Category: Economics

Has the ECB provided the missing piece to resolve the EU debt crisis?

On September 6, Mario Draghi, president of the European Central Bank (ECB), announced that the ECB would engage in unlimited secondary market purchases of government bonds of member countries adhering to the policy conditions agreed to with the IMF and EU (and thus qualified to borrow from the European Financial Stabilization Fund – EFSF – or the European Stabilization Mechanism – ESM) to the extent needed to promote the efficient transmission of monetary policy throughout the Euro area. The over all liquidity impact of such purchases will be sterilized (offset by the sale of some other ECB assets), as needed, in order to preserve the ECB’s inflation objective of an inflation rate below but near 2% over the next two years. What does this add to the existing European tool kit and is it enough to resolve the EU debt crisis?

All responsible government officials recognize and accept that in the long run nations, like individuals, must live within their means (pay fully for what they consume). Their standard of living will depend on what they are able to produce (productivity).  Eliminating government deficits requires reducing government spending and/or increasing its tax revenue. Increasing the sustainable standard of living of its people (the level of consumption they can fully pay for with what they produce) requires liberalizing restrictions on labor and product markets and investment that will increase the productivity and thus output of workers and businesses. The debate is primarily over the optimal pace of introducing the measures needed to balance budgets and increase productivity and competitiveness.  This matters in that it takes time for the economy to adjust to reforms before it enjoys the benefits of more rapid growth. In the interim continuing but declining deficits must be financed either in the market (if market lenders have confidence in the effectiveness of the measures being taken), or by the IMF/EU/ECB until market confidence can be established.

I have elaborated these points in earlier blogs: “European debt crisis: causes and cures”; “Saving Italy and the euro”;   “Buying time for Italy”; and “Saving Greece-Austerity and/or Growth”.

Throughout the crisis Germany has demanded that Greece and other over indebted and uncompetitive countries undertake the needed corrective measures before being granted the financing needed for the transition back to normal market borrowing.  Events have proven Germany to be right as earlier “bailout” commitments have led to a suspension or slow down in policy reforms thus prolonging recovery.  For the same reason Germany has vigorously opposed (correctly in my view) the adoption of Eurobonds, which would allow Greece and others to borrow at the same interest rate as Germany and all other EU members. The moral hazard of bad fiscal behavior when market discipline of over borrowing is removed is a real and serious issue.

On the other hand, Germany is also pushing for Fiscal Union in order to gain better EU wide control over excessive national deficits. This may or may not be a good idea for Europe (I have my doubts) but it is certainly not, contrary to much opinion, essential for the viability of the Euro. The idea behind the German push for Fiscal Union stems from the markets’ failure to properly price the risk of lending to Greece, Portugal and some other overly indebted countries and Germany’s belief that the only way it can protect its tax payers from supporting inflated living standards to the South is by gaining control over their governments’ expenditures. Until the last few years, the governments of Greece and Portugal could borrow in the market at interest rates very close to the rates paid by the German government, which by the way has borrowed quite a lot itself (the ratio of German government debt to its GDP is currently above 81%). These governments spent and over promised future benefits recklessly on the (temporary) basis of relatively cheap debt financing in the market.

It is certainly a fair question to ask why the market failed in this regard and over lent to a number of governments that now have difficulty repaying. The expectation that Germany and other Northern EU countries would not allow the profligate southern ones to default made such lending seem risk free and the market priced it accordingly.  Fiscal Union and/or EU-wide fiscal rules are one way to limit such excessive borrowing and unfunded future promises. Improved market discipline of borrowing via more accurate risk premiums on market lending is another, and in my opinion, superior approach. Greece’s orderly default (75% haircut) on its publicly held debt and the current crisis have restored a large measure of market discipline to sovereign borrowing. Greece and Portugal do not need to borrow from the market for several more years as long as they implement and adhere to the reforms demanded by the IMF/EU/ECB. However, Spain and Italy closely watch the now far more sensitive interest rates demanded by the market when lending to them. Given the substantial outstanding debt of these countries, those interest rates can make the difference between the success or failure of reform efforts. Ireland, which has successfully, though painfully, implemented all of the conditions of the IMF et al “bailout,” is well on the way to full recovery and is now able to borrow again in the market at reasonable interest rates.

