Month: November 2011

Buying time for Italy

Buying time can be useful if you get something useful with it, otherwise it is a waste of time and money. Italy needs to borrow less domestically to finance its government’s expenditures (reduce its fiscal deficit) and to borrow less abroad to finance its imports in excess of its exports (reduce its trade deficit). The lower interest cost of the IMF and/or EU lending money to the governments of Italy and Spain at German sovereign debt interest rates can buy them time to enact and implement government spending cuts, tax increases, and market reforms that improve productivity and reduce labor costs before they need to borrow in the market at potentially much higher interest rates. Why might the IMF and the EU’s European Financial Stability Facility (EFSF) be willing to lend money at German rates when market investors aren’t? That is a good question without a clear answer, though most commentators seem to assume it without much question.

The pay off from the measures Italy needs to implement will take time to materialize. Liberalizing markets takes years to actually improve productivity and exports. Some domestic wage and price deflation will probably be needed as well. Reforms to the tax system take time to produce revenue. Above all it will be difficult for the Italian economy to grow (the essential ingredient of financial sustainability) while the rest of Europe, if not the world, is stagnating. In the interim, Italy’s deficits will remain above the levels expected to result from current reforms in the future (say two to four years down the line). If they cannot be financed at “reasonable” interest rates, Italy will be forced to default on its fiscal debt of about 2 trillion U.S. dollars (of which about $500 billion falls due and needs to be refinanced in 2012). The impact on the banks, pension funds, and others that hold this debt would be devastating beyond our experience.

Thus IMF et al financing can be useful if a) Italy actually enacts and implements now the reforms needed to become viable in the future, and b) if the IMF is more confident that Italy will achieve the desired outcome than are market lenders. Without condition “a”, buying time is a waste of time because Italy would default anyway only somewhat later after running up even more debt. With regard to “b”, it may be that the IMF is better able to assess and enforce Italy’s reforms than the market (the IMF reviews progress every quarter against agreed performance criteria before authorizing the next quarterly tranche of its loan), but it is not obvious that this is so. Market lenders can see any reforms actually undertaken and the result almost as easily as the IMF can. If these measures are credible and convincing, market lenders will reduce their risk premiums for lending to Italy. If so, no funds from the IMF would be needed.

On the other hand, lenders may have become risk averse in the conditions now existing in Europe and the U.S. and world economy. If so, they will demand an interest rate to lend to Italy that is more than the premium needed to cover the expected loss from default. In these conditions IMF/EU financing could make the difference between success or failure. Undermining confidence in the ECB and the purchasing power of the Euro would be bad under all scenarios. While more rapid growth in the supply of Euros as the result of ECB purchases of Italian and Spanish debt might not be expected to be inflationary in today’s depressed economies, the effect on Euro interest rates will depend heavily on public confidence in the ECB’s anti-inflation commitment (i.e. inflationary expectation. See my earlier note on the role of the ECB: https://wcoats.wordpress.com/2011/11/17/saving-italy-and-the-euro/).

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Comments:

Here are some interesting comments from friends on my earlier note on the use of the ECB to buy Italian debt.

Thanks Warren, it is hard to be optimistic that the politicians and technocrats of Europe will stumble on the only thing that will work.

Thought experiments: why do we never see calls for “break up of the $ zone” such as when Puerto Rico got into fiscal troubles (see Stossel and Cal Thomas or recent reforms)?  Why don’t El Salvador, Ecuador and Caribbean Islands “leave the $ zone” so they can devalue to prosperity?  So far, we have a credible “no bailout policy” so even Harrisburg must go into bankruptcy.  In the US $ zone, counter-party risk is still important.

What if: instead of a “euro zone” we had seen 16 countries in the EU unilaterally adopt the DM?  The Frankfurt-managed currency would have appreciated sharply in recent years compared to the US $, much like the C$, Aus$, et. al.  The adopting countries would then have been in the position of Chile 1981.  When pegged to a weak US $ during the Carter years, Chile thought pegging was great.  Then, on the first Tuesday of November 1980 the US $ started to appreciate, and Chile found themselves holding the tail of a tiger until they rediscovered the virtues of floating.

If Italy and others are to stay on the “paper-gold standard” of Frankfurt, they will have to reduce real wages (& pensions etc.) the old fashioned way.  If that is too painful politically, and if Frankfurt refuses to abandon administration of “paper gold”, then Italy, et. al. must remain the Appalachia of the euro zone.

Why would Cameron want the ECB to monetize euro-zone debts?  Is it because more inflation in the euro zone as well as the US will take the pressure off the UK pound?

