the head of the Greek debt agency (PDMA) is now stressing that no date has in fact yet been set: "Finance ministry officials said the roadshow might take place at the end of February or in March, depending on Greece's borrowing plan, which has not been finalised."

Really, this is all a very, very sorry story, and the main issue facing the Greek authorities at this point is one of credibility since, as the Financial Times says: "at the heart of Greece’s problems is a lack of confidence in its trustworthiness". Such confidence has been lost in the course of a decade of "incidents" with the EU Commission and the Eurostat statistics office, and it is just this loss of confidence which the recent handling by the Greek administration of the China bond issue will have done little to restore. Is the Greek government batting with us or against us at this point?

Competitiveness Gaps Could Hurt Euro - No Really!

2010-01-26T12:51:00.000-08:00

Reuters Jan Strupczewski gives more details of the EU Commission report first leaked by Der Spiegel. According to Strupczewski the "new European Commission report has expressed concern about gaps in competitiveness that could undermine confidence in the euro zone and point to tensions related to wage levels and capital flows in the 16-member club". The report was prepared for the finance ministers meeting on January 16.

Of particular interest the report acknowledges that the real effective exchange rate for Greece, Spain and Portugal is overvalued by more than 10 percent - I would put the Spanish figure at nearer 20%, but still, a start is a start - and this gives us an indication of how much either wages and prices in these countrieshave to fall, or productivity rise, to make them competitive again, given that they are locked into the euro.

The report also said that large and persistent differences in competitiveness across the zone are a serious concern and can undermine confidence in the single currency "Competitiveness divergences within the euro area may hamper the functioning of the Economic and Monetary Union, because of large trade and financial spillovers across Member States.......In particular, the persistence of large cross-country differences jeopardises confidence in the euro and threatens the cohesiveness of the euro area,"

The report, which runs to 172 pages, was requisitioned by the Commission to examine the competitiveness problem in the 16 countries using the single currency, such differences in competitiveness are reflected, for example, in the size of the respective current account deficits or surpluses in the eurozone.

To put things in perspective, the Commission estimates Greece had a current account gap of 8.8 percent of GDP last year, Spain 5.4 and Portugal 10.2 percent. Cyprus had a current account gap of 11.6 percent while Germany had a surplus of 4 percent, Luxembourg 9.4 percent, the Netherlands 3.1 and Finland 1.1 percent. These numbers are well down from 2008 in the cases of Greece, Spain and Portugal, where the deficits were more like 15%, 10% and 9%. As Krugman says, its all about "numbers, numbers, numbers".

The note said that the accumulation of large current account deficits could not be sustained forever and that they entailed a build-up of external and private sector debt. "If [these imbalances] remain unaddressed, the eventual correction can be abrupt and highly disruptive not only for the countries concerned but also for the rest of the euro area," it said.

"The combination of competitiveness losses and the excessive accumulation of public debt in some Member States are worrying in that context," the note said. Rigidities in labour and product markets may make regaining lost competitiveness a long and painful process , but the longer the adjustment is postponed the higher the ultimate cost will be, the Commission said.

"The divergence trend observed in the early years of euro reflects a worrying build-up of a range of domestic imbalances in some Member States," according to the Commission.

More controversially, the report suggests that while the real effective exchange rate for Greece, Spain and Portugal is overvalued, Germany's was 5.1 to 3.1 percent undervalued last year, indicating that companies have scope for wage increases without losing competitiveness. This is controversial, because naturally this rise in wages would bring Germany back into trade equilibrium, GDP growth would turn negative, since as a high median age society Germany is now completely dependent on its trade surplus for growth.

In addition the report said that most indicators of price and cost competitiveness pointed to a further divergence in competitiveness in the many euro zone countries during the financial crisis and in the early stages of the recovery. This is not good news, and the only clear signs of rebalancing come from Ireland gaining in competitiveness in 2008 and 2009.

"A smooth adjustment of intra-euro area competitiveness divergence and macroeconomic rebalancing is key for the recovery and, more generally, for the economic resilience and a smooth functioning of EMU in the long term.......It is therefore essential that Member States put in place an ambitious and comprehensive policy response geared at speeding up and improving intra-area adjustment mechanisms......The successful adjustment of intra-euro area competitiveness divergence and macroeconomic imbalances is of vital importance for the long-term functioning of EMU.

The EU Does Have The Legal Power To Organise Bailouts

2010-01-26T04:59:00.000-08:00

Sometimes I am surprised by what some people consider to be news. Tony Barber points out today in the FT Brussels blog that the EU has the power to mount bailouts of any member country under "exceptional circumstances". As Tony rightly points out, under Article 122 of the EU’s Lisbon treaty, which came into effect last December, when a member-state is:

"in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council [of national governments], on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the member-state concerned.”

So there it is, as he says, "in black and white", whatever the propaganda smokescreen some widely quoted but anonymous "EU Officials" have been mounting for the press in recent days.

What Tony omitted to mention is that Article 122 of the Lisbon Treaty is simply another version of article 119 of the [Foundation] Treaty of the EU (which was presumeably incorporated directly into the Lisbon Treaty. Article 122 stated the following:

Where a Member State is in difficulties or is seriously threatened with difficulties as regards its balance of payments either as a result of an overall disequilibrium in its balance of payments, or as a result of the type of currency at its disposal, and where such difficulties are liable in particular to jeopardise the functioning of the common market or the progressive implementation of the common commercial policy, the Commission shall immediately investigate the position of the State in question and the action which, making use of all the means at its disposal, that State has taken or may take in accordance with the provisions of this Treaty

This was the article cited in justification for the assistance to Latvia and Hungary, and as I pointed out in February last year, give the grounds to justify the issue of EU Bonds (as was in fact done). Now some recent statements of EU Officials point to the fact that help was given to Hungary and Latvia was only given as a result of the fact they were suffering from a "Balance of Payments" crisis, since the crisis those countries (Latvia and Hungary) was described in this way, and that this help would not be available to members of what is now being called the EuroGroup of countries. They say this, correctly, since these countries can't (almost by definition) suffer a Balance of Payments crisis, since the Eurosystem funds trade and current account deficits almost automatically. Precisely, there "danger signal" problems can't arise. But what can arise are funding problems for the government debt which eventually arises in their wake, which is where we are now in the cases of Greece, Ireland, Portugal and Spain.

So we move on to the second line of defence, which is "as a result of the type of currency at its disposal". This wording was no doubt adopted to cover cases of those countries with so called "vulnerable currencies", but when you stop and think about it, it perfectly describes the predicament of those countries, who given the lack of an adequate (red light flashing) warning mechanism on balance of payments and reserves issues, now find themselves in a much deeper problem and with no currency of their own to devalue. The definition fits the case like a glove.

The thing is, as Tony Barber points out:

Article 122 stresses it would be EU national governments, acting on advice from the Commission, that would take the decision to rescue Greece - or Ireland, Portugal and so on. There is nothing in the treaty requiring the ECB to state its opinion one way or the other. So, on this question, it is important to listen to eurozone political leaders, above all Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France, as well as Commission president José Manuel Barroso.

So look tot he statements of national leaders and EU Commission Officials for road maps on how this particular topic will develop.

The ECB Is Here To Help

But there is another area we need to think about, and that is liquidity provision. Here the ECB can be of enormous help. Basically, as I outlined in my Debt Snowball post, the critical debt to GDP ratio depends on two factors: growth in nominal GDP and the interest rate spread on government bonds. Now, EU Bonds (or whatever) can help with nominal GDP, since they can be used for fiscal support, and to provide domestic demand to an economy during the correction, but the ECB liquidity provision to the banks can also help to keep spreads under control, and thus reduce the cost of borrowing for national governments.

If we are all Europeans, and all in this together, isn't this what our leaders should be doing - for those countries willing to make sacrifices and trying to put their house in order - providing fiscal and demand support via the powers of the Commission, and liquidity support via the spreads. Is this not what M. Trichet meant when he said "we are here to help" - it would be a strange form of Union wheree the main collective institutions were working against the interests of the individual members.

Surely it is this sense that we should read yesterday's statement by ECB council member Axel Weber (one of the leading pretenders to M Trichet's thrown) that the bank will discuss reverting to long-term refinancing auctions after March,according to a report in the German newspaper Boersen-Zeitung.

After the end of the first quarter, “we will talk about returning to the auction process in the refinancing operations with longer maturities,” Weber said, according to the newspaper.

This makes perfect sense, as any other approach would be near suicidal, given the difficulties we are now all facing. Flexibility is the word.

And it is in this sense we should be looking at another piece of news that has generated considerable interest today. According to reports, investors placed about €20bn in orders for the new Greek five-year, fixed-rate bond - four times more than the government had reckoned on offering. A sign of success? Hardly, since if you look at the interest spread they needed to offer, it is clear that Greece is being made to pay dearly for all those years of fiscal profligacy, with the bond carring a record high interest rate spread relative to the rate for German bonds, the eurozone’s benchmark. The terms were described by Bloomberg as "generous".

Greece sold 8 billion euros ($11.3 billion) of bonds at premium yields to ensure the country’s first debt issue since being downgraded was a success. The five-year securities yield 6.2 percent, the Greek ministry of finance said late yesterday in an e-mailed statement. The ministry said it received 25 billion euros in orders, after offering 0.3 percentage point more yield than on the nation’s existing debt with similar maturities. The new bonds yield 3.5 percentage points more than the benchmark mid-swap rate, after being first offered at 3.75 percentage points. That compares with 3.2 percentage points on Greece’s 3.7 percent notes due July 2015, according to ING Groep NV prices on Bloomberg. The yield on Greece’s existing five-year bonds declined 7 basis points yesterday to 5.88 percent. That narrowed the difference with comparable German debt, the European benchmark, to 358 basis points, from 365 basis points last week, the widest since Greece joined the euro in 2001.

“It showed we have the ability to raise funds that we need,” according to Spyros Papanicolaou, head of the Greek debt agency. “We expect the spread to start to tighten after the sale, because Greece has been misread and misjudged.”

But Mr Papanicolaou needs to read the Credit Rating Reports (and paricularly Moodys) more carefully (or alternately he could read my blog). In fact Moodys (who stand apart from the other agencies on this one) argued only last month that investors' fears that the Greek government may be exposed to a liquidity crisis in the short term are totally misplaced. As they said in their press release "the risk that the Greek government cannot roll over its existing debt or finance its deficit over the next few years is not materially different from that faced by several other euro area member states". And they took this view since it is obvious, as a member state of the EuroGroup they can receive liquidity via the ECB (one of the strongest liquidity providers in the world), and if they implement an EU Commission approved correction programme, then the ECB is obliged to help them. It makes no sense at all, for any of us, to make this correction process more difficult.

And Spain Will Need All the Help It Can Get, From Both The EU Commission and the ECB

Now finally, one piece of news few seem interested in. Santos Gonzalez, President of AHE (Spain’s Mortgage Association) has come out today and warned that Spain's banks do not have the financial capacity to assume the outstanding debt of property developers, which amounts to around 325 billion Euros, This he says "gravely endangers the viability of the Spanish property sector as well as Spain’s financial industry".

The problem is growing, according to Gonzalez, since the need to refinance 15,000 million euros worth of interest payments annually against assets which are continuously losing value becomes insustainable. The numbers are not so much what matters here as the growing number of people who are coming out and talking publicly about the problem.

As Mark Stucklin editor of Spain Property Insight says, "You can see how bad the situation is just driving down the Spanish coast. Vast quantities of capital have been sunk into unsold developments and abandoned building sites, the result of deranged lending during the boom. Debts have will have to be written down further to get the market going again. The longer it takes the more painful it will be. Spain needs to grab the bull by the horns".

