Feldstein on the Coming Greek Default …

… and France’s and Germany’s risky postponment gamble.

Excerpt:

“The markets are fully aware that Greece, being insolvent, will eventually default. That’s why the interest rate on Greek three-year government debt recently soared past 100% and the yield on ten-year bonds is 22%, implying that a € 100 principal payable in ten years is worth less than € 14 today.”

My comment: the best analysis of the current situation by the economist that clearly saw the future consequences of the euro as soon as projected, in 1992.

The complete post is well worth reading, here .

Greece on the Brink, Euro Should Fall Further

Twenty-four centuries after History’s first sovereign default, that of ten Greek municipalities in the 4^th century BC (the creditor was the temple of Delos), the country is at the edge of a major default, five times the size of Argentina’s default in 2001.

The expected “haircut”, could be as severe as 80% of the debts’ amount. But it would still be manageable, as far as French and German banks, as well as the ECB, are concerned, because they are said to be able to weather this magnitude of losses, given the small absolute size of the Greek economy and thus of its debt, compared to the size of the whole European economy and of the banks themselves. Their shares have been savaged nonetheless, for fear of something worse. The real danger would come from investors’ reaction to a Greek default: many would be selling Italian and Spanish government bonds to avoid a similar amputation on their much larger holdings of these countries’ debt, thus making for a fall of bonds’ market values and a rise of interest rates, and further aggravating the state of these governments’ finances. Italian and Spanish haircuts would also inflict much larger losses on the European banks and that would jeopardize the financial system in Europe, and maybe elsewhere too.

Fearing this, European governments, under pressure from the US, appear now ready to issue more bonds (possibly Eurobonds, even though it is not significantly different from pure German bonds) in order to avoid Greece a default. And the ECB is ready to lend more money to the governments (a monetization of their debts).

The question is: while all this would be good for the banks, would it be good too for economic growth? Incurring more debts is not going to help European economies to deleverage, nor reduce the burden of their over-indebted governments. It would increase in fact the debt/GDP ratio. But monetization would help:  is Mr. Trichet, finally, seeing the light and accepting a depreciation of the euro (which has already begun during the past week, the euro falling to less than 1,35 dollars)? There is still, however, a very long way to go to a value for the euro nearing equilibrium … (a one for one value to the dollar or even less in my opinion).

For Greece however, absent a very large depreciation of its currency, the drachma that is, after an exit from the euro zone, one cannot hope a return to positive growth even after default, but on the contrary a prolongation of the economic slump.

To conclude, remember that Japan tried the increased indebtedness policy strategy to get out of depression for a decade, thus avoiding the worse outcome, but accepted stagnation to this day. In a balance sheet recession, more debt is not the solution. A major realignment of exchange rates accompanied and caused by differential, and possibly massive, money creation is required. This is the common element between the 1930s required exit from the gold standard, and the present day required exit from the de facto Deutsche Mark standard. The later the exit, the later will be the return to growth.   

Read a very interesting Bloomberg post covering the very wide range of possibilities here .

The Most Dangerous Decade

A difficult transition awaits developed, corporatist capitalist economies: their problem is how to downsize both states and corporations to confront the competition of emerging economies in the new era of “small is efficient”.

Here is a lucid diagnosis posted in the CNBC’s blog:

“Robin Griffiths, technical strategist at Cazenove Capital, told CNBC that key markers, including the long-term low yields on U.S. Treasurys, indicate that the U.S. is in a depression not just a recession.

The bond market is clear and unequivocal in its message—this is a depression, not just a period of slower growth," he said, adding that a different approach was needed by developed economies to get out of the current mess.

History shows that what we need are small government, low taxes, and low regulation, but what we have is big government, big taxes, and big regulation, which is not going to work this time," Griffiths said.”

This is nothing less than a U-turn in economics conceptions and policies.

The European Debt Crisis

An excellent post by Jeffry Frieden, Professor of International Peace at Harvard University, in Econbrowser, yesterday: “Europe’s Lehman Moment”.

Frieden explains that “Europe is in the midst of its variant of the great debt crisis that hit the United States in 2008. Fears abound that if things go wrong, the continent will face its own “Lehman moment” – a recurrence of the sheer panic that hit American and world markets after the collapse of Lehman Brothers in October 2008.”

