Tag: Euro

Brexit

The reality of Brexit unleashes a flood of questions, most of which cannot be answer for quite a while. The near term consequences of the UK’s exit from the European Union will depend on the details of the divorce, which will take several years to unfold. Divorces can take place smoothly and amicably or not. The result—the new reality—can be seen as fair (but invariably diminished on both sides, at least economically) or not.

My concern in this note is whether the underlying public sentiments that pushed Brexit over the finish line—the fear of job losses and cultural dilution as a result of excessive immigration—herald a retreat from the globalization that has dramatically raised standards of living and reduced poverty around the world in the last several decades.

As we know from Adam Smith, our ability to increase our output and thus income rests heavily on the productivity gains made possible by specialization. But we can only specialize in our work and output if we are able to trade what we produce for the other things we need and want to consume. The freer and more extensively we can trade, the more we can specialize and prosper. As I never tire of pointing out, the boundaries of trading within the family, the village, the province and the country and beyond are largely arbitrary. However, trade requires shared rules and standards. Within the family these can be more informally developed and understood. Even within villages customary understandings of weights and measures and value may suffice among people who know each other. But as the domain of trade expands and buyers and sellers no longer know each other, such standards and rules need to be formalized into laws and their enforcement supported by courts and impartial judges. Parties to agreements need to be confident that their contract will be enforced as agreed.

The U.S. Constitution gives our federal government the power and responsibility to establish standards of weights and measures and the monetary unit without which trade within the United States would be greatly encumbered. Agreeing on the voltage standard for electrical devises is one of thousands of examples. Businesses themselves recognize the benefits to themselves and their customers of harmonizing many elements of the products they produce and trade. Thus bottom up negotiations over many years have produced the Uniform Commercial Code, which removes many unnecessary costs of trading across different legal jurisdictions through standardization.

Trade across national borders could not exist without international laws and understandings about the nature of contracts and their enforcement, the description and measure of content and statements of value (unit of account), etc. Leaving the EU does not free the UK from the need to conform to such standards if they wish to continue trading with the rest of the world.

In their efforts to facilitate free trade within Europe by harmonizing product standards, the European Commission bureaucrats in Brussels got off to a bad start by failing to distinguish between those standards that facilitated trade from those that unnecessarily limited product diversity and competition. Their definition of the acceptable features of bananas has become the poster child of their misguided and laughable efforts. This does not mean, however, that the facilitation of international (or intra EU) trade does not need harmonized standards (weights and measures of food content, length, volume, etc.) in order to remove unproductive and unnecessary costs of trade.

The huge benefits of trade—global trade—also require that each of us can produce (work at) whatever we do best. The fullest measure of such freedom—free labor mobility—would require the free movement of labor to the best jobs they can find and this is what the EU required of its members within Europe. It is also what has raised fears and reactions within the UK of having, for example, too many Polish plumbers. As the vote for Brexit dramatically demonstrates, we dare not ignore these fears and they are not easily dealt with. See my earlier discussion of this challenge: https://wcoats.wordpress.com/2016/06/11/the-challenges-of-change-globalization-immigration-and-technology/

The growing anti-immigrant sentiments in continental Europe have little to do with free labor mobility within the EU and are more directed to the refugee problem created by the wars in the Middle East. The British vote to leave the EU seems to reflect some mix of a reaction to ill informed harmonization measures taken by the EU (largely some time ago) and a lack of appreciation of the benefits of properly directed harmonization of codes and standards as well as of fears of losing jobs to immigrants (and on the part of some, a natural fear of strangers). The key question for the future of free trade and globalization and the enormous benefits they bring is whether Brexit is the beginning of a closing of that door. We need to make every effort to address and mitigate these fears so that that does not happen.

The establishment of an efficient international trading order (the international establishment of rules and laws and their enforcement) can come about in a variety of ways. The international agreements and organizations established after World War II to perform this role (e.g., UN, WTO, IMF, World Bank) have generally served this international order well though they are not perfect. The statement by Boris Johnson, former mayor of London and possible successor to British Prime Minister David Cameron, that: “I believe we now have a glorious opportunity: We can pass our laws and set our taxes entirely according to the needs of the U.K. economy,” either reflects stunning ignorance of the role of international law in underpinning globalization or blatant dishonesty. The international institutions that oversee our liberal international order need to be preserved and where appropriate strengthened, not destroyed.

The European Union itself was always much more than an economic (free trade) project. Following WWII after centuries of devastating wars, the European project was always more about establishing the mechanisms of political cooperation that would avoid another European war. It has been stunningly successful in this endeavor, but still struggles to find the right balance in the devolution of authority and the best formulation of European wide governments for preserving peace and promoting economic well-being. An excellent discussion of these issues can be found in Dalibor Rohac’s Toward an Imperfect Union: A Conservatives Case for the EU.

The consequences of Brexit for Britain (what ever might be left of it) and for the EU (what ever might be left of it) will not be known for many years. But the risks of an inward looking nationalism and a retreat from a liberal international order that it seems to reflect should be taken seriously and resisted vigorously.

Greece: What should its creditors do now?