Jerry [Jordan, former President of the Federal Reserve Bank of Cleveland]

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Warren,

You make a very elegant and compelling case. But I’m not convinced that it will work. The likelihood of the ECB remaining politically independent is slight. And the only way Germany will be able to enforce the kind of austerity it’s promoting will be to invade and occupy these countries’ finance ministries (which has already begun, but without decisive popular support). Just as in the US, the people who need to bear the brunt of a recovery–the largest banks (in this case, the French banks which are the most exposed) and the bond markets–are the least likely to do it, and so hold a near monopoly on the recovery. At some point the people really bearing the brunt—the people least able to do it–may just give up: on the ECB, on the Euro, on the EU. Russia in the 1990s is a case in point. How many European Putins are there waiting in the wings? So long as the US and China and nearly every other power is dealing with this crisis publicly at the other end of a ten foot pole, I find your, and any other positive, outcome, very unlikely at the present moment. Sacred tenets of central banking aside, from where I sit this looks like little else besides beggar thy neighbor. On every level.

Ken [Weisbrode, in Boston]

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Hi Warren,

I don’t have the time these days to read your lengthy blog essays, alas, but I did want to make an admittedly superficial comment or two.  I really wish somebody would actually treat a sovereign borrower like an ordinary client some time.  These Greek demonstrations are disgusting. Your country doesn’t have money, and you’re insisting that it keep the generous welfare taps wide open.  Just where is the budget supposed to get the money to pay you to shut you up?  It would be wonderful if the Greek demonstrators were given what they want, the country would default in a few days, and then the banks would take over the bankrupt estate and liquidate it.  Not that banks are such wise and nice entities, but I just feel the Greek demonstrators deserve exactly this.  It’s the logical consequence of their irrational demands.

Next topic:  I’ve never understood the phrase (one that I have translated you saying many a time, I might add) that “of course, interest rates can’t go negative, so central banks are seriously constrained in their ability to loosen the money supply once the rates are down near zero already”.  Why can’t they go negative?  If the economy is so moribund that banks aren’t lending any more, only fuelling the moribundity further (not that you can fuel moribundity…), why can’t/shouldn’t the central bank loan money to the banks at negative interest in order to kick start lending and economic activity in general?  It’s Keynesian deficit spending by other means – monetary instead of fiscal.

Just having a rare moment of economic musing, sorry to bother you with my infantile thoughts.  Hope all is well with you, and that you have a good Thanksgiving.  Nailya and I will be passing through DC in the next month or so, but literally passing.  If plans change and we end up staying a little while, I’ll let you know and perhaps we can get together for a bit of socializing.  Nailya’s gotten quite interested in economic and political affairs (she never had been in Russia, because there’s no point in getting excited about something that gets arbitrarily decided by the corrupt suits in the Kremlin without regard for anybody else), so I know she’d make a lively conversationalist.

Steve [Lang, former personal Russian/English translator for Mikhail Khodorkovsky after being the same for me and the IMF]

Saving Italy and the EURO

If Europe and the U.S. can’t focus more on the long run conditions needed for healthy economies, they will never climb out of the short run emergencies they keep creating. Germany deserves credit for trying to do just that.

The fear is that panicky market investors may over price the risk of Italy defaulting on its debt raising interest costs on that debt to levels that Italy cannot afford, thus becoming a self-fulfilling prophecy. A sufficiently large European Financial Stability Facility (EFSF) that was prepared to lend to Italy (buy its bonds in the market) at more “reasonable” interest rates could give the Italian economy time to recover and grow out of its current problems. The mere existence of such an arrangement and commitment should reassure market investors making it unnecessary for the EFSF to actually buy any Italy debt, or so the thinking goes.

The fact of the matter is that substituting EU/IMF funding for market funding cannot reassure markets nor improve Italy’s long run prospects unless Italy itself takes the measures needed to reduce its government’s deficits and to improve the productivity and competitiveness of its economy. If Italy’s new government is successful in adopting and implementing truly credible measures to achieve these two goals, the market will continue lending with more modest risk premiums and no lending by the IMF or EFSF will be needed. To be sure, it will take time for such measures to take hold and actually improve Italy’s economic growth and improved competitiveness so it will need to continue borrowing from someone for a few more years. And by the way, balanced trade (imports paid for with exports so that no external borrowing is needed) does not require that Southern Europeans acquire Northern European work ethics. It only requires that they live within their means, whether they wish to work a lot or a little.

