The debate is profound, and the two stake out radically different positions, even though they end up at pretty much the same place. Soros says that Germany should make a simple choice: either sign on to Eurobonds, where the euro zone as a whole would issue low-yielding debt to the benefit of all, or else leave the euro zone entirely. Either way, he says, Europe would win — either from reducing the fiscal burden of the various national debts, or else from seeing the euro devalue against the new Deutschmark.
Sinn agrees with Soros that Germany would be making a huge mistake were it to leave the euro zone; he disagrees vehemently, however, on the subject of Eurobonds. But both men are clear that given political realities in Germany, neither of Soros’s two choices is going to happen. Germany is going to stay in the euro zone, and Eurobonds aren’t going to happen.
That, says Soros, is a tragedy:
Europe would be infinitely better off if Germany made a definitive choice between Eurobonds and a eurozone exit, regardless of the outcome; indeed, Germany would be better off as well. The situation is deteriorating, and, in the longer term, it is bound to become unsustainable…
There is no escaping the conclusion that current policies are ill-conceived. They do not even serve Germany’s narrow national self-interest, because the results are politically and humanly intolerable; eventually they will not be tolerated. There is a real danger that the euro will destroy the EU and leave Europe seething with resentments and unsettled claims. The danger may not be imminent, but the later it happens the worse the consequences. That is not in Germany’s interest.
And even though Sinn thinks that Soros is wrong, his prognosis seems just as grim, filled with painful austerity and sovereign default:
The only remaining option, as unpleasant as it may be for some countries, is to tighten budget constraints in the eurozone. After years of easy money, a way back to reality must be found. If a country is bankrupt, it must let its creditors know that it cannot repay its debts.
My sympathies in this debate are with Soros, although Sinn does make a good point about the unintended consequences of Alexander Hamilton mutualizing state debts in 1791. (There really aren’t a lot of precedents for the kind of Eurobonds Soros envisages.) The overarching message from both of them, however, is that, as Soros puts it, “the current state of affairs is intolerable”. The only question is whether there’s a better alternative; Soros says there is, while Sinn says there isn’t.
The conclusion from them both, then, would seem to be that Europe as a whole is doomed to misery for as far as the eye can see, and that things are going to get worse before they get worse. I really hope they’re wrong. But so long as Europe’s future generations remain jobless, it’s hard to see a silver lining to this cloud.
It’s always illuminating to sit down with Lee Buchheit. He’s the dean of sovereign debt restructuring, he’s living through by far the most interesting period of his career right now, and this week I got the rare opportunity to ask him a bunch of questions on the record. Argentina, sadly, was ruled off-limits, but that just meant we had more time for Europe, where Buchheit was very, very interesting.
The Reuters TV crew has put the headline “Sovereign debt 101 with Lee C. Buchheit” on this one, which suffers a bit on the truth-in-advertising front: it’s a high-level discussion, and it helps to have a pretty sophisticated understanding of what has happened in Greece, Portugal and Ireland; and also to have read Buchheit’s recent paper with Mitu Gulati, “The Eurozone Debt Crisis — The Options Now”.
In that paper, Buchheit puts forward a novel idea for what Spain and Italy should do if they lose market access at acceptable yields: they should basically do the mother of all can-kickings, and restructure their debt by pushing every bond’s maturities out by five years.
But before we talked about that idea, we talked about Greece, which Buchheit said was pretty much unique in the annals of sovereign debt restructurings in that it was not designed to get the country’s debt load onto a sustainable footing. And as in many ways the primary architect of that deal, he should know.
Buchheit’s point, and it’s a good one, is that Greece was never in control: it basically just always did whatever it was told to do by the official sector. For a good two years after the country lost market access, the official sector told Greece that it must not default on its debts, and instead provided all the money to repay those debts in full and on time — on top of all the money needed to finance Greece’s fiscal deficit. Then, suddenly, the official sector changed its mind, and demanded a private-sector haircut. So, that’s what Greece did. But even after a steep haircut, Greece’s debt is still unsustainable. Which raises the question: what is the official sector going to do about that, and when is it going to do it?
Buchheit’s answer — and I think he’s right about this, at least so long as Greece remains in the euro — is that eventually the official sector will be forced to do a reprofiling, or “treatment”. They’ll avoid taking a nominal haircut: they’ll keep the principal amounts intact, which won’t do any favors to Greece’s debt-to-GDP ratio. But they’ll push maturities out very far indeed, and attach extremely low coupons to them, to minimize the debt-service burden on Greece.
There are massive problems with this, however, not least the fact that I can’t imagine how Greece could ever regain market access under such a regime. Buchheit thinks the same thing: “Greece could not, I think, return to the voluntary markets even if you did stretch out the official sector debt until the 12th of never.”* If it stays in the euro and doesn’t reduce the face value of its official-sector debt, private-sector participants will have no real interest in funding the deficit. What Buchheit is talking about here isn’t a strategy, so much as it’s the absence of a strategy: it’s almost literally the least that the official sector can do. And even then it’s not going to happen until after the German elections in September 2013.
And there’s another problem too. If Greece gets its official-sector debts reprofiled, then Ireland and Portugal are going to want exactly the same thing. Private-sector debt defaults have large costs; official-sector debt reprofilings do not. And so if the official sector does do this for Greece, they’re going to have to find the wherewithal to do exactly the same thing in Portugal and Ireland. Which won’t be cheap or easy.
If reprofilings are unattractive things to the official sector, they’re much more unattractive to the private sector, which considers them to be a default. So why would Italy and Spain ever consider such a thing with their private bonds?
Buchheit’s answer is that Spain and Italy can’t do a Greek-style restructuring of their domestic debts, with a principal haircut, because that would just render their entire domestic financial systems massively insolvent at a stroke. The resulting bank bailout would cost more than the amount saved on the national debt, making the whole exercise a false economy.
What’s more, such an exercise would put a lot of foam on the runway, as the crisis-management types like to say. As we saw with Argentina, a default which everybody sees coming is actually a lot less damaging, from a systemic perspective, than a default which happens suddenly. (Argentina’s slow train-wreck had much less impact on the markets generally than did Russia’s smaller, but much more unexpected, default, and one of the big problems with the Lehman bankruptcy was the fact that it was unforeseen by the markets.) The exercise of reprofiling Spain and Italy’s debts would give the markets notice that something a bit more drastic might have to happen in five years’ time — and with that kind of advance notice, both the official and the private sectors would have a lot of time to prepare for such a thing.