Unfortunately the links are in Spanish, but the gist of the problem is that the number mentioned is around 30% of Spanish GDP, and if the government have to mount a bailout of this order (as I have long been arguing they will need to, and this is only for the developers) then Spanish sovereign spreads are going bo be in for a very bumpy ride. Maybe English language journalists should broaden their horizons a little.

Eurozone Imbalances Weaken Trust in The Euro and Undermine Euro Area Cohesion

2010-01-26T04:49:00.000-08:00

This is the conclusion drawn - rather surprisingly - not by some bank analyst, or by a Credit Ratings Agency, but by the European Commission itself, according to the contents of a report "leaked" to the German magazine Der Spiegel at the end of last week. "(The imbalances) weaken trust in the euro and endanger the cohesion of the monetary union,".

Here is a rough translation of the Der Spiegel report:

The EU Commission Sees Monetary Union At Risk

The EU Commission is concerned about the survival of monetary union. The differences in competitiveness between member countries and the resulting imbalances give "cause for serious concern for the eurozone as a whole", according to a presentation given by the Directorate General for Economy and Finance to the finance ministers of the Eurogroup.

The experts who advise the Finnish Commissioner-designate Olli Rehn fear that the differential development of the economies in the various Member States undermine confidence in the euro and may ultimately threaten the cohesiveness of the monetary union. Of particular concern to the Brussels officials is the economic condition of those countries who in the past ran huge deficits in their current account balances, because they lived for many years thanks to ample credit which was avaialable due to the low interest rates prevailing. Now these countries are suffering, especially Spain, Greece and Ireland, under the weight of escalating government deficits. "The combination of declining competitiveness and excessive accumulation of public debt worrying in this context," the experts say.

As a way out of trouble, the EU officials first propose that the countries concerned put their own houses in order and introduce the necessary reforms. Wage levels need to be set with due consideration to falling productivity and the loss of competitiveness. In plain language: workers ambitions should be modest, with low wage settlements. "The adjustment will be accompanied by a marked increase in unemployment."

The Commission officials also recommend that the deficit countries employ a strategy which was used by Germany in its recent efforts to exit from many years of weak growth. At the same time the German federal government does not escape criticism in the report, since Germany and other relatively successful countries such as Austria and the Netherlands need to tackle the chronic weakness in their domestic demand.

To achieve this the Brussels experts recommend enabling more competition in the services sector, the intriduction of tax reforms and the elimination of credit hurdles. The longer the countries concerned delay introducing the necessary measures, the higher the social costs which will be incurred. The Commission believes the euro countries have no choice: "These adjustments are vital for the long-term functioning of monetary union."

As far as can be seen from this Spiegel report, while it is the case that some of the wording used is similar to things we have seen before, there would seem to be an underlying transition going on here, one which in EU terms is quite rapid. The EU's own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject - the issue of Eurozone imbalances. These were, in fact, supposed to disappear with the passage of time, so it was expected that they would have diminished rather than increased. In that sense there is now an implicit admission that the institutional environment in which the common currency has been operated was severely deficient and badly needs to be improved. In my view this change in approach is already a big improvement, as is the fact that people are begining to face up to the reality that the Euro has exacerbated the imbalances, rather than reducing them.

In particular the Commission seem to be starting recognising that countries like Spain whose main export became pieces of paper (or IOUs on their future) which were securitised against assets which we can now see didn't have the value they were thought to have (the housing stock, or should I say glut) entered a dynamic which was seriously unstable. Now we need to see the measures which can be applied for correcting these distortions.

Juergen Stark, member of the Executive Council of the ECB was out with another interview more or less along the same lines on Saturday:

Stark told the Welt am Sonntag newspaper that Greece, which is battling to get its budget under control, must make comprehensive consolidation a priority but also reform its economy to stop producing deficits. "Countries like Greece must not only bring their deficits under control, but also enact a fundamental reorientation of their economic policy," Stark said. "Some countries have even managed to accept falling wages -- there is no alternative for economies in a difficult situation," he added in the interview, which had been held on Thursday.

The reference in the Spiegel report to the earlier German expience is to the earlier "internal devaluation" Germany carried out between 2001 and 2005 in an attempt to restore competitiveness after having entered the common currency at an exchange rate which was later discovered to have been too high. The thing is, the German devaluation was quite limited and quite slow. Greece and Spain have large devaluations to carry out, and the time scale is likely to need to be short, since it is urgentto restore growth to these economies to avoid the debt to GDP percentages snowballing upwards.

Another aspect to this whole problem is the new emphasis on correcting the imbalances as a shared process, one which, as Mr Zapatero would have it, involves "solidarity", and joint responsibility. That is to say the surplus countries are going to be expected to play their part: no wonder the German economy minister became so angry with Mr Zapatero's 2020 strategy initiative.

Of course, it is not really posible to present the problem in quite this way, since one set of economies are competitive, and another set are not, so it is hard for the Greeks and the Spanish to really blame the Germans and the Dutch for their present situation, although everyone, both centre and periphery, will have to play a part in the search for solutions. I tend to put it this way: the South must make sacrifices, and then the centre must help. Thus talk of no "financial bailout being possible", or, as M Trichet would have it, simply stating that the "external surpluses of some member countries (in the balance of payments) finance the external deficits of some others" without recognising that the presence of these very same surpluses form a problematic part of the internal Eurozone imbalances is hardly helpful at this point.

As Martin Wolf said recently:

What people do not seem to understand is that peripheral European countries cannot escape from their trap because they are caught in a game of competitive deflation with Germany (and the Netherlands). So long as the eurozone has an external balance (roughly) and Germany has a vast surplus, the rest of the zone MUST be running aggregate deficits. That is a subtraction from their domestic demand. This then means that either the private sector runs deficits (spends more than its income) or the public sector does. If the latter is pushed towards balance, by eurozone pressure, GDP must contract enough to force the private sector finally back into deficit and so towards bankruptcy. Ultimately, the only way out of the trap is for nominal wages and costs in peripheral Europe to fall so much that it forces core Europe into depression . That also means a depression in peripheral Europe. No advanced polity can cope with a permanent depression. Anything can then happen. I have always feared that the euro could break the EU. I believe this is quite possible.

"Alternatively, demand must start to rise substantially in core Europe. Is that possible? The other alternative would be for the eurozone as a whole to move into surplus - but how, given the weakness of external demand and the strong euro?"

No easy answers yet awhile, but lots of interesting problems to talk about, and plenty of food for thought.

Half a League Onward Rode the Six Hundred

2010-01-22T08:48:00.000-08:00

Well you may doubt their wisdom, and you may doubt their rigour, but there's no doubting their tenacity. This looks like being Marathon all over again.

New EUR 5 Year Mandate for Greece

The Hellenic Republic, rated A2/BBB+/BBB+, has mandated Credit Suisse, Deutsche Bank, Eurobank EFG, Goldman Sachs International, Morgan Stanley and National Bank of Greece for its forthcoming Greek Government 5-year Euro benchmark. Due 20 August 2015, the transaction will be launched and priced in the near future subject to market conditions.

And here's how the ten year bond spread with the comparable German bund performed today.

Reuters William James described the situation as follows:

Greek plans to issue new bonds re-ignited concerns over peripheral euro zone sovereign debt on Friday and helped push benchmark German debt futures to a one-month high. The risk attached to Greece's sovereign debt continued to dominate investor sentiment with the announcement of a syndicated issue of 3-5 billion euros causing Greek 10-year bond yield spreads over German Bunds to widen beyond 300 basis points. "The announcement that Greece are looking to issue five- or 10-years in the near future, albeit in small size, has put the periphery under pressure once again," said Peter Chatwell, fixed income strategist at Calyon.

Other peripheral sovereigns were again affected by contagion from Greece, with Portuguese 10-year yield spreads over Bunds hitting their widest since early May.

Speaking at a conference in Athens yesterday Miranda Xafa, a prominent Greek economist and an ex Executive Board member at the IMF, said that Greece could well have a difficult time borrowing in April and May, since during these months a total of 22 billlion euros in bonds are set to mature.

“This year, we have a big expiry of bonds in April and May. With the five-year bond from 2005 and the 10-year bond issued in 2000, this concentration of maturing bonds leads to a re-financing risk.”

“The issue is that slowly, the ECB will start to withdraw its extraordinary measures for obtaining unlimited liquidity, and we will return to the system that was in effect before the crisis. This means Greek banks will have to look for alternative ways of securing liquidity, not through the ECB but through markets. In June, Greek banks will owe 28 billion euros ($39.5 billion) they have borrowed from the ECB, and it is almost certain that the total of this amount cannot be refinanced for more than a few months. If Greece’s credit rating falls below A- at the end of the year, it will mean that Greek bonds cannot be used as collateral for borrowing from the ECB.”

Does Anyone Really Know The Size Of The Greek 2009 Deficit?

2010-01-22T00:56:00.000-08:00

While investors are generally aware of the dire state of the western economies’ accounts, quite a few of them are optimistic that these large budget deficits can be closed through a combination of fiscal discipline and expenses reduction. Such optimism, based on other countries’ past experience, is likely to be disappointed for mainly two reasons. Firstly, the closing of the gap relies on consensus growth estimates that appear overly optimistic, leaving room for tax revenues disappointment. Secondly, the budget deficit problem concerns countries accounting for more than 50% of global GDP, meaning that single countries’ past experience does not necessarily provide a reliable guide here.
Andrea Cicione, PNB Paribas

The risks to the EUR from the events in Greece arise from a number of different factors. In summary, however, it boils down to credibility: The credibility of the Greek government in meeting their targets, the credibility of the EU institutions to deal with non-compliant states and the credibility of the EUR itself. In periods of fiscal deterioration, the EUR has typically benefitted from the understanding that all countries would adhere to the conditions of the Growth and Stability Pact (GSP) envisioned by the European Treaty. The GSP requires that they would need to employ deficit reduction programs. The fact that Greece had yet to implement reduction programs, and now evidence that historical financial statistics were not accurate, calls this market assumption into doubt.
Emma Lawson, Morgan Stanley

This is a problem I have touched on before. What exactly is the true size of the Greek 2009 fiscal deficit? Well, according to a report signed by the Greek Finance Minister which has been sent to the EU Commission, and leaked to the Greek finance and business portal Kathimerini (Greek only I'm afraid), it is likely to come in at around 13.7% (and not 14.5%, as I forecast in this post) since the final decision on some hospital expenses which were dancing around in-no-mans land has been to attribute them to the 2008 deficit (and consequently increase the recorded size of that years debt).

Now before going further, we need to have some things very clear in our minds. In the first place, all national accounts are governed by accounting procedures, they are - that is to say - conventions. As I pointed out yesterday, Greece is far from being alone in having "issues" surrounding its debt. Hungary is currently witnessing a major pre-election battle between the two main parties about how much of the debt being accumulated in state owned entities should be passed on to the general government deficit. Spain notoriously has its "Peajes en la Sombra" - or motorways/highways financed with private capital, where there is no evident public debt, but where the Autonomous Community government involved pays revenue to the private companies who built them based on the level of use (rather than openly charging tolls). Here in Barcelona we have just opened a new legal complex (the City of Justice) which seems to have been financed using similar techniques. In fact Spain's central government seems to have far too little quality information about what its regional governments and municipalities are up to, since currently, the government only gets detailed information on revenue, spending and deficits once a year. "We need to get this information more frequently," Economy Minister Elena Salgado told the Wall Street Journal in an interview this week. And then there is Silvio Berlusconi's famous "bridge to nowhere" (Sicily, sorry). Just how is the private capital contribution being structured and serviced?