Following Sunday’s NO vote in Greece, what ever that might have meant, it is tempting to tell Greece to get lost and be done with them. Aside from the unseemly lack of compassion for our suffering fellow man, the further collapse of the Greek economy and society that would likely follow Grexit (the Greek exit from the Euro and introduction of its own currency) would open unknown and potentially very dangerous risks to the rest of Europe from its southern periphery. However, any new deal between Greece and its creditors should be mutually beneficial for Greece and the EU in the long run and achievable and practical in the short run. What are the key elements needed for such an agreement?

Greece’s second bailout program with its creditors (the EU, ECB, and IMF) expired June 30 after a four-month extension without disbursing the final installment of around $8 billion dollars. It cannot be resurrected. Thus any further discussions between Greece and its creditors will concern a third bailout program.

Greece’s recently replaced and unmissed Finance Minister, Yanis Varoufakis’, stock speech said basically that Greece does not need or want more loans because it is bankrupt rather than illiquid. In short, it wants debt forgiveness. In fact, many European officials have acknowledged the possible need to write off (reduce the present value one way or another of) existing Greek debt but insisted that any such consideration be put off for a new program. Discussion of a new program has now arrived.

The foundation of any financial assistance program with the IMF is its assessment that the borrowing country can repay the loan. This assessment is contained in the IMF’s “Debt Sustainability Analysis.” This analysis imbeds the agreed (or assumed) level of government spending and estimated tax and other government revenue and of the level of economic activity (GDP growth) upon which it depends in a forecasting model of the deficit and debt/GDP ratios expected from implementation of the agreed policies. The IMF was badly embarrassed by its acceptance of overly optimistic assumptions about income growth government revenue in its first bailout program in 2010 with the EU and ECB. Under political pressure from the EU and ECB, these assumptions allowed the IMF to conclude that Greece’s debt would be sustainable thus avoiding the need for some debt write off favored by the IMF but opposed by Germany and France, whose banks held large amounts of that debt. The second bailout program included a write off of about 70% of the privately held Greek debt. However, this came too late and the adjustment in the Greek government’s annual deficits required by the first program proved too severe causing a much larger and longer lasting contraction in the Greek economy than expected and assumed in the IMF Debt Sustainability Analysis at that time.

On June 26, 2015 (i.e. prior to Greece’s default on its $1.7 billion payment to the IMF and to the July 5 referendum) the IMF released a draft Debt Sustainability Analysis based on the information available at that time. It concluded that “If the program had been implemented as assumed, no further debt relief would have been needed under the agreed November 2012 framework…. At the last review in May 2014, Greece’s public debt was assessed to be getting back on a path toward sustainability, though it remained highly vulnerable to shocks. By late summer 2014, with interest rates having declined further, it appeared that no further debt relief would have been needed under the November 2012 framework, if the program were to have been implemented as agreed. But significant changes in policies since then—not least, lower primary surpluses and a weak reform effort that will weigh on growth and privatization—are leading to substantial new financing needs. Coming on top of the very high existing debt, these new financing needs render the debt dynamics unsustainable…. But if the package of reforms under consideration is weakened further—in particular, through a further lowering of primary surplus targets and even weaker structural reforms—haircuts on debt will become necessary.”

In short, the Greek economy was finally beginning to recover by the end of 2014 but the reversals by the new Syriza government of some of the policies contributing to that gain and the loss of market confidence in the muddled and amateurish behavior of the new government reversed the recovery and further increased Greek deficits. In addition, increasing capital flight has been financed by short-term emergency liquidity loans from the ECB, thus adding to Greece’s over all indebtedness. Capital flight per se should not reduce banks’ capital, as they lose the same amount of assets and liabilities, as long as they are able to liquidate sufficient assets by selling them or by using them as collateral for loans from the ECB or other banks. These loans and the process of transferring Euros abroad are described in the paper I presented in Athens May 19 at the Emergency Economic Summit for Greece: http://works.bepress.com/warren_coats/32/.

Under these circumstances it would be desirable (i.e. consistent with and/or required by a European desire to keep Greece in the Euro Zone while returning it to fiscal balance and sustainability over a reasonable, if somewhat longer, period of time) for Greece’s creditors to forgive some of the debt held by the ECB and IMF and to lower the structural fiscal surpluses initially required in a follow on program for the next few years (this latter element had already been offered by the creditors before the referendum). In short, by reducing Greece’s debt service payments and lowering its primary fiscal surplus, it would endure less “austerity.” Former Finance Minister Varoufakis actually proposed a sensible risk sharing form of refinanced Greek debt indexed to the economy’s economic performance. Creditors would do better than expected on their concessional loans if the economy performed better than forecast and would suffer losses if it did worse. This would give both sides a financial incentive to get the pace and balance of fiscal adjustment right (growth maximizing). While Europe’s political leaders sort out the details, the ECB should continue to provide liquidity credit to the extent that, and as long as, Greek banks can provide realistically valued collateral.