The missing piece in the EU/ECB tool kit to manage the ongoing debt crisis is the availability of sufficient temporary adjustment financing for larger countries such as Spain and Italy should markets loss confidence in one or both of them before their reforms have had time to bear fruit. The resources of the EFSF/ESM, still waiting for the German constitutional court’s approval, are not sufficient to finance stabilization programs with both countries. This leaves markets uneasy and volatile.  Market interest rates on ten-year Spanish government bonds have varied this year between under 5% to 7.6%. German government bond rates have varied between 1.24% and 1.85%.  Mario Draghi’s commitment of ECB funds to buy short-term sovereign debt (with maturities of up to three years) in secondary markets does not augment the resources available to the EFSF/ESM to finance adjustment programs with the IMF, but by buying such bonds in the secondary market should liquidity in a program country dry up, the ECB should be able to significantly reduce the prospects of what it considers unrealistically high risk premiums for such bonds. The ECB would only buy bonds of countries meeting the conditionality of an IMF supported adjustment program. Outright secondary market purchases are a standard and traditional liquidity management tool for central banks. What is unique in the European context is that open market purchases must be for the bonds of individual countries and the choice of countries matters. It is for others to determine whether, as Mr. Draghi claims, the new initiative is consistent with the ECB’s mandate.

This past week I attended a meeting of the Mont Pelerin Society in Prague. Friedrich Hayek, Milton Friedman and a few other free market champions founded the MPS in 1946. Czech President Vaclav Klaus, also an MSP member, hosted this year’s meeting. President Klaus has opposed the Czech Republic’s adoption of the Euro. It has kept its own currency, which the Czech National Bank has managed very well under an “inflation targeting” policy regime. However, Spanish economist Jesus Huerta de Soto spoke at the meeting in defense of the single currency. He favors a return to the gold standard but convincingly argued that the monetary discipline on Spain provided by giving up its own currency to the Euro was a good second best.  The key to success or failure of the Euro for the overly indebted countries that use it is whether they reform deeply enough to live within their own means within a few years and to sufficiently improve their competitiveness with the rest of Europe and the rest of the world. Failure to do so will harm the defaulting country far more than it will harm the Euro.  I wish them well.

Spain’s Financial Crisis: First Principles

Europe’s debt crisis has many contributing elements: bloated government bureaucracies, unaffordable social welfare programs, and productivity stifling labor and commercial laws.  However, none is as central as the condition and behavior of those European banks that overlent to and undercharged many European governments, and whose potential insolvency should one or more European governments default (as Greece has already to some extent) has dominated the EU’s slow, halting approach to dealing with it. Focusing on the case of Spain, the following note illustrates the importance for the future of Europe’s financial markets of resolving the banking sector’s problems properly.

Overview

In some respects the financial and debt situation of Spain is similar to that of the U.S.[1] Its central government debt is less than the U.S.’ and Germany’s (68%, 103%, and 83% respectively). This year its public sector deficit is expected to be 5.9% (8.5% last year), less than the U.S. at 7.6%, but more than Germany’s at 1.3%. Its total debt (public and private) to foreigners (external debt) is less as well (84%, 103%, and 142% respectively). Spain’s housing bubble and subsequent collapse were average. The decline in Spain’s real housing prices from their peak in 2007 of about 20% was about the same as the UK’s and the Euro zone’s and less than in Ireland and the U.S.