There are a lot of mirky areas in the financing of all our public sectors, so before entering the "dark areas" of Greek finance, we would do well to remember that. As IMF Hungary representative Iryna Ivaschenko said last week “the definitions [of government debt]are not always comparable, so you should not compare the 3.8% [of GDP deficit forecast] with the 7% (deficit that some economists are arguing exists). You cannot say they are not right, but it is comparing apples and oranges.”

Secondly, I think we would do well to remember that the Greek situation is now out in the daylight, and on the table. Thus it is likely to be remedied. The principal worry being expressed by almost all analysts at the moment is not that the Greek government will not start to put the accounting house in order, but that the Greek population will not swallow the measures being introduced. In this sense I think we need to tread with caution. If the deficit really is 13.7%, then what is important (for Greek credibility) is to get it back under control in a reasonable period of time. What is not interesting is to place hopelessly unrealistic targets on Greece, and then see these objectives not kept.

So, rather than be treated as a whipping boy for all our ills, Greece needs to be cut some kind of slack at the moment. But the other side of that one-and-the-same coin is that the Greek government needs to publicly recognise it needs help to sort this mess out, and ask for it, from the IMF if need be.

All the above having been said, the point about the current chaotic mess in Greek finances is that the deficit irregularities were not acquired using accepted accounting conventions (debt avoidance), but by breaking the generally accepted rules (debt evasion). Rather than resorting to sophistocated techniques of financial engineering, what they are really guilty of is deploying what here in Spain they call "chapuzas" (or back-street botched jobs).

So now for the details of the report.

Will the Real Greek Deficit Kindly Stand Up!

According to the report which Kathimerini had sight of, Greece’s public sector debt could be over the officially reported one by some 300 billion euros. The report, which was requisitioned by the Finance Ministry from an independent committee of six widely respected experts, found that outstanding obligations relating to areas like unpaid arrears to public sector suppliers, interest rate swaps with commercial banks, and debt guarantees for public sector companies have all been excluded from the official data. "Beyond the officially declared 300 billion euros, fiscal chaos is covering up a public debt of many billions of euros" according to Kathimerini. "The Committee recorded in detail all manner of distortions and misunderstandings in the system used to collect and monitor data. But the ingredient that can lead to the conclusion that this is a report to catapult the country's fiscal problems into the limelight are those concerning the manner of recording or not recording of public debt". Some of the comments the experts make on these topics are:

1. Debt as currently recorded has been reduced through a number of "interest rate swaps. One such trade involves the use of Greek banks. The government owes, for example, the National Bank of Greece about 5.5 billion, which is not recorded in outstanding debt. The agreement was originally with Goldman Sachs and it was then passed to National Bank of Greece. The 5.5 billion euros involved is effectively a 30 year loan, and during this time both parties pay interest to each other, with the difference that the State pays a much higher interest to NBG than the NBG pays to the state. That is, the debt is paid off through higher interest payments rather than via the normal amortization process.

2. Credit providers: The European System of National Accounts (ESA) does not take such provision into account because government debts must normally be paid within 60 days. Greece, however, does not comply with the normal condition of early repayment, thereby releasing billions of euros in extra debt, debt which is later recognised and produces a subsequent revision of deficit and debt numbers for the year in question. The most widely quoted case of this is that of public hospitals, which by September 30, 2009 owed suppliers (for the period 2005 - September 2009) 6.3 billion euros. It was the recent addition of these obligations (21 October 2009) which led to the increase in the general government deficit for 2008 and 2009 and the corresponding increase in debt. In addition to the debts of hospital debt, the Committee estimated that there are still further outstanding government obligations of around 6.0 billion euros. Once these liabilities have been paid (or recorded in official figures) the debt will be naturally revised upwards.

3. The debt balance also includes the debt of various public bodies which are guaranteed by the state. Debt guaranteed by the Government at the end of 2009 tamounted o 26.2 billion (or 10.9% of GDP) up from 6.2% of GDP in 2002. About 40% of that debt is owed by the OSE (Greek Railways) and is body is unable to repay (shades of the Hungarian situation here).

4. Much of the above is possible due to the following practice: in order not to increase the budget deficit and debt, public bodies are encouraged to open bank loans guaranteed by the government (but not recorded as outright debt), usually with a higher rate of interest than if the government borrowed the directly and then subsidized the organisations directly. When these obligations are eventually formally assumed by the State, there is then a sudden increase in debt.

As former IMF Executive Board Member for Southern Europe said in a Bloomberg interview yesterday, “In Ireland, it was the banking sector that was the undoing of fiscal management. In Greece it’s the opposite, it’s the country’s fiscal management that is the undoing of the banking system.”

The EU Is Reportedly Exploring Making a Loan To Greece

2010-01-21T04:28:00.000-08:00

Pressure on Greek finances continues unabated. According to European Voice this morning the EU Commission and Finance Ministers remain most reluctant to call in the IMF (which I think would be the best solution) but they are themselves actively comtemplating providing some kind of IMF-type "straightjacket loan". My only big fear here is that they take too long to put the necessary mechanisms in place while the situation in Spain continues to deteriorate, leaving wide open a serious contagion risk.

European Union officials are exploring the possibility of providing a heavily-conditioned loan to Greece instead of seeing it turn to the International Monetary Fund. Officials are worried about the possible impact on banks elsewhere in the eurozone of Greece defaulting on its sovereign debt. But they would prefer to avoid the ignominy of a eurozone country seeking IMF assistance.

The worry is not, in fact, that Greece might leave the Eurozone, or even default in the short term, but that unless someone external takes control of the situation the Greek government will prove unable to sell those much needed competitiveness reforms to a population which will not be happy about being faced with what looks set to be quite a steep economic contraction. As Martin Wolf said on Monday:

Given these tight constraints, a big structural fiscal tightening will generate a deep recession. That is sure to increase the cyclical deficit. Assume, cautiously, that for every percentage point of structural tightening there would be 0.2 points of offsetting fiscal deterioration. Then the structural tightening needed to reduce the actual deficit to 3 per cent of GDP would be close to 12 percentage points. The Greek government would find that, for every step it takes forward, it would slip a bit backwards. So far Greece has not suffered a significant recession. That seems sure to change. The government will soon be facing miserable public and private sectors, with no policy levers.

And PNB Paribas's Luigi Speranza remains equally unconvinced:

In sum, while ambitious, the Greek Stability Programme did not resolve the main concerns expressed by the markets. Amongst the main shortcomings are: persistent lack of credibility of Greek statistics on fiscal accounts, lack of details on the adjustment beyond 2010 and overly-optimistic growth projections. A credible long-term strategy should be focused on sharp cuts to public spending, particularly for wages and pensions. But this would probably lead to strong social opposition. Against this backdrop, markets will remain sceptical on the feasibility of the overall planned adjustment.

The big fear has to be that a "contagion process" will lead the Greek problem to become a Spanish one.

In an interview with the Wall Street Journal yesterday Spain's Finance Minister Elena Salgado stated that the government was preparing "deep" cuts in spending, cuts which will only add to the difficulties of an economy which is already reeling under the weight of a very strong contraction:

Spain's Socialist-led government is trying to forge a broad political consensus with the country's regional leaders to rein in one of the euro zone's highest budget deficits, Finance Minister Elena Salgado said in an interview. Getting bipartisan support for deep spending cuts would be a crucial step to avoid the credit ratings downgrades now plaguing Greece, which this week has been scrambling to convince financial markets that it can get fiscal imbalances under control.

She also admitted that Spain's deficit was likely to come in above the government forecast, which makes me rather nervous about the kind of market reaction we might then see, given the nervousness which has been produced by events in Greece.

The government recently warned it would surpass its forecast of a 2009 deficit of 9.5% of GDP. "It will be a little more, we hope not too much," Ms. Salgado said, adding the overrun is the result of a new benefit introduced for the long-term unemployed and lower-than-expected value-added-tax revenue from a still ailing real-estate sector.

Basically, what the Spanish government lacks is a credible policy not only for reducing the deficit, but also for restoring growth and creating employment. How all this will finally work out is hard to see at the moment. It is, as they say, a "developing situation". As one Greek economist friend pointed out to me Finance Minister Papaconstantinou yesterday limited himself simply to saying "We are not expecting anyone to come to our rescue," ...he didn't say Greece didn't NEED anyone to come to the rescue. Reading between the lines is evidently something of a fine art in the Greek case. But then, ever since the time of Demosthenes, the art of rhetoric has been one of their strong points.

In similar vein, a spokeswoman for the European Commission, on being asked this morning by Dow Jones Wire Service about the reports said "she isn't aware of any financial bailout packages being arranged for Greece". Well, in the first place they may exist, even without her knowledge of them, and in the second, they would have to be total fools (which they most definitely are not) not to have any kind of contingency arrangement under the circumstances (for imminentl deployment or otherwise), and even while some degree of Euro weakening has been welcomed by some, there must be a "stop loss" button they can hit somewhere if the slide continues and if the spreads continue to rise. In Greek markets, the premium demanded by investors to buy Greek bonds compared with benchmark German Bunds rose to 311 basis points yesterday, the highest since the euro was introduced. The yield on Greek 10-year bonds is now 6.2 percent. And talk of issuing a people's bond, or bonds in US Dollars or Yen will do nothing to calm things down. And the yield premium on ten year Spanish bonds over the German bund jumped to over 100 bps this morning, a level which hasn't been seen since April last year. Whatever the issues of communal pride, simple damage containment considerations suggest the Greek government should be calmly told to go to the IMF, and they should be told to go now.

The Debt Snowball Problem

2010-01-15T03:56:00.000-08:00

OK, just for a change let's start with some math. The increase in a country’s sovereign debt stock to GDP ratio is given by the following formula:

where D is the total debt level, Y is nominal GDP, PD is the primary deficit, i is the average (nominal) interest paid on government debt, y is the nominal GDP growth rate and SF is the stock-flow adjustment.

Now, if like me, you don't especially love maths, you may want to ask "what the hell does this rigmarole mean?".

Well, in simple plain English the above equation - which in fact comes from the recent Danske Bank report on EU Sovereign Debt- means that movements in the critical debt to GDP level depend both on the level of the annual fiscal deficit (the primary deficit, on which so much attention is currently focused in the Greek case) and on changes in the ratio between the value of the stock of debt and the value GDP. The key term is the one in brackets, and it is often referred to as the “snow-ball” effect on debt - the self-reinforcing effect of debt accumulation (or de-cumulation) arising from the difference between the interest rate paid on public debt and the nominal growth rate of the national economy.

Nominal here means GDP values before adjustment for inflation (what is known as current price GDP). So what we can say is that the trajectory of (for example) Greek debt to GDP going forward (and thus the effectiveness of the adjustment programme) depends critically on only three main variables - the rate of deflation/inflation, the rate of GDP growth, and the interest spread charged on Greek bonds. Ideally, Greece needs solid GDP growth, inflation, and a low spread on Greek bonds vis-a-vis German ones. The problem is the Greek Stability Programme may achieve none of these.

In the first place, the attempt to reduce the primary deficit will involve withdrawing some 10% of GDP in government demand from the economy in the space of three years (to go from an annual fiscal deficit of 12.7% a year in 2009 to one of 2.8% in 2012). The Greek government plan projects the economy to shrink by 0.3 per cent this year before rebounding with growth of 1.5 per cent in 2011 and 1.9 per cent in 2012. Most analysts are very sceptical about this forecast, since sustaining any kind of GDP growth under the present circumstances will be hard, and I think the most realistic expectation is that the Greek economy will see some sort of annual contraction during each of the three relevant programme years.

Secondly, to keep the debt GDP level from snowballing Greece needs inflation. But to get GDP growth Greeec needs to restore competitiveness, and this means (given they have no currency of their own) price and wage reductions (ie the so called internal devaluation) so they will have deflation not inflation, or they will not "correct" and move towards GDP growth.