The purpose of these adjustments by the creditors should not and must not be to throw more good money after bad allowing a continuation of decades of corruption, rent seeking and government inefficiency. Long before it joined the Euro Zone, Greece suffered poor government services by a bureaucracy overstaffed by friends and supporters of the government in power at the time. Not receiving expected government services, many Greeks have decided not to pay for what they are not getting. Hence tax evasion and a large underground economy added to Greece’s deficits. Quoting from Bret Stephens’ July 6 column: “Greeks retire earlier and live longer than most of their eurozone peers, which means they spend close to 18% of GDP on public pensions, compared with about 7% in Ireland and 5% in the U.S…. As of 2010, Greek labor costs were 25% higher than in Germany. [As a result of internal devaluation since then, this is no longer true.] A liter of milk in Greece costs 30% more than elsewhere in Europe, thanks to regulations that allow it to remain on the shelf for no more than a week. Pharmaceuticals are also more expensive, thanks to the cartelization of the economy…. Greece wanted to be prosperous without being competitive. It wanted to run a five-star welfare state with a two-star economy. It wanted modernity without efficiency or transparency, and wealth without work. It wanted control over its own destiny—while someone else picked up the check.”

Changing this behavior by Greek governments and the Greek public will not be easy if it is possible at all. The still very strong support by the Greek public for keeping the Euro suggests a strong awareness of the need for some restraints and discipline of its government’s spending. But is the desire for a truly better deal (from their own government) strong enough to overcome the resistance of the entrenched and favored interests, who would lose from liberalizing the economy and cleaning up the patronage mess and tax non compliance, etc.? The best hope is the formation of a unity government that strongly endorses a well balance program of gradual further fiscal adjustment and the continuation of the structural reforms so badly needed. Close monitoring by the creditors of Greek compliance with its promises and the phasing of financial assistance tied to such performance benchmarks, is the IMF’s standard approach to enforcing compliance with the measures the government agrees to. There are risks in agreeing to a third program and risks in not doing so and thus Grexit.

Grexit, even with total default on all external debt, will surely force more austerity on Greece than would any program now contemplated, even before taking account of the almost certain collapse of all of Greece’s already “temporarily” closed banks. The Greek government will hardly be in a position to bailout its banks suffering a surge of non-performing loans. Depositor bail-ins will need to cut all the way into “insured” deposits. The pain will be largely felt only in Greece, and unfortunately mostly by the ordinary Greek citizen.

Printing Money

Isn’t that just printing money?  Here is a quick, and hopefully simple, primer on what central banks do.

Central banks print money. They are responsible for issuing a country’s legal tender (banknotes and bank deposits with the central bank) and regulating its value. Most of what we call money is actually privately produced (deposits at commercial banks, credit and debit cards, paypal, etc.) but tied to the money printed by each country’s central bank by the public’s demand that it be redeemable for the central bank’s money. There are a few exceptions to this demand by the market, such as bitcoin (see: the-rise-of-the-bitcoin-virtual-gold-or-cyber-bubble), but they shall ever remain unimportant fads. There is never a question about whether central banks print monetary or not. It is their responsibility to do so. This is as true for a pure gold standard or other fixed exchange rate monetary regimes, as for the variety of fiat money regimes (from monetary targets to inflation targets to flying by the seat of their pants day-to-day).

The important and proper question about a central bank’s behavior is what guides its decisions about when and how much money to print. A secondary question is what does it buy when it issues money (there are no helicopters that drop it from the sky)?

The gold standard: Under a gold standard the central bank buys gold with the money it prints and is legally bound to buy that money back with gold at the same price whenever anyone holding its money wants to redeem it. While this is still printing money, the supply is determined by the preferences of the market (each and every one of us) to hold and use that money. Such central banks have no monetary “policy” in the usual sense. They passively supply whatever amount of money the public demands.

Fiat money: If the central bank issues money with no obligation to redeem it for anything in particular nor at a particular price, its value is determined in the market by its supply and demand. The amount supplied by the central bank relative to the market’s demand for it will determine is value (the price level). Monetary policy consists of the decisions made by central banks that determine the amount of the money they supply and manner in which they supply it.

The public’s demand for money reflects its convenience for making payments, its expected value when exchanged for goods and services, and the opportunity cost of holding it (inventory costs, i.e., the interest rate that could have been earned on holding wealth in other forms). Rapidly changing payment technology (debit/credit cards, Paypal, e-money, etc.) has a profound impact on this demand. There is a vast academic literature on this subject. Unlike any other good or service money’s value derives solely from what it can be exchanged for or more specifically from the economy it brings to exchange/trade.  Fiat currency is always useable and thus “redeemable” for the payment of taxes and other obligations to the government that issued it. These obligations are denominated (valued) in the same units as the currency. These guaranteed uses of fiat money anchor its demand and thus value in the same way that the demand for gold for jewelry and other non-monetary uses anchors its value. Bitcoin has no alternative use and thus has no anchor to its value.

Central banks have learned the value of establishing clear rules for issuing money, such as targeting the rate at which the money supply (by one definition or another) grows, or targeting nominal income, or inflation. These rules guide how much money they “print.” They also influence the public’s demand for money by informing its expectations of the central banks actions. The policy regime adopted—rule—determines the behavior of the money supply and thus its value (or visa versa). The supply of bitcoin also follows a well-defined rule, but its demand is unanchored. The fact that the central bank is printing money is irrelevant by itself.