The European Central Bank (ECB) cannot save Italy by buying its sovereign debt. Those who point to the ECB as the savior of Italy, do so because the ECB can (by twisting or violating its mandate and charter) buy Italian bonds in unlimited amounts now, while the EFSF does not have sufficient funds for that and cannot acquire them soon enough. But once again, none of this will help in the long run unless Italy adopts corrective, market liberalizing measures that improve its economic performance (growth rate and external competitiveness). But leaning on the ECB has a very large risk rarely mentioned (though it is implicit in German reluctance to turn the ECB loose). The moment European markets (North and South) come to believe that the ECB will allow inflation to increase as a by produce of buying Italian bonds or for any other reason, interest rates will rise to reflect the higher expected inflation. Rates will rise not only in Italy, but also in Germany and everywhere else in the Euro zone. This really would be a disaster for the Euro.

Thus there is no substitute, no short cut, to Italy’s taking appropriate measures. Everyone is now so scared that I am optimistic that Italy will actual succeed in doing so. The IMF review of its measures requested by Italy should go a long way toward reducing market uncertainty about any measures taken. Dealing with the short-run in a proper way will make for a brighter future for everyone.

Comments on Libya and Greece

As usual, some of my friends have strong views of their own and interesting observations to add. Here are a few comments mainly on my Greek referendum blog.

Thanks, Warren

I totally agree with you regarding Greece.  I wonder if a similar referendum might be a good thing for the U.S., with the implication that if the majority of the population does not wish to cut spending and unsustainable entitlements, then the Federal Reserve will be mandated to expand the money supply to cover the shortage by inflation.  Actually, a referendum should put the choice that starkly.

Alternatively, we could rerun the election of 1896  — Fiscal conservative William McKinley versus Inflationist William Jennings Bryan (“free monetization of silver”)…  Then Bryan lost  — I wonder if he would win today.

Obama seems in many ways like another Bryan (without the Bible belt), but where is McKinley when we need him?

Ron [Bird, Virginia]

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I am not that keen on this referendum… It Will take 2 more months to have an answer and as you know, Time is money. Moreover they Will say no, do you know a kid who say yes when his father tell him at a party “do you want to go to Sleep”? They are not masochistic as far as I know.

Finally, it s a complete lack of balls from the politicians who are afraid to take strong decisions. However, that s what they were elected for!

Hugo [Gervais, Paris]

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Warren is smoking crack.

He writes, “If they accept it and embrace and stand behind the reforms

needed, the crisis for Greece will be over.”

And I say that if I grow 10 inches overnight and learn to play

basketball, I’ll be in the NBA.

The only difference between our two statements is that mine has a

.000000000001 chance of happening.

Dan [Mitchell, Washington DC]

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Greetings, Warren

I’m surprised that no one seems as yet to have noticed the irony that the country that invented democracy, and coined the term for it, is the first to be rounded on by a supra-governmental gang of unelected ideologues. I agree with you that the referendum is a good thing but not quite for the same reason you suggest. A ‘yes’ vote might give the Greek government enough political clout to clear out some of the Augean stables. But a ‘no’ vote would be even more fun: it would mean no bailout and lead to default and the exit of Greece from the euro and thus begin the unraveling of the entire misbegotten enterprise. The current prevailing message from the europhiliacs is that the eurozone must not be allowed to fragment, but there may come a time when they see the costs of a no-exit policy as too high and will then ditch the Greeks (and then the Portuguese? and then?) so as to save the currency for the handful of fiscally continent countries still left.

And I’m appalled by the fact that none of the commentators I’ve read has thrown up any hands at the suggestions of ‘closer fiscal union’ as a way of safeguarding the euro. That means, very clearly, taxation without representation, and from there it’s only a small step to tyranny. So the sooner Greece buggers the euro in the grand manner, the better for us all.

Cheers

Martin [Anderson, London]

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hi Warren,

Thanks for sending these.. though I disagree with both. On Libya: it’s way too early to count our chickens. But as I see it, the US got dragged into this by the French and the British on spurious grounds and then overthrew a dictator by force, which was nowhere in the UN mandate, however nasty that dictator was to his own people (for over 40 years, I might add, although we choose to overthrow him only now, and only after he gave up all his nasty weapons and was, so far as anyone could tell, no threat whatsoever to us).

On the Greeks, I’m dumbfounded by the referendum move. Your case makes nice sense in theory but hardly on the ground. How is it possible that Papandraeou, who has been negotiating on a more or less hourly basis with his European counterparts for at least the past six months, could pull off such a surprise? What is really going on? It suggests, at least to me, that the EU is so dysfunctional that there’s nothing to hope for at all. The Greeks voted to join the EU and then the euro. Now is not the time–particularly during the peak of a crisis right after a major negotiation–to second guess that by referendum in the name of validating an EU-wide decision. The EU is not the US but we did away with the doctrine of nullification a long time ago and I suggest the same holds for the EU. This referendum is essentially asking the Greeks to decide to pull out, and if they do it, anyone else can. It’s mad.