Thirdly, and this one is easier: Greece needs to reduce the bond spread to keep interest rates on the debt as low as possible. This is doable, should Greece be able to convince market participants a viable correction plan is being operated. The ECB could also play a role here. But Monsieur Trichet, in his wisdom, said two things which were relevant in the post-monthly-meeting press conference yesterday. In the first place he said, quite correctly "we are here to help" - which I read as meaning that he is saying to the Greek government that "you take the steps you need to take, and we will help with liquidity", but on the other hand he also said "we will make no exception for individual countries" in setting our collateral rule, which effectively means that (from 1 January 2011) should Greece lose it's A2 status from Moodys (by two notches), the ECB will not be able to accept Greek bonds.

The first statement clearly offers support to the Greek spread, but the second (which might lead people to think they should start to steadily remove Greek sovereign debt from their portfolio) obviously wasn't.

It was hardly surprising then that the yield on the 10-year Greek government bond remained above 6.1% this (Friday) morning, up around 0.2 percentage point from early Thursday. The yield stood some 2.79 percentage points above the yield on the comparable 10-year German bund, the euro-zone benchmark, up about 0.25 percentage point from early Thursday. The spread even widened as far as 2.9 percentage points at one point yesterday, following the ECB meeting, and details of the Greek government's budget plan.

So basically, to make Greek debt to GDP dynamics sustainable, and avoid the snowball effect, my guess is you need two things:

a) to convince investors that Moody's will not downgrade, or some that some other form of support will be offered to the country.

b) some solution to the restoration of competitiveness dilemma. Basically, at the moment the Greek government has no interest in carrying out an internal devaluation, since the deflation impact on the debt formula would simply precipitate the snowball. But if they don't carry it out the economy will not return to growth, and investors will lose confidence and the bond spreads widen again, effectively setting off the snowball via another route.

So there needs to be a quid-pro-quo here, where the EU authorities undertake to restructure Greek debt in some way via the use of (eg) EU bonds (the famous bail-out) should Greece comply with a certain number of specified conditions first. Now many will scream at this point, "well they got themselves into this mess, now let them get themselves out of it". But matters are never that simple. Greek sovereign debt is in part a by-product of the eurosystem experiment, which made the accumulation of such debts at apparently cheap rates of interest possible (although none of those responsible for overseeing the system seem willing to recognise this). The Greek people have to accept their share of responsibility for the mess, and for the behaviour of their elected representatives. But there should be a limit to the "financial penalty" imposed. As Martin Wolf says in the Iceland context:

The final and, in truth, most important question is whether these demands are reasonable. After all, in every civilised country it has long been accepted that there is a limit to the pursuit of any debts. That is why we have introduced limited liability and abolished debtors’ prisons. Asking a people to transfer as much as 50 per cent of GDP, plus interest, via a sustained current account surplus is extraordinarily onerous.

In fact, asked in a Reuters poll carried out between January 11-14 what they felt was the the probability of Greece actually seeking a bailout this year, the median response from around 30 analysts that they would was 20 percent, with the same likelihood being expressed that it would be necessary at some point in the next five years.

This is not a very high probability at this point, but then when the same sample of analysts was asked about future ratings decisions, some 16 of the 27 analysts involved said they thought Moody's Ratings Service would downgrade its rating from A2 to a below-A rating by the end of the year. This is a much more significant result.

As it happens, I personally don't agree with either verdict, since in the first place Moody's are concerned with long term sustainability, so I doubt they will change their view on that one this year if the Greek government follow an agreed EU programme, while I do think (for the reasons expressed above) that some sort of Greek "bail-out" will be necessary over the next five years (to stop the snowball) if the government does what it has to do.

But all of this only serves to highlight juest how precarious the Greek situation actually is, in particular since the government still haven't accepted the need for internal devaluation, which is the only policy which will really restore growth. With a majority of analysts thinking Moody's will move to a below-A rating by the end of the year, and Monsieur Trichet saying that as of 1 January 2011 the ECB will not accept such bonds as collateral for lending, something, somewhere is likely to give, which is why I think the Greek government should at this very moment be throwing itself into the welcoming arms of the IMF before matters reach the point of no return on the spreads and the debt snowball. To do otherwise would be to risk far greater problems in a future which will not be that far away.

Will She....Won't She? The Greek Government's "Latin Tango" With The IMF

2010-01-12T05:17:00.000-08:00

Well the wires are really alive this morning. Greece is receiving a visit from the IMF today. The meeting was scheduled well in advance, but that doesn't mean the agenda was.

A team of International Monetary Fund officials arrive in Greece today to aid the government in its efforts to tame Europe’s biggest budget deficit. The mission, “within the context of the regular surveillance that the IMF provides to its membership,” will help the government with “pension reform, tax policy, tax administration and budget management,” a spokeswoman for the Washington-based lender said in an e-mailed statement yesterday.

Really we have what is know as a "fluid" situation right now, and no one seems to be very clear about what happens next. The IMF arrive in the wake of an Athens visit by EU and European Central Bank officials last week (to discuss the government’s plan to be submitted to the EU before the end of the month), and EU President Herman van Rompuy is also scheduled to visit today. It is hard to know what the outcome of last week's visit was, but press reports speak of the delegation pushing Greece to adopt tougher measures to cut the fiscal deficit.

It is however very important to understand that the issue in Greece is not simply one of reducing public spending to rein-in the deficit. The underlying problem is the external deficit (15% of GDP current account deficit) and the distortions in the economy and loss of competitiveness that this reflects. Simply cutting the fiscal deficit without addressing these issues will not reduce the government debt to GDP ratio, and may well actually increase it. It is the sustainability of Greek finances in the longer term that is the issue, and the only way of putting government finances back on a sustainable path is to return growth to the economy, and the only way to do that is to carry out an internal devaluation.

This is one of the principle reasons that I personally am arguing of the the IMF to take Greece into its arms now. Basically, I fear the Greek government itself is far from convinced of the necessity for the measures it needs to take, and a government which is itself not convinced will prove incapable of convincing a citizenry who still remain substantially in the dark about why what is about to happen needs to happen. The IMF is the only institution which I can see available at this point to oversee the process with the firmness which will be needed.

Olli Rehn Fails To Convince

What is required of Europe's leaders at this point in time is some clear speaking, and this is exactly what we are not receiving. Asked by the Catalan MEP Ramon Tremosa (CDC) during his confirmation hearing yesterday whether he intended to put in place the kind of mechanism which IMF European Director Marek Belka has been calling for Rehn fought shy of an outright commitment to direct means of compulsion, and suggested that the desired result could be achieved by using “incentives” to encourage states which found themselves in difficulty to move toward compliance adding that there was a need for “broader surveillance”. But he did pledge to use “all instruments” to help member states restore their finances and come into compliance with the terms of the stability and growth pact, so I imagine that we are still talking about a "fluid situation" whose actual significance will only become clearer at the February EU summit. It could simply be that in order to get the 2020 plan consensually agreed Olli Rehn is putting the emphasis on incentives rather than coercion, but it must be evident that the means of coercion must be there if needed, and this must be clear to all, and in particular to the electors who vote-in those otherwise wavering politicians.

Certainly Spain's leader José Luis Zapatero hasn't made things easy for Rehn, as he seems to have bungled matters yet one more time in the present case, and his proposal that the EU should adopt "biting economic safeguards" only met with a full frontal rebuttal from German Economy Minister Rainer Brüderle, who on being interviewed stated he was opposed to what he described as plans by the Spanish EU Presidency to "sanction" member states who do not comply with the European Union's "growth objectives".

Basically this confusion is all Zapatero's fault, since he presented the proposals as a move to set binding economic goals for member states under the coming 10-year plan to boost growth and competiveness, and called for corrective measures for those that do not comply. The 2020 strategy is intended to replace an earlier plan (the Lisbon aganda) that has manifestly failed in its goal of making the EU the world's most competitive economy by 2010.

"It's absolutely necessary for the 2020 strategy [...] to take on a new nature, a binding nature," Zapatero told reporters in Madrid one week after Spain began its six-month EU presidency, a mainly organisational role in which it can influence policy. He made clear he had not secured the agreement of other member states to make the economic goals binding under the 2020 strategy, but called for such proposals to be discussed at an economic summit in Brussels next month. "The informal summit on 11 February must bring up, in my opinion, measures including incentives and corrective measures for objectives set out in our economic policy," he said. "European competitiveness depends on two words - unity and competitiveness. European unity and a competitive economy."

All of this is really a complete confusion. The "binding measures" are need to reinforce the Excess Deficit Procedure which is applied under the Stability and Growth pact, and to give the right to the Commission to oversee the necessary structural reforms and internal devaluations. They are not needed to police growth targets which may or may not be realistic. No wonder the German economy minister got irritated. These measures are likely to be used against Spain, not Germany, and the growth issue only arises in the context of enforcing the SGP, since for those countries who enter a negative debt dynamic, a return to growth is essential, if default is not to be come inevitable.

Greece Is Not Argentina, Yet

Moving now from the ridiculous to the even more ridiculous, Desmond Lachman has an article in the Financial Times this morning entitled Greece looks set to go the way of Argentina.

"....much like Argentina a decade ago, Greece is approaching the final stages of its currency arrangement. There is every prospect that within two to three years, after much official money is thrown its way, Greece's euro membership will end with a bang."

This is nonsense, at least at this point. At this moment in time no country is either near, or even remotely near leaving the Eurozone, and I'll tell you why. If Greece's Eurozone membership ends with a pop (or even a whimper) that wouldn't be anywhere near the end of the matter, since Spain would come hurtling right along behind, producing in the process the largest external debt default in recorded history, and the most likely aftermath would be that the whole Eurozone would end with a bang (with totally unknown consequences for the global financial system). So, quite simply, we cannot let that happen. Greece would not be Argentina (which was, after all the shouting, a mere financial pinprick). Greece could potentially be a much more serious matter than Argentina ever was.

I repeat, the issue is internal devaluation, and enforcing it. And if we can't do it in the Greek case the markets would be quite entitled to draw the conclusion that we won't be able to do it in the Spanish one.

The basic problem is returning the key countries to a sustainable growth path. As Standard & Poor's stated when they took their recent decision to lower their ratings outlook on Spain, the reason for the change was the probability that the country will see "significantly lower" gross domestic product growth and "persistently high fiscal deficits relative to peers over the medium term".

Personally I find nothing especially exaggerated in this judgement. S&P's preoccupations seem valid, and widely shared, among others by the technical staff who prepare forecasts for the European Commission. The issue is not that Greece and Spain are on the verge of default, but that it would be dangerous to allow the situation in these two countries to deteriorate further. Reducing the level of external debt has to be one of the top priorities for both the Greek and the Spanish administrations, and it is clear that the only way to do this is by exporting more, importing less, and running a trade surplus. This is what the whole issue of restoring price competitiveness is all about, and since Spain no longer has the means to carry out a conventional devaluation the technique known as internal devaluation is the only one presently on the table and able to do the work in the time available.

So the immediate issue is not the inability of Greece and Spain to repay their external debt, but the fact that anti-crisis measures that simply have the effect of pushing up both the external debt to GDP ratio and the government debt to GDP one are hardly a helpful contribution. Both countries need to correct their external imbalances, not increase them further. What the Greek and Spanish governments need to apply are not policies which simply allow their countries to limp along from one year to the next, but reform measures which help them straighten out all the distortions which have accumulated during the course of the property bubble.