Finally, Buchheit points out that when it comes to the eurozone, countries always end up doing what the official sector wants, rather than what private-sector bondholders want. And there are lots of reasons why the official sector would like a reprofiling — the biggest of which is that it doesn’t involve the official sector being forced to bail out the private sector. The official sector would still need to fund the countries’ deficits, but at least it wouldn’t need to fund their private-sector principal repayments as well.
There is one more possibility, which Buchheit largely dismisses — and that’s the break-up of the euro. He says, quite rightly, that the euro has brought many benefits to the peripheral countries — but it seems to me that the era of those benefits is largely over, and that we’re now entering an era where the costs are becoming unbearable.
The problem with Buchheit’s reprofiling idea, whether it happens to official-sector debt in Greece and Portugal and Ireland or to private-sector debt in Spain and Italy, is the same as the problem with the Greek debt restructuring: it doesn’t address any of the big problems of a heavily-indebted uncompetitive country with sky-high unemployment. The technocrat’s answer to such problems is always the vague-sounding “structural reforms”, but in most of these countries, I don’t think that “structural reforms” are either politically or practically feasible. Sometimes, huge problems require drastic solutions. And the most drastic solution for a troubled eurozone country is, clearly, a default and devaluation. Which could be quite attractive, if it came with some one-off official-sector financing (to protect depositors), as well as continued membership in the European Union.
*Update: Buchheit emails to clarify that “if indeed the official sector were to stretch out their claims against these countries to the 12th of Never at a very low coupon, I suspect that the markets would be prepared to resume lending. In effect, by virtue of the maturity dates, the official sector will have subordinated itself to new (short and medium term) private sector lending.”
The timing of the Nobel Peace Prize announcement was set in stone a long time ago, of course, but I love the way in which it comes just two days after EADS and BAE — two European arms-dealing behemoths — announced that their greatly-desired merger had been killed by European political infighting. Here’s the Nobel announcement:
The EU is currently undergoing grave economic difficulties and considerable social unrest. The Norwegian Nobel Committee wishes to focus on what it sees as the EU’s most important result: the successful struggle for peace and reconciliation and for democracy and human rights. The stabilizing part played by the EU has helped to transform most of Europe from a continent of war to a continent of peace.
And here’s EADS:
Notwithstanding a great deal of constructive and professional engagement with the respective governments over recent weeks, it has become clear that the interests of the parties’ government stakeholders cannot be adequately reconciled with each other or with the objectives that BAE Systems and EADS established for the merger.
The stock market, for what it’s worth, quite liked the failure of the deal: mega-mergers, after all, rarely work. Maybe they should send flowers to Angela Merkel, who bears most of the credit/blame. Meanwhile, as a proud EU citizen, I’ve been walking on air all day: I can now add the Nobel Prize to the Time Person of the Year award in the list of my personal achievements. Jose Manuel Barroso says so himself!
This prize belongs in much the same category as Barack Obama’s, or Paul Krugman’s: it’s designed to push a certain vision of how the world should look in the future, as much or more than it is designed to recognize some achievement which happened in the past. But there’s a problem here: the things which worked in the past won’t work in the future. The Nobel committee surely has a vision of prosperity and unity — as Dylan Matthews explains, the two have gone hand-in-hand for the past 60 years. But where they used to work together, they’re now working against each other: as Gary Cohn says, there’s a good chance that the EU, or at the very least the eurozone, is going to break up precisely in order to generate the kind of prosperity which no longer seems possible anywhere south of Milan.
All of which is to say that fractiousness, these days, seems to be more remunerative than unity. We’re becoming a go-it-alone, winner-takes-all world, where opposition beats cooperation — and that, in turn, bodes ill for peace and for federalism wherever it’s found. There’s no chance of outright war within the EU: that particular achievement is nailed down, and has been for decades now. But riots and unrest and national-independence movements are on the rise, in large part because the European project of ever-greater integration and unity has stopped producing wealth and started destroying it instead.
The dot-com boom of the late 1990s was financed in large part by the peace dividend of the early 1990s: money which used to get poured into the Cold War could be spent much more productively elsewhere. Indeed, for most of the past 50 years, western Europe has been steadily moving money out of swords and into ploughshares and the welfare state. But that trend has been taken about as far as it can go, at least in Europe. And so while peace and prosperity have historically been aligned, as the consultants might have it, that alignment is getting thrown out of whack right now.
Which is why I think the Nobel committee decided to give the EU its gong this year. It’s their way of saying that the European project is a worthy and noble one regardless of whether it creates wealth and prosperity. In reality, however, if a European economy falls into a deep recession where the only visible way out is exit from the euro, then that economy will inevitably exit the euro. Politics might sometimes trump economics, but economics nearly always trumps ethics. Almost everybody likes the EU in theory. But unless it works for them in practice, it will certainly fall apart.
Sony Kapoor has a very good post on the Spanish bank bailout today, explaining that when Spanish credit spreads rose in the wake of the bailout, that had nothing to do with the fact that bailout funds were senior to privately-held bonds, and everything to do with enforced austerity.
The clever thing about Kapoor’s post is that he explains this empirically, through simple force of arithmetic. Basically, channelling new money to a liquidity-constrained debtor is always good for existing creditors, even if the new money is senior. That’s obviously the case if the new money prevents insolvency, but it’s also the case if it doesn’t:
Imagine a country has an NPV of expected future primary surpluses equal to x euros, which defines its sustainable debt carrying capacity and that its debt stock is y euros; we don’t need to say whether x is bigger than y or not. Now on a date say the 1st of Jan 2013, it gets a public bailout equal to z euros. Its debt repayment capacity is x+z euros as it now has the equivalent of z euros in a bank and its total debt is now y+z euros. If y>x then y+z>x+z and nothing changes. Assume x = 0.8 y, then bondholders would face a 20% haircut, whether before or immediately after the public injection of z euros.
Now imagine that the z euros bailout is at a concessional rate of interest. Then it will improve the sustainability of debt, all else remaining the same and increase the potential pay out to private bondholders. Equivalently, if the country invests the z euros it obtains in NPV positive projects, the sustainability of its debt improves, making the outcomes for private bondholders more positive.
So why are Spanish bond yields now so much higher than they were before the bank bailout? Isn’t the bailout a good thing? Not necessarily:
There is one exception to this rule, which is when the conditionality accompanying a public bailout is so flawed that it makes the recipient country adopt policies that actually hurt growth prospects and reduce its debt carrying capacity thus increasing the likelihood of insolvency and the size of private sector losses. This is a big and legitimate fear given the current excessive focus on austerity in the Eurozone and may play some part in the panic around Spain.
The logic here is scary, but also entirely coherent: the more bailout funds a country gets, the more it ends up being forced into austerity programs which will ultimately do more harm than good.