To over simplify, what sets Spain apart is a) its lack of competitiveness (its current account deficit with the rest of the world relative to GDP was 9.6% in 2008 and is currently almost 3% while the Euro area as a whole is balanced – i.e., 0); b) the heavy reliance of its banks on borrowed funds (its loan to deposit ratio is about 150% compared with 80% for U.S. banks; and c) its banks’ large exposure to the real estate and construction sectors (56.5% compared to 30% for U.S. banks). In addition, Spanish and European banks in general operate on much less capital than do American banks. Going into the recent financial crisis—2007—the ratio of total European bank assets to capital—i.e., the leverage ratio—averaged around 30, while for American banks it averaged around 13 (i.e. capital gearing ratios of 3.3% and 7.7% respectively).

Spain was confident that it could make sufficient budgetary and policy adjustments to convince markets that it was still safe to lend to while gradually winding down excess spending and liberalizing rigid labor and product markets (its no bailout strategy). But after four years of inadequate measures Spanish voters ousted the Socialist Party and gave the center right party of Mariano Rajoy a solid majority in Parliament with a mandate to move more aggressively. Prime Minister Rajoy’s reform program has been a mixed bag (see “Spain’s Economic Reforms: A Mixed Bag”). The central government’s spending and deficit are falling rapidly, though excessive regional government spending remains a problem. Labor market reform has been quite quick and strong and is already producing improvements in competitiveness. However, Spain has fallen back into recession and unemployment is the highest in Europe at over 24%.  (see Rajoy government reform program)

Spain’s Banks

Spain’s primary vulnerability comes from its banks. In fact, a central feature of the European debt crisis is the relatively large exposure of European banks, including German banks, to the sovereign debts of Greece, Portugal, Ireland, Italy, Spain, etc. If depositors think that their deposits are at risk, they will move them. If they think all banks in Spain suffer this risk, they will move them out of Spain to other banks that accept Euros. If depositors withdraw their deposits too rapidly (i.e., bank runs) then even solvent, well capitalized banks can have trouble liquidating assets fast enough to fund the withdrawals. The total deposits of Greek banks have fallen from € 245 billion at the end of 2009 to € 175 billion at the end of April 2012. However, Spanish banks’ deposits have not begun to decline until very recently.

Countries limit the risk of deposit runs by explicitly insuring bank deposits up to a limit and/or by standing ready to intervene (bailout) failing banks. In Spain, all deposits are insured up to € 100,000 per depositor. If governments guarantee all deposits as a result of a comment to bail out insolvent banks, deposit insurance is redundant and not needed. Even a full deposit guarantee provides some market discipline of bank behavior if the regulator intervenes promptly when a bank becomes insolvent, because shareholders lose all of their investment in the bank. Market discipline is strengthened further if bank bondholders also incur losses when the assets of an intervened bank are not sufficient to cover their repayment.

The Importance of Bank Capital

Without deposit insurance or government deposit guarantees, their bank’s capital is the primary protection for depositors against the risk of loss.  If depositors think that their bank’s capital is too low to cover potential losses, they will move their deposits to safer banks. Unfortunately, the value of a bank’s capital cannot be known with certainty. Economic capital (net worth) is the difference between the value of assets and the value of liabilities. A large share of banks’ assets is loans. The value of a loan is less than its face (book) value if it is not repaid fully or on time. It is impossible to know for sure which loans are “good” and which are doubtful and how doubtful they might be in the future.

Minimizing the risk of deposit runs via capital adequacy consists of three elements:

  1. The level of capital banks are required to hold in normal times (dynamic or cyclically adjusted capital requirements deserve more serious attention) must be sufficient to absorb possible losses. Higher capital requirements provide more deposit protection.
  2. The rules for valuing assets and thus capital must reflect their real value as best as possible. Most bank loans have no secondary market from which to measure their value. Thus bank regulators have established rules of thumb for estimating the probable loss in value for loans that are not performing or are at risk of falling into arrears and potentially defaulting. Banks are required to provision (write down capital) to cover such probable losses. This is the equivalent of “marking to market” the probable value of loans that have no market. Loan valuation and loan loss provisions need to realistically reflect and cover the most likely repayment outcomes.
  3. Depositors must have confidence in the adequacy of the first two measures and the faithfulness with which banks apply them. This is the issue of transparency. The recent deployment of stress tests, when properly explained (especially when undertaken by third parties, such as the IMF), is meant to reduce the uncertainty surrounding the adequacy of measured capital.