Excerpts:

“most of the public discussions have been highly misleading. In Northern Europe, and especially in Germany, the tone has been one of outraged indignation. The high moral tone is misplaced. Certainly many Southern European banks and households, and the Greek government, borrowed irresponsibly; but German and other Northern European banks and investors lent just as irresponsibly. It’s not clear that there’s any real ethical distance between irresponsible borrowers and irresponsible lenders.

And most Northern Europeans also seem to believe that the bailouts have gone to lazy Southern Europeans. In fact, their purpose has been to shore up the fragile Northern European financial systems. German banks are among the weakest in Europe; some of them (especially the state-owned landesbanks) are effectively bankrupt. If they were forced to mark down their Southern European debt, they might well collapse in a heap, and the European financial system could grind to a halt.”

“In Europe as in America (in 2008, JJR), the real question is how the costs of this devastating debt crisis will be distributed. Who will pay – creditors or debtors? Taxpayers or government employees? German or Greeks? More realistically, what combination of sacrifices will be politically tenable, both across countries and within countries. The aftermath of every debt crisis sinks into conflict over who will bear the burden of adjustment to the new reality.”

Europe’s experience, however, differs from that of America’s because of the existence of the euro. While the United States went on a consumption spree financed by borrowing trillions of dollars from abroad, much of it going to the housing’s market, in Europe the ECB’s interest rates at “Northern” relatively low levels have been made available – due to the euro – to rapidly growing countries in Southern Europe that had previously had high interest rates, reflecting both their higher inflation rates and their past exchange rate risks.

It followed that for a decade, a group of countries on the edge of the Euro zone borrowed massively from Northern European banks and investors. In Spain, Portugal, and Ireland, most of the borrowed money flooded into the overheated housing market, while in Greece, it helped finance a continual budget deficit and a consumption boom.

This, I would add, even though Frieden does not mention the point, is a classical case of an artificially distorted price (here the “Northern euro interest rates” offered, due to the euro and the single monetary policy, to the more inflationary and more risky Southern borrowers that should have paid inflation and risk premiums) generating a massive misallocation of resources, and specifically a boom in borrowing that reached unsustainable levels. As in the U.S. case, the responsibility of the lenders is a major one: they made huge profits in providing excess finance to the South, just as the mortgage lenders in the U.S. were offered an excess supply incentive by the governmental regulations subsidizing housing finance.

Frieden rightly concludes that the very solvency of major European financial systems is at stake and that “this – not some abstract desire to extend a hand to the Greek and Portuguese people, or to save the euro – has been the principal reason for Europe’s ongoing debt bailout.”

But until now, these bailouts have not been enough:

“It seems clear that the Greek and Portuguese austerity measures will not be sufficient to allow the countries to service their debts; Spain seems on the verge of a similar slide into default; and even Italy is now at risk of going the way of the other debtors. Some or all of these debts will have to be restructured, the interest rates reduced and maturities extended. If not, there will be a wave of defaults whose reverberations will rival those of Lehman failure.”

What Frieden does not contemplate, however, is that the situation is made much worse by the existence of the euro, and the absence of a central government in Europe. The euro has destroyed, over a decade of existence, the competitiveness of the Southern economies that benefited mostly to German exports. It follows that the austerity policies intended to reduce the indebtedness of the South are applied to enfeebled economies, thus pushing them further towards contraction and default. Today, the U.S. economy is still paying the price of the credit bubble’s burst. But in Europe the price will be much higher if the Southern economies are not allowed to regain competitiveness through an exchange rate depreciation that would purge it from the large costs differentials relative to the rest of the world in general (due to euro overvaluation) an to the Northern ones within the euro zone, accumulated over a decade of euro membership. And that means both a euro depreciation, and, on top of it, specific national currency depreciations that imply a return to national currencies.

The euro zone is thus facing a worse challenge than the one to which the U.S. were confronted in the 2008 debt crisis, because not only the sharing of losses is at stake, but simultaneously a radical reform of the monetary constitution is required. While the U.S. economy if following a slow, uncertain path back to recovery four years after the crisis, the recession could be much worse and extend for a longer period in Europe because of the difficulty involved in accepting to acknowledge the reality of the euro’s failure, and of the responsibility of the single currency in the current crisis. What is required is nothing less than a reversal of the monetary empire-building of the last few decades. And I understand that this is a rather hard truth to swallow for the euro zone elites.