On the other hand, there’s hope here, too. If Mediterranean Europe eventually manages to tear Germany away from its unhealthy austerity addiction, then all this extra liquidity in the Eurozone could trigger a significant tightening in sovereign yields. Even if it’s subordinating those bonds at the same time.
Essentially, Soros characterizes the European project as being a bit like a runner, moving at a steady clip in the direction of greater unity. Running is a weird thing: it’s basically the art of falling over continuously in a particular direction. So long as you keep on moving forwards, you can maintain a dynamic equilibrium. But stopping is really hard, because whenever you try to do that, you’re out of balance:
The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble.
The problem here is that the statesmen didn’t understand that they were running: they thought they were walking. They thought that while forward momentum was a good thing and maybe even necessary, ever-greater union was in and of itself a good thing, which would bring the continent closer together and make it stronger. With hindsight, by contrast, we can see that it was a way of turbo-charging the European bubble, and setting it up for a catastrophic pop if and when the process of integration didn’t continue far beyond what was politically feasible circa Maastricht.
The bubble was a consequence of the convergence trade, which in turn, says Soros, was a function of BIS risk weightings:
When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive. Then came the crash.
The problem here is that the convergence trade could probably have been better described as a divergence trade: it created a two-tier Europe, with a strong creditor-filled center funding a weak debtor-filled periphery. And as a result the political union — which had always been the necessary other shoe to drop — became impossible, rather than inevitable.
At this point, says Soros, optimistically, Europe still has three months to pull together a comprehensive package to save the union — a package which is just as economically necessary for Germany as it is for Spain. But politically, getting this done is going to be incredibly hard: “the disintegration of the European Union,” says Soros, is “just as self-reinforcing as its creation”.
The economic necessity for Germany, here, is a product of Target 2, the mechanism by which the Bundesbank’s balance sheet now holds €660 billion in peripheral-country claims. Germany needs to throw money, more or less continuously, at the European periphery at this point, because if it doesn’t, its central bank will suddenly find itself insolvent to the tune of roughly €1 trillion. That wouldn’t be the end of the world: if Germany got its Deutschmark back, then the Bundesbank could simply print €1 trillion worth of Deutschmarks to fill that hole. But a world where the Bundesbank is willing to print €1 trillion worth of Deutschmarks is simply not the world we’re living in, and the Germans will do pretty much anything to avoid that outcome.
Which leaves us with the only alternative:
Germany is likely to do what is necessary to preserve the euro – but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments. That would turn the European Union into something very different from what it was when it was a “fantastic object” that fired peoples imagination. It would be a German empire with the periphery as the hinterland.
This is, in a nutshell, the bet I have with Joe Weisenthal. He, like Soros, says that Europe — including Greece — will become a German empire, where the Germans reluctantly dole out a stream of transfer payments to a resentful periphery. I’m taking the other side of that bet, because I think it’s politically impossible, in a union of democratic nations. And also because I think that even if perpetual transfer payments to Spain are justifiable, perpetual transfer payments to Greece are not. Either way, here’s the video.
Mark Dow has found an astonishing set of results from a February opinion poll in Greece; it’s hard to imagine that Greek attitudes to Germany have improved since then. Here’s just one of the 13 slides:
The final question, in particular, renders rather unfunny the joke about the German Chancellor flying to Athens for some meetings, and being stopped at immigration. “Name?” she’s asked. “Angela Merkel.” “Occupation?” “No, I’m just here for a couple of days.”
For his part, Dow seizes on a different question — one which shows that 51% of Greeks attribute Germany’s strong economy to corruption, and only 18% attribute it to competitiveness. Greek public opinion, it seems, is decidedly of the view that the only way Greece can compete with Germany is to become a lot more corrupt.
Stephan Faris, in his profile of Alexis Tsipras’s far-left Syriza party, writes:
Tsipras possesses not just a deep knowledge of the Greek electorate but a populist’s knack for channeling mass emotion…
Polls show Greeks are pulled by two seemingly contradictory desires. Roughly two-thirds of the country opposes the bailout conditions. Yet almost 80 percent say they want to stay in the euro…
Tsipras’s demand that other EU countries — namely Germany — renegotiate the bailout deal on Athens’s terms reflects a seeming indifference to the very real failures in Greece’s economy.
Looking at the poll, I see something different. The overwhelming majority of the Greek electorate believes that Germany, quite literally, owes Greece money. In the decades since World War II, Greece has been waiting patiently for its rightful reparations — and instead it’s finding itself in the midst of another attempted takeover by Germany, a Fourth Reich. Looked at through this lens, the Syriza position doesn’t seem contradictory or indifferent to the realities of the Greek economy. Instead, it’s noble resistance to a dangerous hegemon.
All of which is to say that the relationship between Germany and Greece is irredeemably oppositional, at this point. The Germans think of Greeks as corrupt scroungers, who just want to live on the fruits of Germany’s productive labor; the Greeks think of Germany as, well Nazis. (Check out page 2 of the opinion poll: when asked “What is the first word that comes in your mind when you hear the word Germany?”, and given one spontaneous reply, 32% of Greeks said something about Hitler, Nazism, or the Third Reich. And in general, again, the overwhelming majority of answers were highly negative.
This is not, in any real sense, a European Union: if two people with these feelings for each other were married, everybody would agree that they should get divorced.
Looked at from the US, it’s easy to see Tsipras as playing a deeply tactical game: he’s advocating that Greece call Germany’s bluff, and thereby continue to get EU financing while reducing the amount of austerity that Greece has to impose on itself in return. But looking at this poll, I don’t see tactics: I think that Tsipras is simply reflecting very real Greek attitudes to Germany — attitudes which consider Germany to be not only fascist, but also deeply corrupt. If you think you’re owed money by such a country, you’re not going to be particularly willing to accept onerous bailout conditions in order to receive it.
All of which says to me that Grexit is inevitable, sooner or later. These two countries have pretty much nothing in common, bar their current currency. And now the tensions caused by that common currency are surfacing in particularly ugly ways. Before things get much worse, it would surely be better for both of them if Greece decided to go its own way.
And yet, there’s a silver lining, here. As far as I know, these attitudes to Germany are not shared by most people in Spain, or Portugal, or Italy. It makes sense for the EU to allow Greece to leave the euro, and then to put a big and credible firewall up around Iberia. Greece really is a special case. And the other 14 members of the euro, if they join together, still have the ability to remain together.
What exactly does the EU’s José Manuel Barroso mean, when he says today that the EU should move towards “a full economic union”, which would include “a banking union with integrated financial supervision and single deposit guarantee scheme”? In a simultaneous EC report, there was also talk of “direct recapitalization by the ESM (European Stability Mechanism)” when banks run into solvency issues.