The risks to Spanish bank depositors come primarily from three sources:

  1. The potential losses from loans to Spain’s now busted housing and construction markets and from holdings of sovereign debt of Greece are uncertain and have almost certainly been underestimated and under provisioned in the past. Significant exposure to Spanish sovereign debt is now becoming an issue as well. Capital injections are needed just to keep actual capital at currently reported levels. Higher levels of capital are needed to compensate depositors for the uncertainty of the actual level of capital.
  2. The ability of Spain to honor its deposit insurance commitments or its implicit commitments to cover deposits in the event of an intervention are increasingly in doubt because the ability of the Spanish government to borrow additional amounts to cover such commitments is in doubt.
  3. The ability of banks to fund their loans from non-deposit sources or to fund deposit withdrawals even if they are well capitalized are in doubt in current market conditions. This is a liquidity problem, not a solvency problem, and should be handled by the provision of central bank liquidity.

Spanish banks fund a large part of their loans with relatively short-term borrowed money rather than deposits. Access to such funds has become difficult and expensive. From the beginning of central banking, a core function of central banks has been to provide banks with the liquidity they need in such circumstances. The long-established principle is that the central bank should provide illiquid but solvent banks with all the liquidity they need (generally by lending to them against good collateral), but should not lend to insolvent banks (banks lacking sufficient good assets to cover their deposit and other liabilities). The ECB’s three-year Long Term Refinancing Operation is addressing banks’ liquidity problem (#3).

But even without deposit runs (or walks), Spanish and other European banks (especially) need to reduce the extent to which they lend long-term on the basis of short-term borrowed funds. They can only do so by reducing lending until their deposits finance a larger share of it and/or by increasing capital. The bank deleveraging now underway around the world is an important source of reduced bank lending and the slow pace of recovery (see Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different: Eight Centuries of Financial Folly”).

Spanish banks were better capitalized than most at the onset of the international financial crisis but more recently have been overwhelmed by the magnitude of the collapse of Spain’s housing and construction markets. The government (previous and current) has taken measures to address banking sector weaknesses but always a bit behind the curve.  Seven failing cajas (regional savings banks heavily exposed to real estate) were merged in 2010 to form Bankia making it Spain’s fourth largest bank. In May the bank was largely nationalized (costing the Spanish government around 20 billion Euros to date) and trading of its shares was suspended on May 25, 2012. Deposit insurance was established then raised. Government guarantees of senior bank bond holdings were introduced (October 2008).

As time passed, depositors have only become more concerned about the safety of their deposits. In an effort to finally get ahead of the curve, the authorities have increased the provisions required against weak and doubtful loans and other assets, and initiated third-party stress tests of its banks. The IMF’s recent Financial Sector Stability Assessment found Spain’s large internationally active banks to be well capitalized and able to absorb the new capital strengthening requirements. However, its former savings banks and some of its medium and small private sector banks are more vulnerable and will need capital injections from the government to cover insured or guaranteed deposits. Because of its own financing difficulties, the government of Spain has turned to the EU to backstop its ability to recapitalize (replace capital lost by or potentially lost by defaulting loans) those of its banks with inadequate capital. For this purpose the EU has committed €100 billion.

The Way Forward

Deposit runs on Spanish banks (including the drying up of wholesale funding) can be prevented only by convincing depositors that their money is safe, i.e. that their banks have sufficient capital to cover any losses. This requires honest accounting and full implementation of the indicated provisioning, and adequate capital; or creditable government guarantees.