A secondary consideration is what it is that the central bank buys with the money it prints. Under a gold standard it buys gold. Under a fiat money standard central banks generally buy government securities because these securities are generally of unquestioned safety and in most countries have the deepest and most liquid secondary markets. Central banks also traditionally adhere to a “bills only” policy, i.e., they buy short-term government security, in order not to interfere with the market’s determination of the term structure of interest rates, i.e. the relationship of interest rates on securities with longer maturities relative to those with shorter maturities. In a free market, rates on longer maturities are determined by the expected value of overnight rates over the period in question plus a risk premium for the uncertainty over the behavior of overnight rates.

Whatever the ultimate or intermediate targets of monetary policy, most central banks in recent decades have pursued them by targeting a short-term interest rate, their so-called “operating target.” The Federal Reserve targets the overnight interbank rate, the so-called “federal funds rate,” as its approach to targeting the money supply, nominal income, or inflation. Given all other market factors, a particular fed funds rate target will result from and result in a particular rate of growth in the money supply.

Because most money and related means of payment are privately produced by banks or is ultimately settled through banks, and because banks only keep a small amount of the money produced by their central banks for which bank deposits are redeemable (the so-called “fractional reserve banking system”), central banks have also been given the role of insuring that banks have sufficient liquidity to function smoothly. They are mandated to lend to solvent but illiquid banks when banks need to convert loans into cash to accommodate deposit withdrawals (the so-called “lender of last resort” function).

As more and more central banks successfully adopted the techniques of inflation targeting and most of the rest fixed the exchange rate of their currencies to an inflation targeting currencies such as the U.S. dollar or the Euro, the world entered a long period dubbed “the great moderation.” However, the long period of very low interest rates following the bursting of the “dot com” bubble produced the housing price bubble in many locations in the U.S. and Europe. Its collapse in 2007-8 plunged much of the Western world into the long, Great Contraction.

Monetary Policy Plus (MP+):  In the last few years the Federal Reserve, the European Central Bank (ECB) and other central banks have undertaken many non-traditional actions in an effort to help lift their respective economies out of recession. In the early days of the serious liquidity crunch following the collapse of Lehman Brothers in September 2008, the Fed, ECB, Bank of England and a few other central banks very successfully pumped needed liquidity into their financial systems by expanding the number of counterparties they would lend to, increasing the eligible collateral, and entering into currency swap arrangements to supply dollar liquidity to foreign banks.

However, after unblocking the flow of funds between banks and other financial firms, the Fed’s concern shifted to fighting deflation, then to reviving economic activity. After driving its operating target to almost zero, the Fed continued increasing monetary growth beyond the rate resulting from a zero fed funds target and dubbed it quantitative easing. However, the channels through which monetary policy is traditionally transmitted to the economy (interest rate, credit, asset price, portfolio/wealth effects, exchange rate channels) seemed ineffective. Thus, the Fed began to purchase non-traditional, financial instruments, such as Mortgage Backed Securities (MBSs) and longer-term government securities, in an effort to keep mortgage interest rates low and to encourage the flow of funds into the mortgage market and stimulating investment more generally. These quasi-fiscal policy measures do not square easily with the Fed’s legal mandates of price stability and employment.

With the Fed’s third program of quantitative easing it is now pushing on a string  (QE3: http://works.bepress.com/warren_coats/28/). It is attempting to stimulate an economy that lacks a clear policy environment that would encourage more investment rather than one suffering from inadequate liquidity. While market measures of inflation expectations remain very low, long periods of very low interest rates influence the capitalized value of income streams. A given monthly mortgage payment will purchase a more expensive house when interest rates are lower. What people and firms invest in is distorted toward more capital-intensive projects than are economically efficient and justified at normal rates of interest.  Pension funds and other endowments lose income that must be made up somehow (often by moving into riskier investments). Asset price bubbles emerge. On top of these economic risks, the Fed’s need to unwind its huge portfolio of securities (purchased by printing money) when the economy recovers more fully is becoming more and more challenging.

Moreover, the policies of one central bank can affect the exchange rate of its currency if its policies are not coordinated with those of other central banks. This can either improve or worsen the balance of payments between countries (balance of imports and exports). The very wide swings over the last decade in the exchange rate of the US dollar with the Euro, for example, cannot be justified by economic fundamentals and is very disruptive to trade and international capital movements. Recent monetary policy initiatives by the Bank of Japan raise such concerns.

In short, the problem is not that the Fed and other central banks are printing money. The problem is the amount they print and their conceit that they can do more to help the real economy than they really can, thus adding to the market’s uncertainty over the economic, policy, and financial environment in which their decisions to spend and invest must be made. The solution is to reestablish a hard anchor for monetary policy that allows the supply of money to be market determined (as proposed in my: Real SDR Currency Board, paper).

The fantasy of a purely private money that would overcome the weaknesses of government money, remains for the foreseeable future a utopian fantasy: “The Future of Money”. But those of you who enjoy fantasy, might enjoy the following story by Neal Stephenson: “The Great Simoleon Caper”.

Cyprus: Bailing in and capital controls

Three European countries with oversized banking sectors have suffered major bank failures. Two of them are in the Euro Zone (Ireland and Cyprus) and one has its own currency (Iceland). Iceland and Cyprus imposed temporary capital controls, while Ireland did not. Iceland imposed losses on the foreign depositors in its large, failed banks while Ireland, under EU pressure bailed out everyone (even bond holders) except the shareholders.