The big idea here is simple, and relatively easy to understand. Banks in Europe’s peripheral countries, most importantly Spain, are understandably seeing their deposits move to countries like Germany, where there’s no risk of devaluation. But that kind of a slow bank run — Mohamed El-Erian calls it a “bank jog” — inevitably weakens those banks’ balance sheets, and the straitened PIIGS governments are in no position to shore up their banking systems with billions of euros in bailout money.
Here’s Mohamed’s suggestion, which seems to be extremely close to what the EC is now signing on to:
An incredibly disruptive situation could be avoided if Greek depositors were given quick access to a region-wide (as opposed to just national) deposit insurance scheme that is unambiguously supported by the fiscal authorities in the strongest eurozone countries. This would need to be coupled with even larger liquidity support from the European Central Bank, along with direct capital injection into the Greek banks from regional funds (e.g., the European Stability Mechanism, or ESM) and multilateral institutions (namely the International Monetary Fund).
I have a funny feeling that this is exactly what’s going to happen, but that implementation is going to be carefully timed so that it happens after Grexit, and not before. First you wait for Lehman Brothers to go bankrupt, then you give investment banks full access to the Fed discount window.
The problem is that deposit-guarantee schemes need to be tested before they’re trusted. Even with an EU-wide guarantee in place, at the margin German banks are always going to be safer places to put your money than Irish banks — and of course a guarantee would only cover relatively small six-figure retail deposits, it wouldn’t cover the huge corporate cash balances which only the most foolish of corporate treasurers would still consider leaving on deposit at, say, Bankia.
All of which is to say that although the degree of risk and uncertainty in Europe is high and can come down, there’s also a limit to how far it can come down. As Walter Russell Mead masterfully explains, Europe’s politics — much of which are playing out at the national level within multi-nation states — will inevitably and fatally trump whatever theoretical economic union the Eurocrats attempt to put in place. And because that risk is now so clear, the one thing that no one has to worry about is the kind of complacency where enormous systemic risks build up quietly without anybody noticing or worrying about them.
That’s the point that Nassim Taleb was trying to make in his Montreal speech yesterday — a speech which got reported by Bloomberg as simple investment advice. I know Nassim reasonably well, and I can promise you that he would never say that he “favors investing in Europe over the US” — he has nothing but disdain for anybody who makes such grand and stupid pronouncements. He would be happy, however, to reprise the theme of of his Foreign Affairs article last year, on the subject of “How Suppressing Volatility Makes the World Less Predictable and More Dangerous”. Clearly, the US is much better at suppressing volatility than Europe is, right now.
That essay has disappeared behind a paywall now, but I excerpted a bit of it here:
A robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast”)…
Consider that Italy, with its much-maligned “cabinet instability,” is economically and politically stable despite having had more than 60 governments since World War II (indeed, one may say Italy’s stability is because of these switches of government).
During the global economic crisis, the US was happy to see many more domestic bank failures than Europe was — and on top of that was happy to put its big automakers into bankruptcy. Those decisions served America well. Now, Taleb’s saying, the tables are turned: the volatility in Europe has become unavoidable, while the US appears to be a beacon and a safe haven. And whenever you achieve safe-haven status, the short-term benefits (the 10-year Treasury bond now yields just 1.65%, which more or less amounts to the markets begging the US government to borrow more) are always offset by hidden tail risks which tend to bite very hard indeed when they finally materialize.
None of which, of course, is or should be taken as investment advice. A long-Europe, short-US trade would be highly risky right now, with a greater-than-even probability of losing money. Now back in his trading days, Taleb specialized in putting on trades with a greater-than-even probability of losing money: he reckoned those trades were generally underpriced, and that the amount you made in the minority of cases where the bet paid off could more than cover the amount you lost in the majority of cases where it didn’t. But Taleb’s not a trader any more, and in any case none of that kind of sophistication made it into the Bloomberg article.
If you want a safe place to put your money, the conventional wisdom remains correct: Germany and the US are definitely safer than Spain and Greece. Nassim’s new book isn’t going to help you find a new, undiscovered safe haven. But it might serve to remind you that the stronger you think a political economy is, the more violently it tends to break.
One of the hardest questions to answer, when people ask about the European crisis in general and the Greek crisis in particular, is “why should we in the US care?” The simple answer is that well, this is an important part of the world, and it’s big news. But if you only care about news insofar as it directly effects the US, then the answer is harder.
One possible answer — I’ve heard this given in a number of places — is that another major crisis in Europe would spill over into the US, cause serious economic damage here, and could quite possibly make the difference between an Obama and a Romney victory. But just how likely is that? I’m no expert when it comes to assigning probabilities to events, but we can at least come up with a general framework which lets us answer the question.
Let’s start with the fiscal pact. Will all of Europe credibly commit to fiscal austerity going forwards? If so, that increases the chances of crisis and Grexit, since southern European countries in general, and Greece in particular, simply can’t operate under an austerity regime in the way that, say, the Baltics have managed, painfully, to do. On the other hand, everybody seems quite likely to break the fiscal pact in one way or another — which means that there has to be a good chance the pact will end up being honored mostly in the breach. Let’s call the probability of a Europe-wide austerity regime A; my best guess for A is roughly 15%, or 0.15.
So the next question is — what is the probability of Grexit, any time soon? That’s really two questions. First, what is the probability of Grexit if there’s Europe-wide austerity. Let’s call that B, and I’ll peg it at 85%, or 0.85. Second, what’s the probability of Grexit if Europe-wide austerity slips a bit? We’ll call that C, and I’ll say it’s 65%, or 0.65. Overall, we can define the chance of Grexit, D, as A * B + (1-A) * C. If you’re playing along at home, that’s 0.68, or 68%.
But just because Grexit happens, doesn’t mean it will necessarily affect the US election. For one thing, by definition, Grexit can’t affect the US election if it hasn’t happened by the time the election takes place. So the next question is: if there’s Grexit, what are the chances that it will happen by November? The Europeans have proven themselves very good at kicking the can down the road, so even if Grexit is inevitable, it’s still not inevitable by November. In any case, let’s define E as being the conditional probability of Grexit by November, given Grexit. I’ll say that’s 50%. Which means that the overall probability of Grexit by November, F, is D * E, or 34%.
Grexit, if and when it happens, will cause a lot of disruption in European markets, and certain deposit flight out of Spanish and Portuguese banks. Again, there are two ways this can play out. Either it will cause a series of further dominoes to fall, or else it will concentrate the Europeans’ mind and force them to build a large and genuinely effective firewall, drawing a line in the sand and saying “this far, but no further”. Will Europe let the Grexit crisis go to waste? Let’s say the probability of a credible, coordinated and constructive pan-European response to Grexit is G. Then the probability of Grexit causing a big European crisis is 1-G. What’s G? That’s a tough one, but I’ll put it at 35%.