The whole post is well worth reading here .

Possible Outcomes for the Euro

The Financial Times presents a very clear and pedagogical explanation of the consequences of a Greek default, leading to a possible euro exit and potential euro break up,  here , including an interactive map describing the mechanism and the succession of events.

The emphasis is put on the “nightmare” that this scenario would represent for

Greek and other European citizens. As such, however, the presentation is unbalanced, first because it neglects to point the responsibility of the euro in leading our economies into this dead end, and second because the high cost of the alternative before us, i.e. higher taxes everywhere in Europe, leading to a deep depression and reduced levels of living for many years to come, is not mentioned at all.

As noted by Paul Krugman today in his blog, “The Conscience of a Liberal” (September 17):

 “It’s astonishing how many European officials and unofficial wise men insist, with a great air of wisdom, that the euro crisis was caused by failure to enforce the stability pact — that is, limits on deficits and debt. How hard is it to look at the data and discover that Ireland and Spain appeared to be fiscal paragons on the eve of the crisis, with budget surpluses and low debt? Yet another triumph of the Very Serious narrative over easily checked facts.”

Indeed, the euro crisis is the result of a chronic overvaluation of the euro with respect to the inflation rates of several member countries, that destroyed their competitiveness and led to a negative cost of funds (the ECB borrowing rate minus the current inflation rate) in many countries, and, logically, to excess borrowing by the private sector and also by governments when the 2008-2009 crisis left them in need of a fiscal stabilization policy, absent any possibility of using the usual loosening of monetary and exchange rate policy to fight the downturn.

This is again the case today. The best policy would be one of substantial depreciation of the euro that appeared likely a few days ago, when its dollar value fell from 1,45 to 1,36, raising the hope that it would fall further to more reasonable values of about 1,1, or even better 0,9.  But this was not to be and it returned towards 1,4 or 1,5.

The second shortcoming of the Financial Times article and of the governments’ official position is in the neglect of the consequences that “saving Greece and the euro” will exert on the economy. The defense of an overvalued euro will continue to depress the European economies (with the possible exception of Germany) while increasing taxes to subsidize Greece and other southern countries (by further transfers to their governments and banks), and simultaneously limiting money creation by the ECB, will make a deep recession more likely.

The real choice then is between disruption now (default and possibly early euro exit) and a durable depression and disruption tomorrow. Politicians having, like the rest of us, a preference for present wealth over future one, and thus for future losses over present ones, it is not difficult to forecast what alternative is most likely.

Given the recent policy choices of the largest governments within the zone, my guess is that they will try to consolidate the euro now by all means, “whatever the cost”, as they repeatedly pledged, that is, by increasing taxes at home and transfers to bankrupt governments, and dampening an already fledging growth to avoid the immediate turmoil and political costs of Greece’s and others’ bankruptcy. They again further the “kick the can” process for a few weeks or months, and by reducing temporarily the risk of an euro exit or break up in the near future they maintaining a high price of the single currency in the markets, and, in the process, lead their countries towards a depression in order to avoid the complete destruction of their political capital and the loss of the coming elections. 

Trying to avoid economic turmoil and political losses they’ll get both economic depression and political turmoil.

Alesina and Giavazzi on How to Cut Deficits

A good advice for deficit ridden governments.

Excerpt:

“The experience of Italy in the 1990s is consistent with three lessons that we have learned from examining examples of large fiscal consolidation in OECD countries with a government sector that accounts for well over 40% of GDP:

1.    Only fiscal adjustments based on structural reductions in spending (as opposed to temporary cuts) can have a lasting effect on the debit-to-GDP ratio.

Tax-based  adjustments simply keep filling the holes in the budget opened by automatic increases in spending.

2.    Cuts to government spending have smaller recessionary effects than tax increases.

3.    To the extent that spending cuts have a negative effect of output, this can be offset by enacting structural, growth-enhancing measures.”

My comment:  I am not too sure about point 3, either about what they mean or if they are right in general.

Point 2 however is straightforward, but usually not understood by policymakers: since the welfare losses from taxes increase as the square of the marginal tax rate, reducing taxes in general exerts a powerful positive effect on production. The same for a tax cut that accompanies a spending cut, leaving the budget deficit unchanged. This is the expansionary effect of a balanced budget reduction (the inverse of the so-called “Haavelmo theorem” of the expansionary effect of a balanced budget increase, in an economy with much unemployed resources).