The jargon used to describe much of this—“bail outs,” “bail ins,” “haircuts,” “good bank bad bank splits,” etc.—can be confusing. In this note I attempt to clarify the key concepts and their importance via the examples of Iceland, Ireland and Cyprus.

Market discipline vs. supervision and regulation

Incentives always matter. Banks, like any other business, are in business to make money. But the amount of risk they take (more risk more return—ON AVERAGE) depends on who regulates their behavior. Fundamentally, the market can regulate bank risk taking—by the willingness of investors to lend to banks and of depositors to place their money there—or the government can.

The last century has seen a steady shift away from market regulation toward government regulation. Deposit insurance is an important factor contributing to that shift by removing any concern by smaller depositors of the condition of their bank. Thus deposit insurance requires a substitution of the due diligence that used to be performed by small depositors with increased government regulation of bank risk taking. In the United States, the Federal Deposit Insurance Corporation (FDIC) provides much of that supervision and regulation.

However, increasingly countries became unwilling to allow banks to fail. While shareholders might be wiped out when a bank became insolvent (i.e., when the value of its assets fell below that of its deposits and other liabilities), country after country have “bailed out” all other bank creditors, including uninsured depositors. Bailing out depositors and other creditors means giving taxpayers’ money to the bank to make up for its losses and thus cover its liabilities (other than shareholders).  For large, “systemically important” banks (meaning banks whose failure could cause fatal losses in other banks or firms), most countries are not willing to let them fail at all, thus bailing out shareholders as well in order to allow the banks to continue to operate. Hence the problem of banks that are “too big to fail.” Bailing out uninsured depositors made deposit insurance redundant and pointless. Market discipline was pushed aside all together. The safety and soundness of banks came to rest almost completely on the adequacy of regulations and the skills of supervisors. Bank owners, the only ones who care any more, now have a financial incentive to take big risks for potential big gains. If they lose, as they do from time to time, the government, i.e., tax payer, will pick up the bill.

It is desirable to shift more of the discipline of bank risk taking back to the market by convincingly putting bondholders and large, uninsured depositors at risk of loss if their bank becomes insolvent. They have a financial incentive to get it right that supervisors do not.

Resolution of insolvent banks

Best practice when a bank becomes insolvent is to resolve it quickly and fully and to put a large part of the cost of its losses on uninsured creditors (shareholders, bond holders and uninsured depositors in that order).  Normal company bankruptcy can take the form of shutting down, locking the doors, and selling off anything of value (normally taking a few years) and distributing the proceeds to the creditors in the order of the legal priority of their claims. It is a transparent and objective, but slow process. In many instances the highest value for a failing company is obtained by selling it whole or in part to another company that is able to run it more efficiently. The recent bankruptcy of Sara Lee and sale of its best products to other companies is an example.

The bankruptcy and resolution of an insolvent bank is more challenging because of the ease with which depositors can run when they sense trouble. Thus the weekend sale of such banks in whole or in part to another bank is the norm for small or medium-sized banks in the U.S.  The good bank bad bank split, as occurred recently in Cyprus, is a recent example. Laiki became the bad bank that was closed and is being liquidated and the Bank of Cyprus became the good bank. After wiping out its shareholders and bondholders and administering a large haircut to the uninsured depositors, it acquired the insured deposits of Laiki and an equivalent value of good Laiki assets. Such bank resolutions, which freeze depositors’ funds only for very short periods (a few days), require special bankruptcy laws for tailored for banks. As the surviving good bank must continue to operate with little to no interruption, more judgment and uncertainty is involved in valuing the assets that it acquires from the bad bank.

It is instructive to look more closely at the resolution process used in Cyprus. First, the two major banks in Cyprus, Laiki and Bank of Cyprus, incurred large losses on their holdings of Greek sovereign debt when all banks were required to “voluntarily” write off about 75% of its value. The magnitude of this loss was clear and well-known from October 2011. The only issue was who would pay for it, the Cypriot government, the EU, or the creditors (depositors) of these banks. Depositor’s obviously thought that they would be bailed out (i.e. that the Cypriot government or the EU would pay for the losses of Laiki and Bank of Cyprus) as had been all depositors in Europe before them, though the deposit liabilities of the Bank of Cyprus fell from 37.1 billion Euros at the end of 2010 to 32.1 billion at the end of 2011 to 28 billion at the end of September 2012 (the latest available).

After a terrible false start in which the Cyprus government attempted to pay for the losses by levying a wealth tax on all depositors (of good and bad banks), Cyprus choose to impose the entire loss on the respective banks’ owners and creditors, and to undertake the good bank bad bank split briefly described above (see my earlier blog on the subject: https://wcoats.wordpress.com/2013/03/27/the-cyprus-game-changer/). This was a dramatic change in approach that shifted the risk of bank behavior back to uninsured depositors. Many were shocked.

This approach is relatively easy for known losses and should have been undertaken a year and a half earlier when the Greek debt write off occurred. But many of the losses a bank has or is incurring are less clear. Of the currently delinquent mortgage loans, for example, how many will actually default and what will be the market value of the mortgage collateral. The recapitalization of insolvent Irish banks suffered from underestimation of the ultimate losses resulting in three separate injections of state money to recapitalize them, which weakened market confidence in the process. In part to deal with this uncertainty but to restore market confidence in the solvency of the surviving good bank (Bank of Cyprus), known losses were totally written off while the additional but uncertain further losses were covered by replacing an equivalent amount of deposits with equity claims on the BOC (shares). If losses turn out to be smaller than was provided for, these claims will have value and will thus reduce the size of the initial haircuts to deposits.