For the purposes of this calculation, we’ll assume that Greece alone is too small to cause a big global crisis: you need contagion, for that. So we’re looking for H, the chance of a big European crisis before the US election. We can calculate that as F * (1-G), or 22% — that’s the chance of Grexit before November, multiplied by the chance of a bigger crisis if Grexit happens. (Note that a big European crisis can happen at any time; the chance of that is D * (1-G), which works out at 44%.)
If we have a big European crisis before the election, then that will certainly send US stocks falling. But will a sharp drop in the US stock market have any effect on the outcome of the election? Probably only if the election is reasonably close — and certainly not if Romney is in the lead. A European crisis, and consequent plunge in US stocks, would only be good for Romney and bad for Obama, just as the crisis in the fall of 2008 was good for Obama and bad for the incumbent Republicans. So what we’re looking for, here, is I, the probability that Obama will have a narrow lead over Romney — one small enough to be erased by a big stock-market plunge. I’ll peg I at 65%.
And thus, finally, we get to the big answer: what is X, the probability of Grexit toppling Obama? That is H * I, which using my off-the-top-of-my-head probabilities, works out at about 14%. But you should work this out for yourself. Come up with your own values for all these:
A: What is the probability of a Europe-wide austerity regime?
B: If we get Europe-wide austerity, what are the chances of Grexit, any time soon?
C: If we don’t get Europe-wide austerity, what are the chances of Grexit, any time soon?
D: What, then, is the probability of Grexit? This is calculated as A * B + (1-A) * C.
E: If we have Grexit, what are the chances it’ll happen before the election?
F: This is the overall probability of Grexit before the election, and is D * E.
G: If we have Grexit, what are the chances of it eliciting a credible, coordinated and constructive pan-European response?
H: This is the probability of a big European crisis before the election, it’s F * (1-G).
I: What is the probability of Obama having a narrow enough lead over Romney that it would be erased by a plunging stock market?
Put these all together, and you can finally come up with a number for:
X: The probability of Grexit toppling Obama. It’s H * I.
I’d be interested to know what results you get, but my guess is that most of them will come up with a number which is low and yet still significant. It’s something to bear in mind, but of course it’s also something which is pretty much entirely out of Obama’s control. That’s the way that crises work: individual politicians are rarely personally responsible for them, but whomever’s in power when they happen nearly always ends up getting the blame.
The size of the run on Greek banks is not at all clear: while it seems that something on the order of €1 billion has left the banks of late, it’s less obvious whether that was over the course of one day, three days, or two weeks. The big picture, though, is unambiguous:
What you’re seeing here is Greece down to its last €165 billion or so in deposits, and at the margin the rate of decrease is probably accelerating, despite the fact that most sensible Greeks will have already stashed their hard-earned euros safely outside the country a long time ago. I don’t know what the minimum amount is that Greeks need on deposit just to serve their near-term liquidity requirements, but we’re not there yet: Greece’s total population is only 11 million. So there’s a long way further this number can fall — especially since the Greek banking system isn’t receiving the support it needs from the ECB.
The more realistic constraint is simply that many Greeks lack the education and sophistication and language skills needed to move their money out of the country. This, for instance, is telling:
A 60-year-old textiles store owner who gave his name only as Nasos said he had transferred 10,000 euros over the phone to a bank in fellow euro zone state Cyprus on Tuesday afternoon.
If Greece exits the euro, there’s no doubt that there will be a massive banking crisis in Cyprus — it’s pretty much the least safe haven conceivable for someone looking to move their money from Greece. The only reason to move money to Cyprus rather than, say, Luxembourg is that they speak Greek there, and the logistics of moving money to Cyprus are easier than the logistics of moving money to any other country.
Meanwhile, in the rest of the eurozone periphery, foreigners are already pulling their deposits from Italian banks, while the Spanish banking system is only getting increasingly precarious:
All of which is to say that the causal relationship between sovereign crises and banking crises is rather more complicated than one causing the other: in reality, they cause each other, in a vicious cycle which clearly isn’t close to being broken in any of the southern European states. Greece is further along in the cycle than Spain or Portugal or Italy, but they’re all still moving in the wrong direction.
Greece’s banks, remember, are the mechanism by which the rest of Europe will force Grexit. Banks are the circulatory system of any economy: if they stop pumping money, the country dies. And so, in extremis, Greece will need to do a complete blood transfusion, replacing all euros with drachmas, if the only alternative is to see the flow of euros dry up entirely.
In the meantime, however, expect to see deposits continue to leave Greece — and the rest of the European periphery as well. Even if your euros are reasonably safe in a big Italian bank, they’re surely safer in a big German bank. And the first thing that all depositors want is safety. Now that questions have been raised about the solvency of various southern European banking systems, it’s going to be very hard to reconstitute the eurozone in a robust fashion. The Eurozone was never designed to cope with millions of Spaniards moving their money out of the country, behaving like middle-class Venezuelans with offshore accounts in Miami. And it also was never designed to cope with capital controls. But increasingly, it looks like we’re going to end up with one or the other. Or both.
A lot of people were looking forward to Richard Koo deliver his paper at INET last week; it comes with associated slides, here. Koo is the intellectual father of the idea of the balance-sheet recession — an idea which was born in Japan, has increasingly been adopted in the US and the UK, and which is now gaining traction in the Eurozone.
Koo’s diagnosis that Europe is in a balance-sheet recession, which he defines as a post-bubble-bursting state of affairs where individuals and companies choose to pay down their debts rather than borrow money, even when interest rates are at zero. That certainly seems to be the problem in Spain; Koo’s charts can be hard to read, but what you’re seeing here is a massive borrowing binge by the Spanish corporate sector — the dark-blue line — suddenly turning into net savings after the crisis hits. And to make matters worse, Spanish households — the red line — did exactly the same thing. As a result, the government had to run a massive deficit after the crisis; the four lines always have to sum to zero.
In this kind of a recession, monetary policy — reducing rates to zero — doesn’t work. And tax cuts don’t work either: they just increase household savings. You need government spending, at least until the economy has warmed up to the point at which companies and individuals start borrowing again. And the good news is that in a balance sheet recession, government spending is pretty much cost-free, since interest rates are at zero.
That’s the good news in Japan and the US and the UK, anyway. But it’s not the case in Spain. This is a big problem with the single currency, as Koo explains: it encourages capital to flow in exactly the wrong direction.
