What A Difference A Day Made!

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

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?

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

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?

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?

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

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.