Ken [Weisbrode, Boston]

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Ken,

 On Libya, I was saying almost the same thing (see my five earlier warning blogs against getting involved: https://wcoats.wordpress.com/2011/03/10/libya-and-the-drums-of-war/, https://wcoats.wordpress.com/2011/03/13/libya-lets-not-make-it-our-war/, https://wcoats.wordpress.com/2011/03/21/another-long-war/,   https://wcoats.wordpress.com/2011/04/22/libya-further-down-the-slippery-slope/,  https://wcoats.wordpress.com/2011/08/23/libya-part-ii/ ). I am not optimistic about Chapter 2 now starting and glad that we have some chance of staying out of it (though I am worried about that too).

Warren

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Warren

All forms of brinksmanship are pretty much welcome at this point. If you think, like I do, that the problem in Greece and Italy is fundamentally a price competitiveness issue, and not a financing one, then things have to get much worse before people change their ways, start cooperating and stop fighting each other.

It will probably not work out, but hey, that’s cheaper holidays in Italy!

Sahil [Mahtani, Jakarta]

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Dear Warren,

I liked your Greek piece.  Insufferable fools.  They’d trade simple (but not so simple…) bankruptcy for a 50% write down and a road back to prosperity.  I’m going to write about it for my column next week.  I wonder how much looking up at Parthenon makes them still think they’re special? The DNA now is mostly Turkish anyway.

I’ll be back in Manila in time for my book launch with ex-president Ramos in a couple of weeks.  I am starting new quickie the Manila publishers want, “For love of a country: 40 years in and out of the Philippines,” which I can write in my sleep.  Though it is amazing how much comes back one had forgotten. Sometimes it’s just hard to believe we’ve been at this game for over 40 years.

I feel my whole life has been a study of empires falling (UK, now USA), new ones emerging (and in Asia no less).  Obama understands…as you pointed out he did the right thing in Libya.  And isn’t it wonderful to say, let the Europeans do this and that, not coming to us with a begging bowl.  A true silver lining to loss of empire.  George W Bush merely hastened the decline.

Scott [Thompson, Bali]

The Greek Referendum

The Greek referendum announced on November 1 by Greek Prime Minister George Papandreou is a big gamble and politicians rightly don’t like to gamble. I, on the other hand, like the idea. It will force the Greek public to face up to the fact that the Germans and other northern Europeans are no longer willing to support their habit of living high on other peoples’ money.

The Greek referendum announced on November 1 by Greek Prime Minister George Papandreou is a big gamble and politicians rightly don’t like to gamble. I, on the other hand, like the idea. It will force the Greek public to face up to the fact that the Germans and other northern Europeans are no longer willing to support their habit of living high on other peoples’ money.

Greece and many other governments, banks, and families have financed expenditures above their incomes with other people’s money for too long. The debt burden that has resulted has become too much to carry and lenders are no longer willing to keep on lending. Greece, to focus on today’s headline country, must reduce its debt, and reduce the government’s and the public’s borrowing (reduce spending and/or increase revenue) that created it and keeps it growing.

Some of Greece’s debt is owed to foreigner. Its borrowing from abroad to pay for its imports in excess of its exports can be reduced or eliminated by exporting more and/or importing less. To eliminate its trade imbalance Greek workers and firms must become more competitive with the rest of Europe and the world. Greek labor and produce markets need to be liberalized to become more productive. Retirement at 58 and generous vacations need to be brought into line with worker benefits in other European countries.

In announcing plans for the referendum, Papandreou stated that: “It is ‘time for the citizens to reply responsibly…. Do they want us to implement it or reject it? If the people do not want it, then it shall not be implemented. If yes, we shall proceed.’” [1]

But just what will the Greek voters be asked to decide? “’It’s difficult to see what the referendum is going to be about. Do we want to be saved or not? Is that the question?’ said Swedish Foreign Minister Carl Bildt.“[2]

The referendum might read: “Yes or No: ‘We agree to promptly adopt the market and fiscal reforms that we need to restore fiscal balance and external competitiveness in the future so that Greece will no longer need to borrow and spend other people’s money. As these adjustments will take time to restore competitiveness and eliminate the government’s need to borrow, the IMF and EU are prepared to lend the money needed to finance an orderly adjustment and banks around the world have agreed to write off half of their existing holdings of Greek government debt.’