When presented with a deleveraging private sector, fund managers in non- eurozone countries can place their money only in their own government’s bonds if constraints prevent them from taking on more currency risk or principle risk.
In contrast, eurozone fund managers who are not allowed to take on more principle risk or currency risk are not required to buy their own country’s bonds: they can also buy bonds issued by other eurozone governments because they all share the same currency. Thus, fund managers at French and German banks were busily moving funds into Spanish and Greek bonds a number of years ago in search of higher yields, and Spanish and Portuguese fund managers are now buying German and Dutch government bonds for added safety, all without incurring foreign exchange risk.
The former capital flow aggravated real estate bubbles in many peripheral countries prior to 2008, while the latter flow triggered a sovereign debt crisis in the same countries after 2008. Indeed, the excess domestic savings of Spain and Portugal fled to Germany and Holland just when the Spanish and Portuguese governments needed them to fight balance sheet recessions. That capital flight pushed bond yields higher in peripheral countries and forced their governments into austerity when their private sectors were also deleveraging. With both public and private sectors saving money, the economies fell into deflationary spirals which took the unemployment rate to 23 percent in Spain and to nearly 15 percent in Ireland and Portugal.
With the recipients, Germany and Holland, also aiming for fiscal austerity, the savings that flowed into these countries remained unborrowed and became a deflationary gap for the entire eurozone. It will be difficult to expect stable economic growth until something is done about these highly pro-cyclical and destabilizing capital flows unique to the eurozone.
The solution to this problem is eurobonds. If all the eurozone countries funded themselves jointly and severally, then the yields on European government debt would be very low, and there would be no fiscal crisis in Spain.
But that’s not the solution that Koo provides to the problem that he quite correctly diagnoses. Instead, he said at the INET conference that the way to bring Spanish government bond yields down would be to massively decrease the number of people allowed to buy Spanish bonds.
This doesn’t make any sense to me at all. After all, in any market, the greater the number of potential buyers, the higher the price. But I’ll let Koo try to explain:
Eurozone governments should limit the sale of their government bonds to their own citizens. In other words, only German citizens should be allowed to purchase Bunds, and only Spanish citizens should be able to buy Spanish government bonds. If this rule had been in place from the outset of the euro, none of the problems affecting the single currency today would have happened.
The Greek government could not have pursued a profligate fiscal policy for so long if only Greeks had been allowed to buy its bonds, since private-sector savings in the country was nowhere near enough to finance the government’s spending spree…
The new rule will also resolve the capital flight problem by preventing Spanish savings from flowing into German Bunds. This will prompt Spanish fund managers facing private sector deleveraging to invest in Spanish government bonds, just as their counterparts in the US, UK or Japan must buy bonds issued by their own governments. That would allow Spanish government bond yields to come down to UK—if not to US—levels. With low bond yields and high bond prices, talk of a sovereign debt crisis would also disappear.
It’s absolutely true that a lot of Spanish fund managers, in a flight-to-quality trade, are buying up German and Dutch government bonds. It’s also true that Koo’s proposed rule would prevent them from doing that. But it’s emphatically not true that if they couldn’t buy German or Dutch government bonds, they would buy Spanish government bonds instead.
I asked Koo about this, in Berlin, and the conceptual problem quickly emerged. On the one hand, Koo is careful not to say that he wants fully-fledged capital controls preventing Spanish fund managers from investing abroad at all. He’s confining his proposal just to government bonds, and is not including corporate bonds, equities, structured credit, or anything else that Spaniards can currently invest in. But, he still thinks that this one rule would, single-handedly, take the 6% of GDP that the Spanish private sector is currently saving, and divert it directly into the Spanish government bond market, sending yields there plunging.
The fact is that when money flows into US Treasuries or JGBs or Gilts during a balance-sheet recession, that has absolutely nothing to do with the fact that they’re government bonds, and absolutely everything to do with the fact that they’re the dollar- or yen- or pound-based securities with the lowest perceived credit risk. If you ban Spanish institutional investors from investing in Bunds, then they’ll just buy something else with extremely low credit risk instead — AAA-rated corporate bonds, perhaps, or covered mortgage bonds from somewhere in the north, or some other kind of highly collateralized structured credit instrument. None of those things might have quite the degree of liquidity that Bunds can offer, but they’re still safer than Spanish government debt right now.
Koo is absolutely right that the flow of savings out of Spain is doing absolutely gruesome things to the Spanish economy: you can’t possibly grow when your companies and households are paying down debt, and all your national savings are fleeing the country. So maybe there’s a case for fully-fledged capital controls. But Koo’s weak-tea version would only serve to decrease, rather than increase, demand for Spanish government bonds. Their price would go down, their yields would go up, and Spain would be in an even worse position than it’s in now.
Remember the Krugman vs Summers debate last year? That was fun, in its own way. But this year’s Munk Debate looks set to be simply depressing. The invitation has the details: the motion is “be it resolved that the European experiment has failed”. And I’m reasonably confident that the “pro” side — Niall Ferguson and Josef Joffe — is going to win.
That’s partly because Ferguson has the public-speaking chops to dismantle his meeker opponents, Peter Mandelson and Daniel Cohn-Bendit. Ferguson is likely to go strongly for the jugular, while Mandelson and Cohn-Bendit will noodle around ineffectually, hedging their conclusions and sacrificing rhetorical dominance for the sake of intellectual honesty.
You can see this, already, in the invite. Each speaker is introduced with a one-liner; Ferguson says that Europe is conducting “an experiment in the impossible”, while Mandelson says that Europe is, um, “getting there” and that the world is “very impatient”. Cohn-Bendit is weaker still: his quote, “We need a true democratic process for the renewal of Europe, in which the European Parliament has to play a central role,” seems to imply that Europe really is doomed, since there’s no way that the European Parliament is going to play a central role in anything, except perhaps an expenses scandal.
It wasn’t all that long ago that public intellectuals could make a coherent case that European union, both political and monetary, was and would be a great success story. In the wake of Greece’s default, however, and credible beliefs that Portugal is likely to follow suit, disillusionment and pessimism is the order of the day. The era of great European statesmen is over; in their place, we have David Cameron.
I was a believer in the European experiment; indeed, I thought it had a kind of grand historical inevitability to it, and that a strong whole could be made up of vibrant and disparate parts. And from a big-picture historical perspective, Europe is indeed a success: a bloody and war-torn continent has transformed itself into a political union where it’s unthinkable and impossible for one member state to invade another. But if by “the European experiment” we mean the euro, that’s been a disaster, and virtually everybody in Europe would have been better off had it never existed.