So “bailing out” a bank refers to covering its losses with someone else’s money (tax payers somewhere) and “bailing in” a bank’s creditors refers to covering its losses (after its capital is used up) with bondholders and uninsured depositors’ money via “haircuts” (writing off part of their value). The former “socializes” losses while leaving any gains from successful bets to the private owners and creates a serious moral hazard leading to excessive risk taking by banks. The latter makes depositors financially responsible for excessive bank losses and restores the market’s discipline of bank risk taking. This is very desirable as market discipline is more effective than regulatory discipline, but the dramatic change in the implicit rules in Cyprus was very large and abrupt.

Capital controls

As part of their respective bank resolutions, both Iceland and Cyprus imposed temporary capital controls, which, however, served very different purposes. Iceland has its own currency while Cyprus is part of the Euro zone.

At the time of Iceland’s banking crisis in 2008 its three largest banks had assets 11 times the total annual output of the economy. About half of their assets (largely loans) and their funding were outside of Iceland. Landsbanki, for example, funding its lending with roughly the same amount of borrowing and deposits (a highly risky strategy). When the borrowed funding of these three banks dried up, their size made it impossible for the Icelandic Central Bank (ICB) to provide their needed liquidity (much of which was in the Euro, a foreign currency), resulting in the failure of all three banks in the second week of October 2008.

Iceland honored all insured deposits domestically and abroad but moved all domestic deposits into newly established “good” banks from the three now bad banks, while leaving their overseas, uninsured deposits in these three banks in receivership. To the extent that these banks failed because of illiquidity (the cut off of their borrowed funding), the receivership should be able to recover all losses to depositors from the liquidation of the banks’ remaining assets.

The UK and Netherland’s objected to the unequal treatment of the uninsured deposits of Icelanders and of foreigners. While Iceland’s decision to bail out all of its domestic depositors may be questioned because of the moral hazard it perpetuated, they had no legal obligation to do the same for Euro deposits by foreigners. The UK and the Netherlands stepped in and followed the same policy adopted by Iceland by guaranteeing the deposits of their citizens. They then tried to collect the cost of these guarantees from Iceland, a very questionable claim.

As the three new “good” banks were fully capitalized, they should have been able to withstand any level of deposit withdrawal as long as the ICB was able to provide any liquidity needed against the good but illiquid assets of these banks. The return of depositor confidence to the banks invariably takes time and some depositors wanted to withdraw their funds. However, because Iceland has its own currency, nervous Icelandic depositors wanting to move their bank deposits abroad, would need first to convert them into Euros or U.S. dollars, which would have depreciated the international value (exchange rate) of the Icelandic króna, and depleted ICB’s international reserves. A depreciation of the króna would raise the cost of imports and reduce the standard of living in Iceland. To protect the exchange rate from excessive devaluation, the ICB imposed temporary limits on the amount of money its residents could move out of the country. These capital controls are still in effect.

Lucky Cyprus is in the Euro zone.  After recapitalizing its banks, in part by writing down their deposit liabilities, they should have sufficient assets to cover all of their deposit liabilities and thus to cover any deposit withdrawals. The only issue would be whether the BOC’s assets were sufficiently liquid to cover the withdrawals. Within the Euro zone payments outside the country are made via the Target Payment System. A transfer of deposits from the BOC in Cyprus to a bank in any other Euro zone country is made by debiting the BOC’s clearing balance with the Central Bank of Cyprus (CBC) and crediting the recipient bank’s clearing account with its central bank via Target. If the BOC does not have sufficient funds in its clearing account with the CBC and is unable to sell sufficient assets to increase that balance, it can borrow the funds from the CBC using its good but illiquid assets as collateral. The CBC is able to do the same by borrowing from the European Central Bank (ECB), which is prepared to lend unlimited amounts against good collateral now that Cyprus has undertaken the measures required for the troika’s financial support (i.e., from the EU/ECB/IMF). There is no exchange rate issue or concern. It is purely a matter of the solvency and liquidity of Cypriot banks.

However, establishing sufficient liquidity to fund large deposit withdrawals may take a few weeks or months and thus Cyprus has imposed temporary capital controls that limit the amount of money that may be withdrawn each day as cash or by transfer. If the arrangements enjoy sufficient public confidence in the soundness and viability of the surviving Bank of Cyprus, the deposit withdrawals should be modest. The period of limits on withdrawals should be measured in weeks rather than months or years.

Conclusion

The resolution of Cyprus’s insolvent banks ultimately, after a false start, was achieved by bailing in its creditors. The resolution was relatively quick and seems complete. While Cyprus’s economy is likely to suffer its abrupt adjustment for some time, its banks should now be sound. The dramatic shift of the responsibility of regulating the risk taking of banks to their uninsured depositors, should, if it is maintained throughout Europe despite nervous claims that it is one-off and not a model, restrain excessive risk taking by banks and lead over time to a stronger banking system. In the interim, there may be some disruptive deposit shifts as previously reckless banks are forced by the market to clean up their acts.