Obviously it would be proposterous to compare Spain's fiscal situation with that of Greece, and indeed I know no one who has actually suggested that this is the situation. The concern being expressed is not that Spanish finances are on the verge of bankruptcy, but rather that the level of government debt to GDP is rising very rapidly, and that unless growth is restored to the economy the sustainability of public finances will become a problem in the longer term. According to the most recent EU Commission forecast Spanish gross government debt to GDP is set to rise from 39.7% in 2008 to 74% in 2011.

The situation with unemployment and job creation is similar. José Luis Zapatero has at long last publicly recognised that Spanish unemployment will only start to fall in 2010 (and not 2009 as previously forecast). The only problem with this is that outside Spain no one seems to recognise this seemingly good news, since the EU Commission and the IMF both maintain their forecasts for no improvement in unemployment in 2010 or 2011. In fact the forecasts for growth in GDP are still so low for 2011 (1% in the best of circumstances) that it will obviously be impossible to create increased aggregate employment if there is even a minimum level of productivity improvement.

Let us be clear then: the number one topic facing the Spanish government is how to restore growth to the economy. All the policy measures applied up to now have evidently failed to achieve this end. And now, following pressure the European Union to change course, Spain is going to have to increase taxes and reducing spending, while interest rates are likely to start to rise slowly. Far from adding momentum to the economy, all of these developments will simply serve to reinforce the recession, driving the level of GDP further and further downwards, and of course debt to GDP levels further and further upwards.

Evidently the Spanish situation is not yet as severe as the Greek one is. But risks abound. In the first place, and as Olli Rehn says, what happens to Greece is vital importance to Spain.

“The problem in Greece concerning the excessive deficit and rapidly rising debt is a very serious one,” Rehn said. “It has also potential spill-over effects for the whole euro zone.”

But risks to Spain are also accumulating inside the country itself, in particular in the form of the large stock of unsold houses the banks effectively are taking onto their balance sheets, houses whose value are effectively an unknown quantity. There are an estimated one and a half million new properties in Spain awaiting a buyer. Some of them are on bank balance sheets after being accepted in debt for property swaps. But far, far more are indirectly on their balance sheet via loans to property developers which will eventually be defaulted on. Many of these loans are continuing to be restructured, with developers generally now unable to afford even the interest payments, which are tending to get "rolled over".

And now a new threat is looming: the rising rate of repossesions that the banks will need to accept in 2010. According to a recent article in the Spanish daily Publico - as reported by Spain Property Insight's Mark Stucklin - Spain's banks will have to cope with between a further 100,000 and 150,000 repossessions which are likely to come to a head in 2010. Many of these foreclosures started as far back as 2008, but have been delayed by overloaded courts unable to process the avalanche of repossession demands. From now on these foreclosures will be the “biggest problem for the banks” according to one real estate professional quoted in the article.

And the situation has become even more complicated, since the banks now find it very difficult to take such properties to auction, for the simple reason that the people who are normally there to buy them - the subasteros - are unable to get the credit from the banks that they normally use to buy with.

As Mark points out:

The big question is what impact this new batch of repossession – the equivalent of 15% to 20% of the current inventory of property for sale – will have on the market. Unable to sell at auction, the banks might end up offering them for sale at their write-off values. The danger is that an avalanche of these properties dumped on the market at write off values will send the market into a spin, with prices falling another 20% to 30%.

So, my final point is, we should not take the idea that the Eurozone is not about to fall apart as a reason for being complacent. Risks abound, and are painfully evident. And what we now need from Europe's leaders is action, more action, and yet more action to establish clearly in everyone's mind that they are aware of the task in hand, and are up to the job of carrying it through.

Stark Raving Mad?

2010-01-06T05:09:00.000-08:00

Not necessarily, but he is causing one hell of a fuss today. The Stark in question here is, of course, ECB Executive Board member Juergen Stark, who stated in an interview with the Italian Newspaper Il Sole 24 Ore that, in his opionion, the European Union would not help bail out Greece if the need were to arise. Certainly the initial reports of his statements sent shock waves round the globe. The euro dropped as much as 0.5 percent to $1.4282 after the remarks before laterrecouping its losses, and the yield on Greece’s 10-year government bond rose 4 basis points to 5.672 percent. Essentially it is hardly surprising that this should be the case, since following what happened in Dubai, two questions seem to have been in the forefront of investors' minds: i) who is going to pay for all that surplus second residence property that has been built all along Europe's periphery (from Ireland, to the Baltics, to Hungary, to Bulgaria, to Greece, to Sovenia, to Spain, and to Portugal); and ii) are the core European states really going to prop up the peripheral ones (in extremis) or will they follow the example of Abu Dhabi, and pick and chose what they will support and what they won't. More than anything else it is uncertainty on these two points which lies behind all the earth tremors currently shaking the monetary union.

In the interests of clarity, and before commenting further, I am reproducing the relevant extract in its entirely below, first in Italian, and then as a rough and ready English translation.

Il Sole 24 Ore: Il caso Grecia continua a tenere banco, nonostante le assicurazioni di Atene su una rapida riduzione del deficit. Non crede che un salvataggio debba considerarsi necessario o forse anche inevitabile?

Juergen Stark: La Grecia è in una situazione molto difficile: non solo il deficit è a livelli molto elevati, ma il paese ha anche sofferto una grave perdita di competitività. Questi problemi non sono legati alla crisi globale, ma sono stati creati in casa. E devono essere affrontati con le dovute misure economiche nell'interesse dei cittadini greci e nel rispetto delle responsabilità che il governo ha nei confronti della moneta unica e dei paesi partner. Le regole, ribadite in una dichiarazione dell'Ecofin a Cardiff nel 1998, sono chiare: la partecipazione all'Unione monetaria non consente alcun diritto a rivendicare sostegno finanziario da parte di uno Stato membro.

Il Sole 24 Ore: Ma appartenere all'Unione monetaria non significa anche solidarietà, oltre che responsabilità? Gli stessi Trattati permettono «un'assistenza finanziaria» nel caso di «gravi difficoltà» e in «circostanze eccezionali».

Juergen Stark: È vero, ma i Trattati dicono anche che queste circostanze devono «sfuggire al controllo» del paese in questione. Non è il nostro caso. Come ho appena detto, i problemi della Grecia sono prettamente greci, come ha ammesso lo stesso premier George Papandreou. In questi anni, il paese non ha tenuto sotto controllo i conti pubblici, né ha lavorato per migliorare la competitività. I Trattati prevedono la clausola di non salvataggio e le regole vanno rispettate. È un aspetto cruciale per garantire il futuro di un'Unione monetaria tra paesi sovrani con bilanci nazionali. I mercati si illudono quando pensano che a un certo punto gli altri Stati membri metteranno mano al portafoglio per salvare la Grecia.

Il Sole 24 Ore: The Greece situation continues to be a focus of attention, despite assurances from Athens on a rapid reduction in the deficit. Do you not believe that a rescue might be considered necessary or perhaps even inevitable?

Juergen Stark: Greece is a very difficult situation: not only is the deficit very high, but the country has also suffered a serious loss of competitiveness. These problems are not related to the global crisis, but were created in-house. And they must be addressed with appropriate economic measures in the interests of both Greek citizens, and with respect to the responsibilities that the Greek government has with both the euro and its EU partners. The rules, as set out in an Econfin statement in Cardiff in 1998, are clear: the monetary union does not allow any right of any Member State to claim financial support.

Il Sole 24 Ore: But doesn't belonging to a monetary union also imply solidarity, as well as responsibility? The very same treaties allow "financial assistance" in case of 'serious difficulties' and 'exceptional circumstances'.

Juergen Stark: True, but the treaties also say that these circumstancesmust be "out of control" of the country in question. Is not the present case. As I just said, the problems in Greece are purely Greek, as was admitted by the Prime Minister George Papandreou. In recent years, the country has not kept public accounts under control, nor has it worked to improve competitiveness. The treaties provide for a "no bail out clause" and these rules must be respected. This is crucial to ensure the future of a monetary union between sovereign countries with separate national budgets. The markets are deluded if they think that at some point the other States will put their hand in their wallets to save Greece

Well, a lot of points arise here. In the first place the ECB simply is not the competent authority to take decisions on whether or not to bail out a country. Decisions of this order would need to be taken by the EU Council (which essentially means the collectivity of individual States) and would involve financial intermediation in which the ECB may or may not participate. Secondly, Juergen Stark is an elected politician, and his view do NOT necessarily represent those of the present German government

As Laurent Bilke, economist with Nomura International says:

"ECB officials tend to consider themselves as the guardian of the temple of fiscal discipline, but Juergen Stark pushed maybe the argument a bit far this time. The ECB is just not in the business of bailing out countries. It is not competent to dispose (or not) of EU states, European Commission or IMF funds. Juergen Stark also sounded more alarmist than his fellow ECB colleagues have recently and this may not be very opportune in the current context. That is hitting where it hurts. The ECB President, in contrast, stressed that he was confident that the Greek government would do what is required, a more positive message."

But there is another detail which most of the press corps who jumped on the story seem to have missed, and that is that a bail out is not in question at the present time, and even if it was, EU institutions would find solutions to go round the problem, like a joint Eurobond issuance or some appropriate funding from the European Commission. Further, it is very important to note that Juergen Stark does not rule out common support in a country where the situation had gotten "out of control". This may, or may not, happen at some point with Greece, the only real reading you can put on Stark's statement is that we haven't gotten there yet. He could also be seen as giving a warning shot to the Greek authorities in the current situation - "sort the problems out yourselves".

Certainly Greek Finance Minister George Papaconstantinou seems to have got that part of the message, since he was very quick to jump in and point out that his government doesn’t need outside help to cut its budget deficit. “Frankly we don’t need that clarification,” Papaconstantinou told Bloomberg Television. “We don’t expect to be bailed out by anybody as, I think, is perfectly clear we’re doing what needs to be done to bring the deficit down and control the public debt.”

But doubts still remain, since while Papaconstantinou talks about correcting the budget deficit, everyone else is talking about deep structural reform and restoring competitiveness, and it isn't clear that the Greek government is single-handedly able to assume responsibility for this inside the country. As Jonathan Tepper of Variant Perception puts it:

The problems Greece faces are not problems the ECB can solve. Greece's problems are problems relating to competitiveness, real effective exchange rates, and fiscal budgets. The Greeks must address these structural problems themselves. If they were to seek outside help, the IMF would be the logical organization charged with helping countries in fiscal binds that are making structural adjustments. The ECB simply doesn't have the power or ability to do that. I'm afraid we'll likely see more internal civil unrest, as the necessary adjustments for Greece will be painful.

Mark Pittaway, Senior Lecturer in European Studies at the UK Open University goes even further, by adding a CEE dimension:

"If the zone does lock weaker economies into 'competitive disinflation' vis-a-vis an export-oriented Germany, why is it in the interests of 'peripheral countries' to say in the Eurozone at all? Why is it in the interests of CEE countries to attempt to join in the first place, since if Martin Woolf is right, it would mean Hungary and other states abandoning their long-term goal of having living standards like those in western Europe?"

"Given that political legitimacy in many European states is all about welfare, and 'European' legitimacy is about the alleged social superiority of a 'European model' over its Anglo-Saxon equivalents (whether this is actually true is irrelevant, the point is that many European believe it to be true), then the potential size of this crisis is quite big. And one thing is clear, that Brussels and others will have to do some fairly serious re-thinking if they want to go forward."

Basically, personally, I haven't that much to add at this stage to what I said yesterday, the big difficulty we have right now is making it clear who is authorised to do what, and then doing it.