In this, curiously, the broad European population was much more prescient than the educated and political elites, who in large part imposed the euro on their unthankful and unwilling countries. Mandelson is a key member of that elite, and he was wrong about the euro and about the advisability of the UK joining it. It’s going to be very hard indeed for him to persuade an audience of Canadians that this time he’s right. Or, for that matter, that they should in any way welcome the prospect of a monetary union with Iceland.
I got a glimpse this morning of what Lance Knobel calls Davos’s “class distinctions, even if you have a white badge” — I was invited to a breakfast meeting under the auspices of something called the Industry Partnership Meeting for Financial Services. Which reminds me of that great line from In the Loop :
What you have to do is you’ve got to look for the ten dullest-named committees happening out of the executive branch. Because Linton is not going to call it “The Big Horrible War Committee”. He’s gonna hide it behind a name like “Diverse Strategy”, something so dull you’re just gonna want to self-harm.
This morning’s breakfast appears nowhere on the official Davos program, but because it was an exclusive by-invitation-only event, it managed to become by far the most high-powered session I’ve yet seen, with a large number of shiny-hologram badges and more big-name economists and central bank governors than you’d think possible. They came because this really was an interactive session, where they can talk in a serious and structured way with each other at a very high level.
This being the WEF, there was lip service paid towards the idea that a group of smart and powerful people, if you get them all in the same room, could come up with ways for the international community to improve the state of the world. But the actual participants didn’t show any sign of believing that: they were insightful with respect to diagnosing the state of the world, tentative in proposing solutions, and downright skeptical when it came to handicapping the likelihood that any of those solutions might actually be implemented.
And indeed there was a strong strain of thought which basically said that we already have the optimal level of international cooperation, and that more would not necessarily be better. Consider the two major currencies of the world: while the euro/dollar exchange rate has certainly been volatile over the course of the crisis years, it hasn’t moved as much in total as it did before the crisis, and there’s no sense at all in which we have had a currency crisis. To a very large degree, this is a function of successful international cooperation: the world’s major central banks all talk to each other regularly, and when they needed to do so they quietly and efficiently opened up unlimited swap facilities with each other. Those swap facilities didn’t cost money, in terms of government budgets, but they were an incredibly effective crisis-fighting tool.
Effectively, the unlimited swap lines have solved most of the global liquidity problems, and have prevented the otherwise very scary prospect that a liquidity run could become a self-fulfilling insolvency process. But that of course doesn’t mean that the world’s economies are all solvent. And so the question then arises: if you want to attack solvency rather than liquidity, is international cooperation (i.e., giving the IMF a massive fiscal bazooka) the best way to do so? And the answer there seems to be no. The biggest solvency problems are the problems within the Eurozone, and it is ultimately Europe’s job to get the necessary cash together if it wants to avert a series of fiscal crises.
Germany and other big northern European countries are running very large trade surpluses: they can remit cash to the periphery if they have the political will to do so. And if they don’t have the political will to do so, there’s no way in which the US, China, and the rest of the world can or should step in to try to save the likes of Greece and Portugal.
This kind of thinking is very much in line with the realism, or fatalism, which I’ve seen a lot of in Davos this year. If you control your own currency — if you’re the US, or China — then ultimately you control your own fate, and you only have yourself to blame if you go belly-up or suffer a major crisis. Certainly the rest of the world won’t come to your rescue. That’s one reason why China has such enormous foreign reserves: it needs them as insurance against a crisis. And it also explains why the yuan is not convertible, and there’s a waiting list of 800 companies who want to go public on Chinese stock exchanges but aren’t being allowed to do so: the Chinese government is keeping tight control of its economy and the way that its companies are financed, because once you lose that control, it’s impossible to regain.
In Europe, of course, the politics of transfer payments are much more fraught — and also much harder to understand. One very senior economist told me as we exited the meeting this morning that he too was decidedly unclear on the details of how TARGET2 works, even though he’s meant to be an expert on such things and he knew that it was crucially important. Similarly, while it’s surely very germane and important that the Bundesbank has more reserves than the ECB, what that means in practice is not at all obvious.
Politically, we still seem to be very far away from a fiscal solution to Europe’s problems, and the baseline scenario has to be that we’re not going to get one — ever. The result is likely to be a series of countries exiting the euro, and/or the “East Germanification” of much of Europe’s periphery: flows of money and human capital away from countries like Greece and Portugal, and towards the more prosperous countries with healthy economies and substantial trade surpluses. Essentially, those countries would become holiday resorts for the north, with all the real economic activity being concentrated in more prosperous nations. If you’re a smart young Spaniard, it’s much more attractive to seek your fortune in the UK than it is to take your chances in a deflating country with a stratospheric youth-unemployment rate.
Certainly there seems to be no belief at all, even among the well-intentioned technocrats at Davos, that coordinated international action will or should solve this particular crisis. And the inevitable conclusion is that the crisis is not going to be averted: it’s only going to get worse. It’s a very scary prospect — but one which it’s very important for global elites to come to terms with. And that’s exactly what they’re doing in Davos this week.
The big deadline in Greece is March 20 — that’s when the country has a €14.4 billion bond maturing that it can’t afford to repay. So Greece and its creditors are playing chicken with each other right now. Both want to do a deal, which would involve a cash payment of about 15 cents on the euro being paid out by a rescue committee comprising the EU, the IMF, and the ECB. Existing bondholders would get shepherded into new debt which would be worth less than the old debt but at least would remain current, while Greece would avoid the parade of horribles associated with a “hard default”, with its banks retaining access to funding from the international community in general and the ECB in particular.
The logical outcome, then, is that a deal gets done — probably along the lines that Marathon Asset Management CEO Bruce Richards sketched out to Peter Coy today. Richards’s math is a bit hard to follow:
The new bonds will probably pay annual interest of 4 percent to 5 percent and have a maturity of 20 years to 30 years, Richards said. They may trade for about half of their face value, he predicted. Altogether, the net present value of the deal for the bondholders will be about 32 cents on the euro, he estimated.
This doesn’t add up: if face value is 50 cents on the euro, then half that would be 25 cents; add in 15 cents of cash, and you get a total of 40 cents on the euro, not 32.
Update: OK, I understand how the math works now. The headline 50% haircut includes the 15 cents in cash: it’s 35 cents in bonds plus 15 cents in cash for a total of 50 cents. If you value the 35 cents in bonds at 50 cents on the dollar, then the bonds are worth 17 cents; add that to 15 cents in cash, and you get a total of 32 cents. Note that Greece, in this scenario, is getting a 65% face-value haircut, rather than a 50% haircut, and is getting coupon relief as well — all in all, Greece is swapping bonds it issued at par for new instruments worth 17 cents on the dollar. Which is an 83% NPV haircut. You can see why the market might object to a haircut that big.