For the future health of Spanish banks, it is important that Spain’s banking interventions preserve the intended discipline of excessive risk taking that results from imposing losses on shareholders and senior bond holders while honoring its commitments to protect depositors. Thus liquidity support should only be given to solvent banks. Nonperforming loans should be properly provisioned. Banks that are critically undercapitalized and are unable to raise their own capital to required levels within a reasonable period should be intervened. Intervened banks should be resolved according to the least cost principle (least cost to the tax payer). Shareholders and senior bondholders should be wiped out before government money is injected to cover other liabilities. Viable banks should be continued and sold to new owners within a reasonable period of time. Non-viable banks should be wound down (liquidated) paying off all insured or guaranteed depositors with the help of public funds as needed.

In requesting EU financial assistance, Spain is committed to abiding by EU rules on state aid to banks. However, emergency responses to a financial crisis much too often produce the foundation of moral hazard and excessive risk taking that creates the next crises delaying true and long-lasting resolution. More market discipline of risk taking needs to be reintroduced via a sound bank resolution policy. Spain will contribute to the future soundness and vitality of its banking sector and that of all of Europe if it adheres to the above principles as it “cleans up” its financial sector.

[1] The International Monetary Fund’s “Financial Sector Stability Assessment”  provides an excellent summary as of May 2012.

The Hutchinson Lecture at the Universtiy of Delaware

Tuesday (April 17) I spent an enjoyable day in Newark, Delaware as the guest of the Economics Department of the University of Delaware. My afternoon, more technical, lecture to the graduate students and faculty covered my proposal for the reform of the international monetary system: http://works.bepress.com/warren_coats/25/

My evening lecture, this year’s Hutchinson Lecture, is reviewed here by the U. of Delaware newspaper (in which there is also a link providing background on the Hutchinson Lecture): http://www.udel.edu/udaily/2012/apr/HutchinsonLecture042012.html.

Saving Greece: Austerity and/or growth

Econ 101: When discussing Greece’s economic problems public officials and the press regularly toss out the need for “austerity” and/or “growth” as if they were clearly defined and understood concepts. I suspect that they mean quite different things to different people. While it is convenient to summarize complicated policies with single words, it can also stand in the way of understanding what is really meant. So what are the policies needed for Greece’s recovery and what should we call them?

Stocks and flows: For starters we need to distinguish the stock of Greek debt (the existing outstanding amount of previous, unrepaid borrowing) from its annual deficit. Greece’s debt reflects the past history of its annual deficits. Its current and prospective deficits foreshadow the future stock of debt. A full default on Greek debt—wiping it all off—would reduce Greece’s annual interest payments on its debt but beyond that would do nothing to reduce its annual deficit and the build up of its future stock of debt, which eventually would again become unsustainable. So forgiving (defaulting on) all existing Greek debt, by itself, will not resolve Greece’s problems.

Sticking with broad simplifications, Greece has two major economic problems. First, its government spends more than it can pay for without borrowing (the deficit — the flow of new debt). Moreover, like the U.S. and many other governments, it has made commitments to spend in the future (e.g. unfunded pension commitments) that are not yet reflected in its stock of debt or its annual deficits. This must change because it is not sustainable. Lenders will lose confidence in the government’s ability to service its debt and will stop lending. This calls for “austerity”, i.e. eliminating the annual deficit, by some combination of reducing expenditures and increasing tax revenue. I will return later to the distinction between structural and cyclical deficits.

Greece’s second major problem is its low productivity and uncompetitive prices. By themselves these would simply imply a lower standard of living for Greeks. But the average Greek has been spending more than his income by borrowing, giving the temporary illusion of a higher standard of living. To the extent that Greek spending is for foreign produced goods and services and these imports are not fully paid for with Greek exports, they must be paid for by borrowing. This artificial standard of living is obviously not sustainable.

Greece shares the same currency, the Euro, with 22 other European countries (including non members such as Monaco, Kosovo, and the Vatican).  If Greeks borrow domestically to pay for imports, Euros will flow out of Greece, tightening liquidity. This should put downward pressure on wages and prices in Greece, which would help restore its competitiveness with the rest of the Euro zone. If Greeks borrow abroad, interest rates on such borrowing should eventually increase to cover the increased default risk. This will discourage Greek borrowing. Greece has reached this point.