A No vote would reduce that debt and any debt service payments to zero (full default), but as the government’s expenditures would still exceed its other spending commitments, the government would need to default on other domestic obligations as well (pensions, larger government salary and employment cuts, etc). Greece would be forced immediately to live fully within its much-reduced means and the suddenness of the government’s cuts would temporarily reduce Greece’s output and employment and government tax revenue even more causing potentially significant overshooting.

The beauty of a referendum is that people will need to face the truth and accept it or suffer the consequences of rejecting it. If they accept it and embrace and stand behind the reforms needed, the crisis for Greece will be over. External financing will still be needed as now planned to minimize the loss of output and revenue from the temporary adjustments needed.

The danger of a referendum is that the people will misunderstand the consequences and say no or will throw a childish tantrum and say no. The consequences of a No vote cannot be fully predicted. When faced with the larger cuts and disruptions full default would cause, civil society could explode with unforeseen results. Furthermore, the losses by banks and (largely Greek) pension funds holding Greek government debt would be larger causing larger losses to bank owners and creditors and probably French and other tax payers (the Greeks seemingly don’t pay taxes).

In this circumstance a possible, but not inevitable, further consequence would be Greece’s introduction of its own currency and a redenomination of Euro obligations of the government (at least) in the new currency at a depreciated exchange rate. If the government can force the re-pricing of wages and goods and services produced in Greece in the new depreciated currency, external competitiveness could be established (at least temporarily) with the stroke of a pen and the running of the currency printing presses. It is not obvious, however, that Greek workers would accept wage cuts via depreciation of the exchange rate of their new currency more readily than directly via nominal wage cuts.

To reintroduce its own currency, the Central Bank of Greece would offer to exchange Euros held by its banks and citizens for its own currency, though it is hard to imagine any of them taking up the offer. The real advantage to Greece of abandoning the Euro, and the source of the catastrophe that would almost surely follow, is that the government could now borrow the new currency from its own central bank. Rather than defaulting on many of its domestic obligations and/or implementing sharper than now planned cuts in government salaries and employment, the government could pay them with the new currency printed by and borrowed from the Central Bank of Greece. Printing money is not the same thing as growing food and building things, of course. So the introduction of its own currency would allow the Greek government to finance its continued deficits via inflation, i.e. reducing the real income and wealth of the private sector in order to transfer it to the government sector.

In Greece’s circumstances, monetary/inflationary financing of the government is a very slippery sloop that is likely to degenerate within a few years into hyperinflation as Zimbabwe recently demonstrated. https://wcoats.wordpress.com/2009/05/29/hyperinflation-in-zimbabwe/

Beyond Greece

But what about Spain and Italy? What would be the consequences for their sovereign debt and for the banks and others that hold it of a No vote in Greece? Europe worries much more about this than anything that might happen in Greece. Restoring fiscal balance and improving external competitiveness will be much easier for Italy, for example, than it has been for Greece, if Italy only get on with it. A No vote in Greece would alarm market lenders but would also alarm the Italian government borrower and might well catalyze the reforms needed in Italy more quickly than a Yes vote. The fiscal and structural reforms that have already been discussed with Spain and Italy by the IMF and EU, if implemented, would remove market concerns about their ability to service their debts and thus restore interest rate risk premiums on such borrowing to German sovereign debt rates.

The uncertainty over the coming weeks of the Greek referendum outcome is unfortunate, but Spain and Italy need not wait, nor do they need EU money, to take decisive and credible actions to reassure market lenders.

[1] Howard Schneider and Michael Birnbaum,  “Greek referendum call upends euro plans” The Washington Post, Nov 2, 2011, page A1

[2] Ibid.

Leading from behind in Libya

The U.S does not own what happens next in Libya, and the prospects for a good outcome are better because of that.

President Obama and Secretary of State Clinton have come out well with the limited role they gave to U.S. support of the now victorious Libyan insurgents. President Gaddafi was removed from power (and life) without the help of American boots on the ground. It was a victory by Libyans and the outcome, and they are just at the beginning of chapter two, will be theirs to celebrate or lament.

The American approach this time around has several advantages. The hit on our over taxed budget was small and is likely to remain small. But more importantly, the resentment that always follows eventually when our (or any ones) troops occupy a country will be missing. This will also contain long run costs and improve American security.

More important still is the almost certainty that the prospects for Libya to develop a liberal democracy that respects its citizens are larger if they must build it themselves. If they fail, that will be theirs as well.  A viable government that respects human rights cannot be simply stepped into no matter how good a model we might give them. It must be the product of give and take and negotiation amount competing Libya groups. Libya is now entering into such an internal struggle. We should take the side of proper principles of government and human respect, but not the side of a particular group. President Obama’s reserve in limiting American involvement makes such a process among Libyans possible. It will not be easy and I wish them well.