This effect should be especially strong in the European economies where overall tax rates are high (a discussion of which taxes should be reduced for maximum result is of course in order).

Accordingly, making one more step in the right direction, one should advise European governments not to try to reduce too hastily budget deficits (as Ms. Lagarde admonishes them) but to cut spending resolutely while cutting taxes even more, not less.

But maybe this is too complex for the limited economic understanding of politicians (and their advisers).

The Alesina and Giavazzi paper concerns Italy but the conclusions are also of value for other European economies. It is downloadable here .

Further reading: Alberto Alesina and Silivia Ardagna, “Large changes in fiscal policy: taxes versus spending”, revised October 2009, on Alesina’s Harvard website. 

The Eurozone Double Dip is Almost Here

That’s what Edouard Harrison* writes in Seeking Alpha.

Excerpt:

“The euro acts as a gold standard for individual euro zone members. As with the gold standard, euro zone members abdicated currency sovereignty in order to benefit from the price stability of the currency tie. Individual euro zone sovereign states are now currency users with limited policy space, meaning that a recession must be met with the deflationary response of pro-cyclical fiscal policy (budget cuts and tax increases).

Over the medium-term, this decreases demand and reduces economic growth. In a credit crisis, when private sector debt levels are high, debt deflationary forces of reduced output can lead to falling asset prices, debt distress, deflation and depression.

I see the procyclicality as one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budgeting during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.

(…)

In the past few months, I have become negative on the euro zone’s chances of survival. I no longer believe the political imperatives for the euro zone will be enough to overcome the politics of this next downturn.”

* Edward Harrison is the founder of the blog Credit Writedowns (www.creditwritedowns.com) and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.

My comment: Neat and concise summary.

A Simple Truth Beginning to Be Recognized

By David Cottle on the Wall Street Journal’s blog “The Source”: “Leaving Euro Zone Isn’t Impossible”, here.

The author still exaggerates the difficulties of getting out, compared to those of staying in the zone. But most commentators now tend to get away from the Eichengreen’s fallacy that the participation in the eurozone is forever.

The End of Empire by Stealth

A recent post by “Charlemagne” in The Economist (September 3^rd) describes “the end of Monnet”, the EU’s godfather.

“The French functionary believed in gradually unifying post-war Europe through discrete projects run by a caste of technocrats, with the end-point left deliberately ambiguous.” His method has gone far. Too far in fact.

By the time when the common market project – a classical free trade zone with obvious economic benefits for the protectionist and fragmented post-war European economies – was achieved, in the late 1980s, the caste of eurocrats led by the prototypical Jacques Delors launched a very different enterprise, that of a supranational public good, a single currency, meant to force a later political integration of several nation-states members of the European economic association. Instead of decentralization through market unification, the process became one of statist centralization without the explicit consent of voters. It was a process of technocratic empire-building by stealth.

The whole enterprise is now in shambles because you cannot manage a public good without a centralized political authority, a state in fact. And precisely at the moment when this statist project was launched, in the 1980s, the underlying prerequisites for its eventual success vanished. On the political ground, the integration of several independent states, quite difficult in itself, requires a common external enemy against which the fundamental public good of a common defense could provide the benefits of economies of scale and increased efficiency. But by 1991 the Cold War was over and the USSR had disappeared. Symmetrically, the US lost interest in the political unification of Europe. On economic grounds, the information and communication revolution of the 1980s (computers plus the internet) reversed the previous trend towards centralization and the advantage of large size, into a trend of general decentralization of large hierarchies, whether private or governmental, into smaller and more efficient units. In organizational matters small became beautiful, or at least efficient. Whereas in the 1970s the use of computers (and thus of efficient information gathering, storing and processing) was restricted by its high cost and limited availability to big organizations (large firms, state bureaucracies) it became available to every individual in the 1980s and 1990s, and instant communication worldwide became the rule. Hence the trend towards democracy, the counter example being found in information repression by Communist China and Middle East dictatorships. The organizational consequences of that revolution were devastating for the largest hierarchies (see my book “The Second Twentieth Century: the Decline of Hierarchies and the Future of Nations”, Grasset, 2000 and Hoover, 2006). Large and heterogeneous states – usually called “empires” – were the first victims, coming just after large and heterogeneous corporations – usually called “conglomerates”. Smaller and ethnically or economically fragmented states followed, such as Czechoslovakia and Yugoslavia, while separatist movements prospered everywhere. Small entrepreneurial firms multiplied. It was no time for large bureaucratic structures and empire building.