Some argue that if Greece had its own currency it could reduce its real wages by devaluing its currency and thus restore external competitiveness. Cutting real wages in this way would be easier, they argue, than cutting nominal wages directly as Greece has just done for government employees. Experience in other countries suggest that devaluing its own currency, if it had one, would set off domestic price increases to offset the loss of real wages unless labor markets were made more competitive. A spiral of devaluations and inflation would likely ensue. Only when real wages can be reduced to competitive levels one way or another can Greece hope to grow out of its current problem.[1] Thus the Greek government is undertaking structural adjustments to liberalize labor and product markets in order to make them more efficient and to make wages and prices more responsive to market conditions.

Some argue that the emphases in Greece should be put on growth.  Given the debate in the U.S. between Keynesian and neo classical economist over whether growth requires “stimulus” to increase demand (the Keynesian view) or “structural adjustments” to make labor and product markets more efficient and to encourage investment (the neoclassical view), it is not completely obvious what the proponents of growth in Greece have in mind. Attempting to promote growth with government stimulus to demand is not in the cards, as that would require more government spending and/or lower taxes and thus even larger deficits that no one is willing to finance. The only way for Greece to enjoy a higher standard of living is to undertake structural reforms that will allow the economy to be more productive and its wages and prices to be more competitive with the rest of the world.

So Greece needs to eliminate its deficits (actually run surpluses to reduce its outstanding debt) and liberalize its labor and product markets to establish balance in its external trade. All serious students of the Greek situation agree with this. The policy debate is complicated, however, by the interaction between growth and deficits and the speed with which an economy adjusts to changes.

If the Greek economy grows more rapidly it helps its debt problem in several ways. First, a growing economy generates more tax revenue from the same tax system. This reduces the deficit. It also tends to reduce government expenditures linked to safety net expenditure (e.g. unemployment insurance). This also reduces the deficit. In addition, the capacity of an economy to sustain and service debt is linked to its size. Thus economists look at the ratio of debt to GDP. A more rapidly growing economy tends to reduce the debt/GDP ratio by increasing the denominator.

While Greece must eliminate its deficits, the initial impact of expenditure cuts and higher taxes is to temporarily reduce income and tax revenue. Greece is experiencing this now. Its expenditure cuts have not reduced its deficit as much as expected because the temporary slow down in economic activity as displaced government employees (for example) look for new jobs, has been larger than expected thus reducing tax revenue by more than expected. A reduction in income has the same but opposite effect on the deficit as does an increase in income. This phenomenon is called automatic stabilization. Both Keynesian and neoclassical economists favor allowing such cyclical swings in government deficits and surpluses. But in the long run the government’s structural deficit (its full employment deficit) should be zero or at least smaller than the economy’s long run average growth rate. In Greece’s case it should be in surplus for a number of years to reduce its existing stock of debt.

The positive impact on competitiveness and income of liberalizing labor, services and product markets will also take time to develop. Balancing Greece’s fiscal budget now, before structural reforms have had time to work, would require much larger fiscal corrections (spending cuts and tax increases) than would be needed for long run balance.

This background should help understand and evaluate Greece’s options. Without external financial help (as is now provided by the EU, IMF and ECB), Greece could not adjust its fiscal deficits enough in the short-term to avoid the need to continue borrowing temporarily. Under these circumstances market lenders are likely to charge such a high risk premium to buy Greek sovereign debt to cover the prospects of default that deficits would become worse rather than better. Greece would default (with or without leaving the Euro). If it had defaulted in December 2011, it would have saved 16.3 billion Euros in interest payments on outstanding debt out of total government expenditures of €76.8 billion, but would have had to cut expenditures instantly an additional €6.3 billion to keep it within its tax revenues of €54.2 billion, over a 10% cut in non-interest expenditures instantaneously. This is austerity on steroids. The Greek economy had already stopped growing in 2008 and shrank by 3.3%, 3.5% and 5.0% in 2009, 10, and 11 respectively. The shock of default would surely depress the real economy further than the 2.0% decline currently forecast for 2012, reducing tax revenue further and requiring even larger cuts in spending. This does not take account of the impact of a Greek default on its banks, which hold a significant amount of Greek sovereign debt, and which the government would no longer be in a position to support. Default is no panacea, and this has not taken into account the possible negative effects in Spain and Italy, to name but two other European countries.