The Cyprus Game Changer

Early banks were established by wealthy men that depositors could trust to return their money when they wanted it. Bank owners had unlimited liability for the trust placed in them. Any losses that exceeded what the bank owed its creditors (primarily depositors) had to be made up from the personal wealth of their owners.

With the introduction of limited liability banks, bank owners invested in significant amounts of capital (the difference between the value of the bank’s assets and liabilities) to reassure depositors that the bank was safe. They also advertised the conservatism with which they lent and invested depositor money. Some countries granted bank owners a liability limited to double the capital they paid into the bank in order to increase depositor protection without tying as much money up in capital.  In the much of the nineteenth century in the United States banks held capital well above 50% of their loans.

These early experiences with banking without any deposit insurance or any expectation by depositors that someone would bail them out (repay their deposits) if the bank failed (failure was the result of the bank not having enough money to repay depositors), maximized the market’s discipline of bank risk taking. Depositors paid close attention to the safety and soundness of the bank they put their money in.

During the great depression, the U.S. and most other countries introduced limited deposit insurance for small depositors thought to be too unsophisticated to evaluate the soundness of their banks. Such deposit insurance pretty much eliminated bank runs by panicked depositors. The level of deposits covered by insurance has risen considerably in most places (in the U.S. it is $250,000 and in Europe €100,000) thus reducing market discipline to some degree.

But outside of the United States, where the Federal Deposit Insurance Corporation (FDIC) has broad intervention and resolution powers to take over insolvent banks and to keep them going (if that is the least cost resolution) by reducing shareholder, bondholder, and uninsured depositor claims, almost no country allows its banks to fail (though this has begun to change in the last decade or two). If a bank experienced large enough losses that it became unable to pay off its depositors (i.e. became insolvent), governments would almost always bail it out one way or another. Depositors never lost anything. This practice and the market expectation it created made a joke of limited deposit insurance (because ALL deposits were implicitly guaranteed) and significantly reduced market discipline of bank behavior. This required more active supervision and regulation of banks to take the place of market regulation.

After a very bad start in Cyprus last week (see my blog from last week: https://wcoats.wordpress.com/2013/03/23/cyprus-and-the-euro/) the resolution of Cyprus’ two largest banks, Cyprus Popular Bank and the Bank of Cyprus, is taking the form intended by the banking law. Rather than bailing out the bank (the Cyprus government doesn’t have the money to do so, hence its need to turn to external help –EU/IMF/ECB and to accept the conditions attached), the shareholders, bondholders, and uninsured depositors (in that order) are being bailed in to cover the losses. The insured deposits of the Cyprus Popular Bank, aka Laiki, will be transferred to the Bank of Cyprus along with good assets of equivalent value. Laiki, the “bad bank”, will be put into receivership and its uninsured depositors will receive whatever value can be realized from the sale of its remaining assets (they are expected to lose about 80% of the value of their deposits). The Bank of Cyprus, the “good bank”, will continue to operate but will be recapitalized by wiping out the shareholders, bondholders and about 40% of the value of uninsured deposits. Depositor risk and the market discipline it provides to banks has returned with a vengeance. Hopefully this will be the practice throughout Europe going forward, which could then stop ignoring its no bailout rule.

In a Financial Times interview Jeroen Dijsselbloem, the Dutch finance minister and Eurogroup chairman stated that: “If we want to have a healthy, sound financial sector, the only way is to say, ‘Look, where you take the risks, you must deal with them, and if you can’t deal with them you shouldn’t have taken them on….’ That’s an approach that I think we, now that we are out of the heat of the crisis, should consequently take.”

This is a very promising change in European attitudes. Sadly it shocked so many EU officials that Mr. Dijsselbloem had to back track by saying: “Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday. Macro-economic adjustment programs are tailor-made to the situation of the country concerned and no models or templates are used.” (quoted in the March 26 WSJ “Shocked about Cyprus”) The big unknown is whether this was too rapid a restoration of market discipline. Changing the rules is always problematic and government explanations to their publics of the situation and their policies for dealing with it have been poor to date. The coming days will be interesting indeed.

Cyprus and the Euro

Does the Euro need to be supported by closer European fiscal integration? Many countries do just fine without their own currency and no fiscal coordination with their currency’s issuer. Panama has used the U.S. dollar for well over a century with good success. Ecuador and El Salvador have used the dollar as their own currency for a much shorter time and are doing better for it. Etc.

The major failing of the Euro, along with its considerable benefits for the Euro zone countries and those doing business or traveling among them, has been the failure of lenders to properly price the risk of lending to the Greece’s and Italy’s of the world. The spread between Greek government bonds over German government bonds collapsed to near parity after Greece replaced its inflation prone currency with the low inflation Euro. Greeks, both private and public, responded by borrowing with abandon. Greece has many other structural problems that keep its productivity lower than its neighbors, but credit markets indulged its borrowing binge on the assumption that there was little to no risk that the Greek government would be allowed to default on its debt.  This gave Greece the illusion of a higher standard of living for a while. Richer brothers to the north would surely step in and bail it out if it couldn’t repay its debts. And so it was for a while.