That mutation made the European process of multi-state integration obsolete overnight. It thus happened that the technocratic "empire-building by stealth" enterprise was doomed at the very moment it was launched, with the currency centralization as its first stage. It follows that the failure of the euro is not specific: it is just one example of the new trend towards general decentralization that characterizes the second twentieth century and the ICT revolution. It is in my opinion a durable trend.

In Europe, governments and banks tried to resist the trend by cartelization, and succeeded temporarily to avoid the downsizing necessity. Instead of reducing their excess capacity they could in that way temporarily increase it. But as a consequence they are now confronted with bankruptcy. The call for a “European governance” (read: a major step in political integration) is just plain wishful thinking and is no real option. The only solution now is to downsize these overblown technocratic structures and increase by this means the overall social efficiency (and level of living for the European populations) by returning to smaller and autonomous and competitive bureaucratic organizations, public as well as corporate. This is also the condition for a return to effective democracy, breaking away with the rule of technocracy.

Yes, this is the second death of Mr. Monnet.

Plus ça change …

An interesting paper by Michael Sauga on the different designs and management styles of “transfer unions” (aka “federal states”): “Designing a Transfer Union to Save the Euro” (Spiegel Online). The author reviews several variants of such unions, and one historical episode stands out as a forerunner of current events.

Excerpt:

"In the mid-19th century, for example, France, Belgium, Italy, Greece and Switzerland established the Latin Monetary Union, a precursor of the European Monetary Union. The exchange rates among the members were set, and all members were required to accept the currencies of their partner countries. But Italy and Greece, in particular, took advantage of the rules of this union to take out high government loans, which they paid for in part by printing money. The other countries resisted the southern countries' inflationary policy, but then the monetary union fell apart in the mid-1920s.”

Read the whole article here.

When Will Euro Rioting Start?

The question is raised by Bob Pisani  (CNBC’s “Trader Talk Blog”). He summarizes an interview in the German newsmagazine Spiegel with economic historian Hans-Joachim Voth who studied the history of 28 European countries over the last 90 years and has come to the following conclusion:

1)    “Austerity and anarchy are closely linked”

2)    “Savings (budget cuts) amounting to just one percentage point of GDP are accompanied by social unrest. And when they reach two or three percentage points, it massively increases.”

Voth also gives the euro another five years before disappearing but says it is Germany that should quit the euro, not Greece. This is precisely what the former head of the Federation of German Industries, Hans-Olaf Henkel, has suggested in a Financial Times opinion, “A sceptic’s solution – a breakaway currency” on Tuesday August 30.

Read the whole CNBC post here .

Read also the complete Voth interview in the SpiegelOnline.

Excerpts:

“Spiegel: Wouldn’t abandoning the common currency sound the death knell for the EU entire project?

Voth: I believe that the consequences of ending the euro have been overstated. Not every dumb economic idea needs to be defended to the bitter end. Europe is infinitely more than the European Union, and the European Union is infinitely more than the euro.”

My comment:

1)    Rioting has already begun in Greece.

2)    Both Germany and Greece could benefit from quitting the euro … but also Portugal, Spain, etc.

3)    Five years seems quite a long time given the deteriorating conditions of Greece, Portugal and Spain and the growing criticism of the euro in Germany. My guess would be that a radical move could be taken after the coming French and German elections.

4)    In the meanwhile the only realistic policy would be to substantially devaluate the euro vis-à-vis the dollar, but with Germany staying in the eurozone to take its share of responsibility for the debasement of the external debts in euros, after benefiting from years of undervaluation of its “implicit DM” vis-à-vis other member countries within the zone.

5)    Lastly, Voth sees a “southern euro” surviving with France, Italy and Spain, and maybe others, but he fails to recognize that the divergences between these economies would perpetuate the present euro problem. It would not constitute an optimal currency area either, and thus it will break down sooner or later.  Sooner would be best.