The approach taken by the IMF and EU is to agree with Greece on targets for both deficit reduction (austerity) and structural reforms (growth) that aim to restore full balance by 2021 and to finance the declining deficits in the interim at modest interest rates so that Greece does not need to borrow from the market. The program requires the “voluntary” write down of private sector holdings of Greek sovereign debt by about 70%. Greece would reduce its deficit from almost 10% in 2011 to less than 5% in 2012 (a primary surplus – i.e. not including interest on its debt—of 0.2%, raising to a primary surplus of 2.4% in 2013 and 5.0% in 2014). This “austerity” is being supplemented by significant structural reforms. The program is a balance between the pace of austerity and growth. Slower implementation of austerity requires a longer period of IMF/EU financing but with potentially more rapid growth.

Government employment is being reduced by 22% between 2010 and 2015 (150,000 employees). Future pension commitments have been reduced. Inflation has fallen below the Euro area average. However, external competitiveness has improved as the result of wage reductions in Greece rather than improved productivity, i.e. living standards have fallen. In general, labor market and business sector reforms have lagged. Changes in labor laws to allow more flexible wage bargaining and to ease the cost of lay offs are showing positive results. A number of services and professions have been liberalized to subject them to greater competition (cruise ships, highway freight, tourist coaches, regulated professions). The cost of starting new businesses has been reduced (“The new law reduces the number of steps (from 11 to 1), days (from 38 to 1), and cost (by more than 50 percent) required to start a business.”). Nonetheless the slow pace of such reforms is the major weakness of the program. Public acceptance of its changed circumstances and how best to deal with them has not be easy or smooth either.

It is noteworthy that the Greeks work more hours on average than any other European county (2,017 hours per year compared to 1,408 hours a year for Germans). German’s enjoy a higher standard of living because they produce more each hour they work. Greece needs to liberalize its markets to become more productive. Lowering wages will make Greek output more competitive beyond its borders but will not raise the standard of living for Greek workers.

The euro group has stated in its communiqué, “We reiterate our commitment to provide adequate support to Greece during the life of the program and beyond until it has regained market access provided that Greece fully complies with the requirements and objectives of the adjustment program.” The proviso is standard but also reflects Greece’s poor record of honesty and implementation.

IMF financial support is parceled out in quarterly installments contingent on Greece meeting the conditions agreed to for each quarter. This combines the carrot of financial assistance with the stick of close monitoring of Greece’s compliance with the reforms needed for long run success. There are no good options for Greece, but the current agreement between Greece and the IMF/EU seems to hold out the best hope for potential success. It balances austerity and growth. It will not work without public acceptance. Government promises to its public are being and must be broken. The Government needs to convincingly explain that these promises cannot be kept and that a brighter future requires the reforms that have been promised to the IMF/EU/ECB and the increased productivity and growth they should make possible.

Iceland and Ireland are well on their way to recovery from their debt disasters. If Spain and Italy can get and stay ahead of the adjustment and reform curve, and they have new governments committed to doing so, Europe should pull through and be stronger for the experience. But the next few years will be difficult.

[1] Mario Blejer and Guillermo Ortiz, “Latin Lessons”, The Economist February 18, 2012, page 94.

The Future of Money

I solicited 12 articles on very diverse aspects of the future of money for the current issue of the Cayman Financial Review (I am a member of the Editorial Board).  http://www.compasscayman.com/cfr/

I wrote two of the articles myself and I hope that you enjoy them:

http://www.compasscayman.com/cfr/2012/01/11/The-future-of-money—What-is-it-/

http://www.compasscayman.com/cfr/2012/01/11/The-Technology-of-Money/

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.