Against German resistance, Greece finally defaulted on much of its debt (the so-called voluntary haircut – write down — of its debt held by banks to about 30% of its full value). This was an important restoration of market risk and hence market discipline of Greek and other EU periphery countries’ borrowing. It will potentially help save the Euro. Most banks were able to absorb their resulting loss, but some big Cyprus banks apparently were not.

The EU/ECB/IMF (the troika) have offered conditional financial assistance to Cyprus but not to cover the cost of recapitalizing Cyprus’s underwater banks. Cyprus is required to raise those funds themselves. At least this is my assumption. Press reports on what the external support covers are almost totally lacking and the conditions for the deal are not yet final anyway. There is a relatively straightforward approach to resolving these banks, though the details would depend on the particulars of its banking and bankruptcy laws. I do not know the details of these laws nor of the conditions of these banks (Laiki and Bank of Cyprus), but I assume that they are viable if recapitalized and worth more as going concerns than from liquidating them.

The insolvent banks should be put into receivership and instantly split into a good, fully capitalized, bank and a bad bank (i.e. what ever is left) to be liquidated. The good banks would be fully capitalized by leaving some of their liabilities with the bad bank, starting with its shareholders, then bondholders (of which there are not many), then uninsured depositors. These creditors would, in effect, be written off. This would enable the new good banks to continue operating without serious interruption. The only real debate should be about how far to cut into depositors (so-called bailing creditors in) to rebalance assets and liabilities. The Economist argues that the write-offs should stop with shareholders and bondholders and all depositors should be made good via bailout funds from the European Stability Mechanism.

Depending on the particulars of the banking law, an insolvent but otherwise viable bank is put into receivership. This removes the shareholders from any control over the bank. Immediately the good assets of the bank, including its branch network and equipment, and staff would be sold to a new bank, which would assume all insured deposits and a proportionate amount of the uninsured deposit sufficient to match the value of the assets purchased. Ideally the new bank would be sold immediately to new private owners. But if more time is needed to organize its sell, it would be sold temporarily to the government for one Euro. What remains of the old bank would be liquidated and the proceeds would be apportioned in accordance with the priorities provided in the law to the credits (deposits that were not transferred to the new bank). As all of the good assets were transferred to the good bank, there would be virtually no further assets in the bad bank to recover and the remaining creditors would receive little to nothing.  The overall loss to depositors will depend on the losses incurred by the bank on its assets that made it insolvent in the first place. The orderly resolution described above almost always result it much smaller losses to creditors than a disorderly default in which the bank closes its doors totally.

Market discipline would clearly be more strengthened if uninsured depositors were also at risk of losing money. But increasing that risk unexpectedly and to too large an extent could cause deposit runs throughout Euro (and the world). Ultimately, but maybe not at the moment, this would be a good thing for the banking sector. Banks would have to behave more prudently or run the risk of losing deposits. Such market discipline is more effective in limited excessive risk taking by banks than is tighter supervision; though required capital and senior convertible bonds should be significantly increased in the future. In my view, the full recapitalization of all insolvent banks should be financed by bailing in as many uninsured depositors as needed to cover their capital deficiency. The IMF’s position, opposed by the EU, was that a good bank should assume only the insured depositors and receive sufficient good assets to cover them. This would leave all uninsured deposits in the bad bank, which were expected to suffer losses of 20 to 40 percent of their value.

The Cypriote officials originally proposed something quite different. They proposed a one-time levy on all depositors with a lower tax rate on smaller insured deposits. Thus both insured and uninsured depositors in good banks as well as bad ones would be paying to cover the losses of insolvent ones. Not exactly a boost to market discipline of banks. Depositors everywhere and especially in the Euro zone were shocked and the Cyprus Parliament rejected the proposal.

It will be interesting to know what motivated this crazy idea. For one thing it protects the shareholders from the loss of their shares and control of their banks, which is not a good idea from the point of view of the health of the banking system, though it may have been a deliberate goal of the plan (the shareholders are likely to be influential people in Cyprus). Antonis Samaras, the President of Cyprus, suggested that he wished to diminish the loss to large depositors (which include many wealthy Russians, some of whom have dealings with his law firm). Steve Hanke states that about half of Cyprus banks’ deposits are owed to Russians (including those of Russian subsidiaries established in Cyprus).

Whether lightening the burden of large depositors (sharing the burden more equitably according to the President) involved murky deals with Russians or the mistaken belief that it might save the large offshore deposit business Cyprus had developed (the deposit liabilities of its banks were eight time Cyprus’s GDP) only time will tell (maybe). Cyprus’s banking business is more like that of Iceland or Ireland before they crashed and burned several years ago, than the typical off shore financial centers like Cayman. The deposits in Cyprus are with Cyprus banks. If they become insolvent, depositors (or tax payers somewhere) lose. Foreign depositors in Cayman banks are actually depositing in branches of international banks with headquarters and assets elsewhere. Loses incurred by Cayman branches would be a small fraction of the total assets of the global bank and more easily absorbed.

Cyprus’s misguided attempt to spare large depositors at the expense of depositors in general, even if rejected in the end, greatly unnerved depositors everywhere and is likely to weaken rather than strengthen market discipline of bank risk taking.  By making the depositor haircut a levy/tax, Cyprus intended to bypass the bankruptcy/resolution provisions of the banking law and deposit insurance provisions. They created a mess.

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.

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.