Basically, what seems to be going on here is a huge poker-style game of brinksmanship, with none of the various parties (the Greek government, the EU Commission, the IMF, and the Credit Ratings Agencies - to name but a few - really absolutely clear about what the others are up to, or what they really want. You could even add-in more “stakeholders” (in terms of parties who will have to assume ownership of any final agreement) if you want, the French and German governments, for example, the EU Finance Ministers, the Greek Socialist Party, the Greek Trade Unions, the list, in fact, is well nigh endless.

This is really far from a desireable state of affairs for a team of people who collectively are going to have to try and solve one of the most complex problems to have emerged from the recent economic and financial crisis, and do it quickly, since there is a clock ticking away in the background. Evidently the Greek government should be having to negotiate with everyone else, but the others should have one common voice, and this is far from being the case, which is what leads to all the confusion, and is why Belka says the EU needs to put a mechanism in place to handle this kind of situation - a uniform mechanism which treats all EU members - whether inside or outside the Eurozone - fairly, and where the rules and procedures are clear to all. This mechanism, should, as I have suggested, include powers for the EU Commission to intervene over the heads of national parliaments (a need which is already evident in the Latvian case), and implement hard and unpopular solutions when they are in the interest of the entire community of Europeans. We cannot have one minority interest after another playing themselves off against the rest, it makes the Union harder to manage than a “hung” parliament.

Actually the FT's Ralph Atkins turns this amibguity into a virtue:

"Mr Stark’s comments fit with Europe’s policy of “constructive ambiguity” towards Athens - by which policymakers are deliberately being vague about what would actually happen if the worst came to pass. Pressure is thus being maintained on Greece to make good its pledges of fiscal discipline."

I am not convinced, I think all this ambiguity is more disconcerting than it is constructive, it isn't like keeping markets guessing before a rate-setting meeting. I think what everyone needs is some assurance that EU authorities are aware of the depth of the problem, have solutions ready, and are hell bent on implementing them. That is the message the financial markets need to hear, and they need to know who is going to be leading this operation.

Finally, I want to emphasise that my argument here shouldn't be read as saying that I don’t wish the EU was equipped to do the necessary and start to shoulder responsibility for Greece. My view is a more practical one: I simply think the EU is not yet sufficiently prepared to go in and tell Greece what to do, in part because Greece are one of the old EU15 and this makes everything more difficult. I simply think it is more practical to get the IMF go in and do the job. You don’t want “good boys” here, you need “nasty people”, with smoothly polished teeth, and indirectly this could give a weak Greek government the strength it needs to sell the changes to a reluctant citizenry.

It’s like taking a child to the dentist. Maybe they scream when the drill comes out, but ultimately they need the filling. But I also accept that the IMF has no magic bullet. I do however hope that the IMF is capable of learning from its recent experiences in the East.

One of the key issues which clinches it for me is the collateral rating issue. Do the ECB say no Greek bonds after the next downgrade (this certainly will cause some chaos, since half Greek bonds are held out of Greece)? It would be chaos, but it would be manageable. Or should the ECB keep the lower level criteria - then what happens to Italy, since this rule was made for Italy, and never forget, Italy is also slippin-and-a-slidin steadily into the default danger zone?

The thing is, my view is that the problem of not having the ECB take your bonds does become a serious one, since it will make it much more difficult to sell debt, interest rates rise, GDP falls, nominal GDP falls further, and debt to GDP keeps rising, as a result of which interest rates rise further, and eventually there is no alternative to default. On the other hand, if the ECB say don’t worry, we will take the bonds anyway, then there is little incentive to do anything, as we have seen over the last decade.

In essence, were the IMF managing a programme in Greece, then the ECB could make an exception, and then say to Italy - “you want to be an exception, then go to the IMF first, or better, put your house in order before you are forced to do so".

Danske on Eurozone Debt - The Peril of Internal Devaluations

2010-01-05T13:54:00.000-08:00

Guest Post by Claus Vistesen (Alpha Sources Blog)

This is really a follow-up to the earlier piece I wrote on my own blog today and my last piece on Eurozone imbalances and internal devaluation. In particular, I want to point you towards two things. Firstly, Edward has, no doubt after a long hard thought, come to the conclusion that Greece should be sent to the IMF or rather that it is ok to ask the fund for help in order credibly sort out the mess in Greece (and possibly Spain). This is not news as such since the proposition of sending ailing Eurozone countries to the IMF has been on the table for a while now. The main question basically is, as it has always been, whether the program proposed by Greece in conjunction with the EU and set in relation to what ever we might have left of the stability and growth pact (SGP) is really credible as a working solution.

Meanwhile, Danske Bank had a very interesting research note out today on the sovereign situation in the Eurozone and the potential for correcting not only in the immediate short term (i.e. preventing a collapse), but more importantly how to get debt to GDP ratios back on a solid footing within, let us say, a decade or so. As it turns out this is very difficult.

These are challenging times for public finances across Europe. Reducing debt to the Stability and Growth pact’s upper limit of 60% of GDP will not happen any time soon for most euro area member states. Indeed, even 100% of GDP appears an immense task for several countries. The situation is most dire in Greece and Ireland, which are to be found in the fast track lane for default in our mechanical “no change scenario”. However, it is still not too late to avoid default. If the plans put forward by Greece and Ireland are strictly adhered to, it would stop the debt-to-GDP ratio from sky-rocketing.

Now, Danske Bank's argument is based on some simple algebra of the government's budget constraint and some equally simple, one would presume, arithmetic. Basically, the gist is as follows and for all the attacks on Neo-Classical economics accounting, this argument is actually pretty solid.

Therefore, high nominal GDP growth and low interest rates on sovereign debt allow a country a larger deficit-to-debt multiple without increasing the debt-to-GDP ratio. A country with nominal growth lower than the interest rate level will on the other hand have to run primary surpluses in order to keep the debt-to-GDP ratio steady.

This is an important point to take away. Basically, it means that if you can maintain a high level of nominal growth (and what ever amount of primary deficit you run (in principle!)) the debt-to-GDP ratio can be kept in check. Well, we need to entertain this possibility a lot here I think and simply note that this is not likely to be relevant for many of the Eurozone economies going forward. This goes especially for those who are in the biggest trouble right these very days. In fact, the whole rigamole begins by taking to heart chart 4 and 5 in Danske's research note which shows that while Eurozone economies, in a pre crisis context, enjoyed high GDP growth (nominal) and low funding costs it is expected to be the exact opposite going forward.

This represents a gordian knot since it means that not withstanding the extremely tough austerity that Greece, Ireland and Spain (etc) now need to take in order to get the ship back into the wind through forced primary deficits, they cannot be sure that this in itself will bring the debt to GDP back on track. Much will of course depend on global yields here and the general discourse on fiscal adjustment and how sovereign risk (rising across the board) will quantitatively be reflected in bond yields.

Yet, I don't want to focus so much on bond yields here (although I do think they are important); rather I would like to focus on the other part of the equation as it were, namely that of nominal GDP. You see, this is where it not only gets complicated but also outright problematic. Consequently and since Greece, Spain, and Ireland are members of the Eurozone, the have no independent currency and thus the nominal exchange correction that would almost certainly had occured had these economies had a floating exhange rates now must occur through internal devaluation or outright price deflation.

So this is not only about public debt but also about net external borrowing which these economies now have to shed in order to become competitive and essentially in order to achieve growth in nominal GDP. However, in order to reach this point they need a large and severe bout of deflation exactly, one would imagine, brought about in part by running primary surpluses to simply shock-force the economy onto a more sustainable path. Notwithstanding the obvious cost on the employment from this process it has another very tangible costs. Price deflation thus, through its effect on nominal GDP, increases the real value of the debt and it is exactly this mechanism and how it intersects with the perspective offered by Danske Bank which is so damn important to understand here. And incidentally, as an aside, it is this point which Edward has been desperately trying to pass on during the past two month's worth of writing (see overview from link above).

---

PS1: I am lining up a paper on Eurozone imbalances (quantifying them essentially) which will also tackle the issues mentioned above in some detail.

PS2: Danske Bank's piece is worth reading in its entirety.

The IMF Is Ready To Help Greece If Asked - So Why Not Ask Them?

2010-01-05T05:16:00.000-08:00

"The EU should create a mechanism to help out countries which found themselves in Greece's shoes. But one has to believe Greece will solve its problems by itself." This is the view expressed by Marek Belka Director of the IMF's European Officein an interview with Reuters last week. Asked whether the IMF would be ready to help bail out Greece, Belka said: "Yes, we are ready. But it depends on whether the EU or Greece will request it."

In a separate interiew with IMF Survey Magazine (worth reading in its entirety) Belka cites Ireland and Spain as “good examples” of countries with “homemade imbalances” based primarily on “real estate and asset price bubbles”. As he points out, Ireland and Spain (unlike Greece) entered the financial crisis with “relatively low levels of public debt”, something which has enabled them “to react to the crisis by using the fiscal space that they had accumulated in good times”. “Now of course, both countries have been forced to start fiscal consolidation". And since, “In a monetary union, depreciating your economy out of the crisis is not an option...countries must rebuild their competitiveness through factory-price adjustment, which often means unfortunately, cutting wages.” He thus essentially reiterates the central point that Paul Krugman, I and numerous others have been making about this situation.

No Clear Decision Taker

So, as members of the ECB and EU delegations board their plane on the way to Athens tomorrow, they will have plenty of things to be thinking (and worrying) about. Basically, what seems to be going on here is a huge poker-style game of brinksmanship, with none of the various parties (the Greek government, the EU Commission, the IMF, and the Credit Ratings Agencies - to name but a few - really absolutely clear about what the others are up to, or what they really want. You could even add-in more "stakeholders" (in terms of parties who will have to assume ownership of any final agreement) if you want, the French and German governments, for example, the EU Finance Ministers, the Greek Socialist Party, the Greek Trade Unions, the list, in fact, is well nigh endless.

This is really far from a desireable state of affairs for a team of people who collectively are going to have to try and solve one of the most complex problems to have emerged from the recent economic and financial crisis, and do it quickly, since there is a clock ticking away in the background. Evidently the Greek government should be having to negotiate with everyone else, but the others should have one common voice, and this is far from being the case, which is what leads to all the confusion, and is why Belka says the EU needs to put a mechanism in place to handle this kind of situation - a uniform mechanism which treats all EU members - whether inside or outside the Eurozone - fairly, and where the rules and procedures are clear to all. This mechanism, should, as I have suggested, include powers for the EU Commission to intervene over the heads of national parliaments (a need which is already evident in the Latvian case), and implement hard and unpopular solutions when they are in the interest of the entire community of Europeans. We cannot have one minority interest after another playing themselves off against the rest, it makes the Union harder to manage than a "hung" parliament.

Timing As Well As Content Will Be Important

Problems and confusion at this point abound. In the first place, we still have no clear indication of what the final 2009 fiscal deficit number is going to look like. There has been a lot of speculation in the press, and little in the way of denial, so it seems to be the case that it will be above 12.7%, but exactly how much above may be just what those EU representatives are on their way to discuss.

In principle Athens submitted the first version of its budget report - known as its Stability Programme - to the European Commission yesterday (4 January), and it will be the content of this report that the ECB and EU Commission representatives will be travelling tomorrow to discuss. At this stage what the Commission have is a draft version for negotiation (there seems to be some doubt that this draft was even sent, but then some documentation must have gone to Brussels for them to talk about on Wednesday) and ammendment. The final plan will more than likely be submitted at the end of the month, after being discussed by the Greek cabinet on January 15 and put to the Greek Parliament on January 20.

According to the web portal Capital.gr there are three measures that both the European Commission and the European Central Bank seem to be insisting on: increasing VAT by one or two points, increasing the age limits for retirement and a continuing wage freeze until the deficit is brought below 3%. But according to the website, none of these is included in the Greek Stability Programme that was sent to Brussels. According to their report, "Greek officials will meet in Athens with EU executives to agree on the starting point, that is on the deficit level for 2009... Eurostat in January will also decide on the height of the deficit", which seems to suggest that the report I cited yesterday that even the 2009 deficit level (we are now in 2010 remember) forms part of the negotiations, a hypothesis which the ongoing silence from the Greek authorities only add credibility to.

In principle the eurozone finance ministers will discuss the outcome of the negotiations at their regular monthly meeting on 15-16 February, but apparently EU President Herman Van Rompuy has just "upped-the-ante" by calling an extraordinary meeting of Europes leaders for 11th February with the only topic - Europe's economy - on the agenda. This evidently on adds to the pressure on Greek Prime Minister Papandreou, since the purpose of the meeting is to allow the various countries to present their exit strategies from the crisis.

The Greek government is increasingly under siege, and the latest indication of this is their decision today to cut the adjustment period from four to three years, and reduce the country's deficit below 3% by the end of 2012. Obviously such decisions are not trivial, and not taken lightly, since the correction involved is rather large - basically the decision means that the Greek Finance Ministry will now need to “pull” between 24 and 25.5 billion euros out of the economy in three years. No mean feat this, even for a Herculean politicians like Papandreou. But the core quest still remains unresolved: it is not the velocity of the fiscal correction which is at issue, but its depth (in terms of structural character), and the fact that it should be associated with a substantial economic correction, capable of putting economic growth back on a sound footing.

Too Much To Do And Too Little Time To Do It In

Let's look now at why what is being proposed is likely to be quite hard. In the first place the Greek economy - before entering a direct body slam with the global economic crisis - had been growing at an average rate of something like one percent a quarter (or around four percent a year). Which looks like a pretty good performance, until you start to think about how they did it.

As can be seen in the following chart, the steady rise in Greek output was being fuelled by a surge in government spending (see chart below) and this gave the impression that the impact of the global crisis was slight, which it was initially, due to the massive support the government was providing, unsustainable support if you look at Greece's overal growth and debt dynamics.

In addition this extra demand being provided by the Greek government was doing nothing to resolve the underlying problem - which is the lack of competitiveness of Greek industry -and was simply sucking in imports to fuel the country's large current account deficit.

But the other part of the equation here is that Greek private consumption has also been losing momentum in recent years - a not infrequent phenomenon in countries with ageing populations, and thus it is unlikely that the Greek economy is going to see any strong internal impetus from this source in the years to come.

In fact bank lending to households, after growing at an rate of around 20% per annum over an extended period, is now down to an annual increase of only 3.9% (in October) and is still falling (see chart).

This is not due to s shortage of liquidity, since liquidity is now abundant in the Eurozone, but due to a lack of demand and unwillingness on the part of banks to risk lending to people with the kind of employment and income profile to be found among those asking for credit at this point in time (ie people with debts, or unemployment, business problems etc). On the other hand, since Greek government bonds are, at least at this point, effectively guaranteed by the Eurosystem, lending to government has naturally boomed.

So here is the problem. The Greek government is going to rein-back some 20 billion euros plus in spending over the next three years in a way which will only fuel the existing contraction. Consumer demand is unlikely to revive, and capital spending and foreign investment are likely to continue to remain weak (see chart below). So everything will depend on exports, and on how long it takes to return competitiveness to the Greek economy. If other countries who have embarked on this path in the last couple of years are anything to go by, results will not be quick in coming, which means the economy will contract, and prices will deflate, while at the same time debt to GDP will surge. This is why the Greek economy will need to be wrapped in cotton wool in the coming years, and why the name of the IMF continues to be mentioned.

Mixed-Signal Mix-up

The big issue in the whole current Greek melodrama, is the one highlighted in the quote by Belka at the start of this post - the EU still lacks clear mechanisms to handle a situation like the present one, and this only leads to more and more confusion, as the name of the IMF gets constantly being invoked.

Obviously the excess deficit process is clear enough. Greece is currently up to the point outlines Art. 126(8) of the Excessive Deficit Procedure (most other countries still being in the Art.126(7) antechamber - for once Greece could be described as being in the vanguard). For Greece to avoid sanctions, it must present a set of credible measures aiming at correcting the deficit, early in 2010, which in theory are as outlined in the draft programme that should have been submitted today and then discussed before the 15th of January. Should an agreement fail to be reached, Greece would then move on to Art.126(9), which is the last injunction before sanctions are triggered. In the hypothetical eventuality that agreement is not reached the sanctions could be things like a) the publication of additional information before issuance of bonds and securities, b) a revision of the ECB policy regarding its loans to the country, c) the requirement of a deposit to be placed with the European Community, and c) ultimately, fines. But really, not of these are either appropriate or desireable in the present situation, although (b) is obviously a possibility, even if it would need to be used as a form of pressure to achieve some other kind of outcome - like Greece voluntarily going and asking for help from the IMF.

But basically this is a measure of last resort, since I am sure all parties want - at this point - to keep this as an "in house" affair. But we in the EU still lack mechanisms, which is why the IMF route cannot be totally discounted.

But it is this uncertainty about just how much the EU has in the way of teeth, and how far it is willing to go in using those teeth that causes part of the problem. It is clear that both the ECB and the EU Commission are convinced that some sort of serious intervention in the Greek economy is essential. The problem is how they convey to Papandreou and Pasok that they are convinced, and how they demonstrate - to Greece, other EU countries and the financial markets - just what their level of conviction is.

On the other hand, even though the ECB is currently talking tough, no one really knows how far they are prepared to go. The ECB is currently accepting bonds which at least one agency rates at BBB- or above, but this is a crisis measure set to expire at the end of 2010 when the previous threshold of A- will be reinstated. ECB Vice-President Lucas Papademos has insisted that the ECB will not hold back on the decision to return to the old collateral standards for the sake of just one country, but at this point few analysts seem convinced, and indeed the only think that really will convince them is if they do eventually implement their threat.

Another way of thinking about the situation is to work back from the end point to the present. If Greece is going to have a really hard time keeping that last A- rating (or A2 in the case of Moody's), and if the ECB really is serious about reintroducing the old collateral standards, then a rubicon is going to have to be crossed in 2010, since while the Eurosystem could undoubtedly cope with a situation where Greek bonds were not acceptable as collateral, this would not be a situation to be welcomed with open arms. So why not take decisions now which will avoid it. That is to say, I find it hard to believe that the Greek government is in any position to refuse the final offer the EU authorities will make to them, so why not include in the list of requirements that the Greek government go to the IMF to seek help. This would give a much tighter handle to the EU on what the Greek government actually gets up to, as well as getting them off the hook about the ratings issue - since Greece would effectively be guaranteed by the Fund, and hence an exception could be made. This is not a perfect solution, but it may be the best we have currently available. What we need to do is put that mechanism together, and do it fast, but in the meantime, let the words of Marek Belka not be lost: "Yes, we are ready. But it depends on whether the EU or Greece will request it."

Other background posts to this situation are:

That "Staggering" Greek Deficit Continues To Stagger Onwards and Upwards

Why The Ratings Agencies Are Right And George Papaconstantinou Is Wrong

Europe Needs Action Not Words From The Greek Finance Minister

So What's It All About, Costas?

The Velocity Of Modern Financial Crises

That Which The ECB Hath Separated, Let No Man Join Together Again!

It's All Greek To Me

That "Staggering" Greek Deficit Continues To Stagger Onwards and Upwards

2010-01-03T11:58:00.000-08:00

Only a few short weeks ago the financial and economic world declared itself staggered to learn that the 2009 Greek fiscal deficit was going to come in at 12.7% (mind you, as the conservative Dutch newspaper NRC Handelsblad pointed out, there was plenty of evidence of what was coming available long before for those who really wanted to look into the matter). Well, now get ready to be staggered again, since according to a spate of articles that have started appearing in the Greek press, the number which only so very recently had us all reeling in shock may be on its way up again, if only by "a few tenths of a percentage point". How many "tenths of a percentage point?" Well at this stage this isn't exactly clear. On 28 December the web portal Capital.gr reported (in Greek, but try Google translator):

“Temporary (cash) data from the flow of government revenues have fallen quite substantially when compared to those of the last quarter of 2008,... not only data for October-November, but the first indications for December show that the delay in the flow of public tax income (mainly) is important. The Treasury has also begun to "mumble" about the possibility that the deficit in 2009 is going "to close a few decimals above the anticipated 12.7 %...". How many decimals? This is unknown at present, although the General Accounting Office (YPOIK) displayed some optimism that the gap will not exceed 0.1% - 0.2% of GDP (ie the deficit will remain below 13%) even if some do not hesitate to speak of a deficit of over 13% of GDP.”

So it definitely looks like the deficit is likely to be signed off at something over 13%, but according to this article (Greek again, I'm afraid) from "Ta Nea online" on 2 January, speculation is still rife that the breach in the 13% mark could be substantial, and that the final figure may even be as high as 14.5%. If it fear was confirmed, it should not really catch is completely by surprise, since it could well be that now that spending is not accelerating as it was before revenue may be contracting very fast (for a simple illustration of how diminishing stimulus - let alone negative stimulus - works, see this post by Paul Krugman), and with both GDP and prices falling (systematic deflation), the deficit as a % of GDP can easily shoot up. Then again, there are reasons why it might be politically convenient to "book-in" a larger deficit in 2009, in order to make next years cuts look a lot bigger than they actually are (you start from a higher base), so who really knows. Will the true Greek 2009 fiscal deficit please stand up!

The more interesting dimension in the Ta Nea article is all the potential for intrigue it goes into. Evidently, nothing here is ever what it seems to be, and the article speculates that there are those in Pasok (the Greek socialist party) who are wheeling out and using the threat of declaring a 14.5% deficit as a bludgeon with which to try and moral-blackmail Brussels. The thinking seems to go that Brussels cannot afford to let Athens go to the wall at this point, so they would not want to see the kind of pandemonium which might break out if the markets cottoned on to a deficit of this magnitude. On the other hand key people in the governing party don't want to accept the kind of deep reforms the Commission is talking about in the Greek case, so they want to trade a smaller budget deficit for a bigger proportion of one-off measures. But then there are even more wheels within wheels, since it seems Brussels is adamant that it wants to present the reform package as a largely "made in Greece" affair, while those in Greece want to sell the package to their voters as being imposed by Brussels, so there are those who think the 14.5% deficit menace is being cooked up simply to make the Commission furious and get it to read the trems of the riot act out in public. Naturally, protagonists of this viewpoint should remember that old Greek saying, "whom the gods would destroy they first drive mad", so they need to be careful. And as the other old English saying goes, playing around with primed bombs is a decidedly dangerous thing to do. Definitely not recommened.

Structural Reforms AND Internal Devaluation

The Greek parliament passed a 2010 austerity budget just before Christmas aimed at reining in the country's soaring deficit by cutting public spending by 10 percent and cracking down on tax evasion. The budget is the government's response to growing pressure after the three main credit ratings agencies all downgraded Greece’s debt. Prime Minister Papandreou has vowed to bring the deficit to below 9.4 percent next year, but doubts remain as to whether the need for fundamental reform has been accepted, or whether Greek politicians are simply looking to apply some cosmetics and ride out the storm. In theory the 2010 budget aims to cut the 2009 deficit to 9.1% of GDP in 2010 through a combination of spending cuts (€8 billion are currently planned) ) and tax increases.

However, the budget has already been criticized by both the EU and the ratings agencies for relying too much on one-off measures, and too little on permanent reforms like cutting the public sector wage bill or stamping out widespread tax evasion. Moody's decision to cut its sovereign debt rating for Greece to A2 from A1 was widely interpreted as a mini victory for the Greek administration, but it could easily turn into a Pyrrhic one if the measures taken fail to convince. As Moody's stressed

"A further downgrade will depend on the Greek government's plan being followed through - as demonstrated, for instance, by a sustained increase in tax revenues and/or the effectiveness in reining in expenditure."

Finance Minister George Papaconstantinou stressed the government's commitment to far-reaching changes: "With this budget we begin our program of restructuring the economy...and cleaning up public finances," he said. But with Greece already under heightened EU budget supervision, what is needed at this point is something more than mere words, and the government will have to move quickly to convince both Europe's leaders and the financial markets that it is serious about reform.

A key moment is bound to come in mid-January when the government is due to present the EU Commission with its three-year stability and growth timetable outlining the government's medium-term plan to bring the deficit below an EU-mandated ceiling of 3% of GDP by 2013. The government has already pledged itself to introduce sweeping tax reform to boost government revenues, overhaul Greece's deficit-ridden pension system and outline plans for some €2.5 billion in privatizations, and it is presumeably the sum total of all these that is leading to those tensions in the governing party Pasok.

Aside from the fact that these measures are all very unpopular with the party's traditional electors, another problem arises. Most of the measures so far referred to are what could be referred to as "structural reforms", and these are very badly needed to lift Greece's long run growth rate slightly, and ensure fiscal sustainability in the face of a rapidly ageing population. But Greece has another problem - it's enormous current account deficit.

This deficit is largely a product of the large goods trade deficit, itself a reflection of the substantial loss of competitiveness that has characterised Greek industry during the years of the Euro-driven boom. Now the imbalances that this has all produced need to be corrected, and this correction needs to happen simultaneously with the fiscal correction. What this means is that in addition to the structural reforms Greece also needs to carry out what is known as an "internal devaluation", in order to make domestic industry more competitive in both the import and export sectors. And here comes the catch, since this devaluation will mean that GDP will fall even faster than otherwise, as prices also fall. Which means that the fiscal deficit will tend to be higher, and the debt to GDP level will rise even more rapidly than envisaged in the EU Commission forecasts - a process we have seen only to clearly in Latvia lately. And as many people continually point out, such processes are inherently difficult to carry through due to the political and social tensions they engender.

Just how serious this kind of problem this can become was highlighted in a Bloomberg article only today, where they point out that Japanese gross domestic product shrank to an annualized 471 trillion yen (or $5 trillion) in the third quarter of 2009. If you don't correct for changes in prices this takes Japan GDP back to levels not seen since 1991. As Paul Sheard, global chief economist at Nomura Securities International, points out, this tumble is unprecedented among developed economies since the 1930s. What's more, as a result of the ongoing economic contraction, the Finance Ministry now projects tax revenue in 2010 will drop to a quarter-century low.

More than a fifth of Japanese are over 65, according to the National Institute of Population and Social Security Research. The nation’s population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade, the Tokyo-based, state-sponsored institute estimates.

Japan faces the biggest fiscal gap among the Group of 20 advanced and emerging nations during the coming five years, according to a Nov. 3 report by the International Monetary Fund in Washington. Its deficit will remain as high as 8 percent of gross domestic product in 2014, compared with 6.7 percent in the U.S. and a balanced budget in Germany. Japan’s debt is projected to be 246 percent of GDP that year, compared with 108 percent for the U.S. and 89 percent for Germany, according to the IMF report.

Now Greece can't have exactly the same problem as Japan for a number of reasons. In the first place Japan currently runs a massive current account surplus, while Greece has an equally huge deficit. Further, Greece has no equivalent of the Bank of Japan, since it has no direct channel of influence over the ECB in Frankfurt (which evidently is responsible to a whole group of countries). But even more to the point, as part of a currency union there is an obvious limit to the deflation process, as the fall in prices would eventually restore competitiveness with the other euro area countries (which is where the root of the problem lies). But in the meantime the level of debt to GDP could be lead to rise even more sharply than currently anticipated, and even if the ECB should prove willing to support such a high debt to GDP level, it would still pose serious taxation and growth issues for Greek society.

So the bottom line here is that nothing is going to be easy. Greece now has a hard road to travel, and will need all the institutional support she can muster. Which is why it is high time Greek political leaders realised that this time there really is nowhere to hide, and that all the old games and tricks simply won't work now. They are playing with the future of others, would that they were capable of realising this.

Ten New Year Questions For Paul Krugman

2010-01-03T03:07:00.000-08:00

I have an interview with Paul Krugman in today's edition of La Vanguardia (in Spanish). Below I reproduce the English original. As will be evident, there are many topics about which Paul and I are far from being in complete agreement. But on one topic we are in complete harmony: the diffficult situation which now faces Spain, the need for internal devaluation, and the threat which continuing inaction on the part of Spain's current leaders represents for the future of the entire Eurozone.

One

Edward Hugh: In your NYT article "How Did Economists Get It All So Wrong", you state what I imagine for many is the obvious, that few economists saw our current crisis coming. The Spanish economist Luis Garicano even made himself famous for a day because he was asked by the Queen of England the very question I would now like to put to you: could you briefly explain to a Spanish public why you think this was?

Paul Krugman: I think that what happened was a combination of two things. First, the academic side of economics fell too much in love with beautiful mathematical models, which created a bias toward assuming perfect markets. (Perfect markets lead to nice math; imperfect markets are a lot messier). Second, the same forces that lead to financial bubbles – prolonged good news tends to silence the skeptics – also applied to economists. Those who rationalized the way things were going gained credibility until the day things fell apart.

Two

E.H. : The late Sir Karl Popper used to contrast what he regarded as science with ideologies like Marxism and Psychoanalysis, because there seemed to be no way whatever of consenually agreeing with their practitioners a series of simple tests which would enable their theories to be falsified. Some critics of neoclassical economics - including Popper's heir Imre Lakatos - have expressed similar frustrations. Do you think we economists are, as a profession, up to the challenge of formulating testable hypotheses in such a way that the public at large might come to have more confidence in what we are up to, or are we a lost cause?

P.K.: I really don’t think that’s a helpful way to pose this question. Economics is about modeling complex systems, and as such the models are always less than fully accurate. What economists do need, however, is some demonstrated ability to get big things right. They had that after the Great Depression, when Keynesian economics clearly made sense of both the depression and the wartime recovery. But now the profession needs to get back on track.

Three

E.H.: Comparing the types and levels of indebtedness in the United States as between 1929 and 2007 one factor immediately stands out, the importance in modern times of the financial sector. You have repeatedly drawn attention to this phenomenon, and to how the unbridled growth of the institutions associated with it inevitably sowed the seeds of the problem which eventually came. Is there a road back? Can we reduce the strategic importance of this sector in developed economies and still generate meaningful economic growth?

P.K.: We grew fine for 30 years after World War II with a much smaller financial sector. I think if we tax and regulate the sector, we can replace it with other, more productive uses of resources – everything from manufacturing to health care.

Four

E.H.: Another of the distinguishing characteristics of the global economy over the last decade has been the development of large and sustained imbalances, with the US-China one being only the most publicly visible. Here in Europe we also have strong and notable differences between export driven economies like the German and the Swedish ones and many of those in the South and East which have evolved models based on consumer and corporate indebtedness and import dependence. Do you think we have the policy tools available to address such issues, and if so, where do we start?

P.K.: On the domestic side in advanced countries, financial reform should help reduce debt reliance. As for the developing country capital surpluses, that’s heading for a big confrontation. In the end, either China in particular increases domestic spending, or there will be some kind of at least threatened trade war.

Five

E.H.: One of the standard pieces of economic observation about countries recovering from financial crises is that their recoveries are export driven. This has now almost attained the status of a stylised fact. But as you starkly ask, at a time when the financial crisis is generalised across all developed economies - whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them - to which new planet are we all going to export? Maybe we don't need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies. Do you think there is room for some sort of New Marshall Plan initiative, to generate a win-win dynamic for all of us?

P.K.: Um, no. Not realistically as a political matter. We’ll be lucky if we can get the surplus developing countries to spend on themselves. My guess is that our best hope for recovery lies in environmental investment: taking on climate change could, in terms of the macroeconomic impact, be the functional equivalent of a major new technology.

Six

E.H.: Last December you publicly warned of a burgeoning economic crisis on Europe's outer frontiers. Indeed you even went so far as to state that the center of the present crisis had "moved from the U.S. housing market to the European periphery" - and by periphery here I take it you mean countries like Ireland, Spain, Greece, Romania, Bulgaria, Hungary and the Baltics. With hindsight, and looking at how Europe sovereign debt, with Greece in the forefront, has suddenly become the "plat du jour" for the financial markets, this seems to have been extraordinarily perceptive. What was it about the situation on Europe's periphery that attracted your attention at such an early stage?

P.K.: Numbers, numbers, numbers. Those huge current account deficits practically screamed “bubble”. In general, it’s been amazing how useful even very rough measures of imbalance have been at predicting crisis, in everything from U.S. housing to Latvia. And that makes it even more amazing how few people recognized the warning signs.

Seven

E.H.: One of the most significant recent monetary initiatives - the Euro - is now nearly ten years old. On its fifth birthday Ben Bernanke described it as a "great experiment", do you think this description still fits the case, or is it now possible to start to draw some tentative conclusions?

P.K.: It’s still very much an experiment. We’re only seeing the real downside now, as the eurozone tries to cope with the unwinding of large internal imbalances. Until we see how that goes, the judgment on the euro will remain in doubt.

Eight

E.H.: A number of Eurozone economies are currently in some difficulty due to their high general level of indebtedness and a loss of price competitiveness which makes exporting their way out of their problems quite hard. This issue becomes even larger given that these economies no longer have a currency to devalue, In a speech earlier this year in Argentina you said that Spain now had no alternative but to carry out a systematic reduction of prices and wages in order to restore competitiveness. For a Spanish public which is far from convinced that this is the case, could you briefly explain why this is so?

P.K.: Put it this way: for a number of years Spain could pay its way within the eurozone by selling assets, mainly real estate, as the inflow of capital financed a huge housing boom. That allowed Spanish wages to rise relative to those in other European countries. But now the housing boom has gone bust, and the big inflows of money are over. So Spain needs to compete in producing real stuff, such as manufactured goods. And it won’t be able to do that unless it has a major gain in productivity through wage reductions.

Nine

E.H.: In the Latvian context the expression "internal devaluation" has been advanced to describe this kind of wage and price correction process. The expression has a very attractive feel about it, but as you recently pointed out in your NYT blog (The Pain In Spain) the changes involved are far from easy to implement, with consequences which are normally none too pleasant for those on the receiving end. Indeed they bear a striking resemblance to what used to be called wage and price deflation in the 1930s. Have we really advanced so little in all these years, or are there now more sophistocated policy instruments available to public authorities to implement such changes in a way that parallels the monetary policy improvements which we have seen in action during the present crisis?

P.K.: I wish I had some clever suggestions. But the essentials of economics change much less than the façade. The truth is that Spain is very much in the same situation as gold-standard countries in the 1930s; in some ways worse, because it lacks the option of using trade policy as a substitute for devaluation. So deflation it must be.

Ten

E.H.: Finally, as one decade draws to a close, and another opens, are there any grounds for optimism? You often speak of the return of depression economics, is what we once called the "modern growth era" now decidedly over, or are we simply passing through an interlude, with a new dawn out there waiting for us, somewhere just over the horizon?

P.K.: We will recover eventually. And we have learned some things since the Depression, which was why this hasn’t been nearly as bad. Overall, leadership is better – I’m especially relieved that we have smart, well-intentioned people running my own country, which is a major improvement. So sure, things will improve. But it’s going to be a hard slog.