But either way, the market is saying that a deal along those lines isn’t going to fly. The March 20 bonds are currently bid at 42, offered at 44, and no one is going to accept a deal worth 32 cents or even 40 cents if you can just sell those bonds outright for 42 cents. And similarly, no one buying the bonds right now at 42 is going to accept any deal at 32.
And it’s much harder to reach a deal now than it was a few months ago, because many of Europe’s biggest banks have quietly sold their holdings of Greek debt to aggressive hedge funds.
Even if a deal is done, remember that the people sitting on the other side of the table are the IIF, the hapless and toothless trade body representing the big banks without really being able to commit them to anything. And if the IIF can’t deliver the banks, it certainly can’t deliver the hedge funds, which are much less susceptible to arm twisting moral suasion.
As a result, we’re not going to see all $14.4 billion of bonds tendered in to any exchange — and there’s an extremely high chance that there will be enough holdouts to trigger Greek CDS contracts. That’s not the end of the world, although many people seem to think it would be; Greece is defaulting, so it stands to reason that default swaps would be triggered.
My expectation is that there will be an exchange; that it won’t be particularly successful; that it will trigger CDS; but that all the same it will be good enough for the EU, which will stump up its €30 billion and keep the can going on its bumpy path down the road. A bunch of hedge funds will be left with a large amount of defaulted Greek debt, and will start all manner of litigation, which will go nowhere for the foreseeable future. And no, there’s no way that Greece will pay those hedge funds just so that it can avoid the CDS being triggered.
Richards will be fine: he’ll tender into the exchange, get the cash and the bonds he’s expecting, and probably sell them at a small profit. Banks who lent to Greece at par will have to take very large losses. And the holdouts will start complaining loudly about the sanctity of contracts to anybody willing to listen, which will be a very small group of people indeed.
Frankly, it’s taken much longer than I thought for the actual default to arrive — seeing as how it was clearly signalled by Greece as long ago as July. That default would have been positively painless compared to this one. But at least we have a date, now. Greece will officially default on March 20. The only question is whether the EU will continue to fund the country after that date. For the sake of the euro zone, we had better all hope the answer is yes.
S&P brought its hammer down on Europe today, with nine — count ‘em — downgrades of euro zone countries. The removal of France’s triple-A has been getting most of the headlines, but for me the bigger news is the fact that Portugal has now been downgraded to junk status.
Both of those moves, however, are pretty standard for ratings agencies in general and for S&P in particular: a slightly belated recognition of what has long been obvious to the rest of us. If anybody really thought that French sovereign debt was risk-free, or that Portugal, with its ten-year bond yielding somewhere north of 1,000bp north of Bunds, was investment grade, then they have surely been living under a rock for the past couple of years.
There’s one area, however, where S&P’s actions are going to have a significant and far from positive effect — and that’s the European Financial Stability Facility, or EFSF. The way that the EFSF is structured, its credit rating is particularly reliant on the ratings of the euro zone’s biggest sovereigns. Here’s how S&P put it back on December 6:
Based on EFSF’s current structure, were we to lower one or more of the current ’AAA’ ratings on EFSF’s guarantor members, all else being equal, we would lower the issuer and issue ratings on EFSF to the lowest sovereign rating on members currently rated ‘AAA’.
What this means is that Europe now faces a choice. On the one hand, it can restructure the EFSF so that it retains its triple-A credit rating. That would almost certainly involve shrinking the EFSF in size. Or, it can be sanguine about the EFSF downgrade and just let it happen. But that’s not a pleasant outcome either, given that everybody’s bright idea, when it comes to Europe’s sovereign bailouts, is to leverage the EFSF to some multiple of its present size. Leveraging a triple-A EFSF is hard enough; leveraging a double-A EFSF is pretty much impossible.
My guess is that the EFSF is going to get downgraded very soon — quite possibly on Monday. There’s actually not much point in Europe restructuring it so that it retains its triple-A: the political cost would be huge, and the benefit would be entirely hypothetical. (In theory, the financial markets are happy to lever up triple-A-rated assets. In practice, if those assets are European sovereign debt, not so much.)
Some small part of me thinks it’s a jolly good thing that the world is losing its store of triple-A assets. They’re dangerous things, precisely because we’re given to understand that they’re risk-free. But in this particular context, there are very few ways that today’s news can help Europe, and there are many, many ways that it can hurt. Not least when it comes to the amount of capital that Europe’s banks need to squirrel away against their stocks of sovereign debt.
Europe’s a risky continent; S&P is simply making that fact a little more obvious. In an ideal world, S&P’s opinions wouldn’t carry any more weight or importance than anybody else’s. But this isn’t an ideal world, and they do. And countries like France, which don’t control their own money supply, aren’t as immune to ratings-agency actions as the US turns out to have been.
The immediate ramifications of this announcement, in terms of global stock market reactions, aren’t important. And it’s even possible that if it accelerates the move away from the EFSF and towards the ESM, we could find a little bit of silver lining here. But the fact is that Europe is more fragile, now — more susceptible to changes in sentiment or genuine exogenous shocks — than it was yesterday. And that cannot be a good thing.
For all that financial innovation has got itself a pretty bad name recently, there’s no shortage of people with bright ideas as to how to address the euro crisis. Robert Barro is one. He thinks the euro should be phased out entirely, and has a plan for how to do just that:
Germany could create a parallel currency—a new D-Mark, pegged at 1.0 to the euro. The German government would guarantee that holders of German government bonds could convert euro securities to new-D-mark instruments on a one-to-one basis up to some designated date, perhaps two years in the future. Private German contracts expressed in euros would switch to new-D-mark claims over the same period. The transition would likely feature a period in which the euro and new D-mark circulate as parallel currencies.
Other countries could follow a path toward reintroduction of their own currencies over a two-year period. For example, Italy could have a new lira at 1.0 to the euro. If all the euro-zone countries followed this course, the vanishing of the euro currency in 2014 would come to resemble the disappearance of the 11 separate European moneys in 2001.
Is this workable? It all depends, I think, on the degree to which contracts could and would be switched over to German law during the two-year period of parallel currencies. While many people might be happy to see their euros converted to Deutschmarks at a rate of one to one, many fewer would be happy to see their euros converted to lire at the same rate. Which means that there would have to be some serious coercion — and a lot of court cases, too — before people holding euro contracts in Italy were forced to see those contracts redenominated in lire.
So while Barro is correct that this approach would help solve the sovereign debt problem, by allowing the likes of Italy to simply print new money to pay off their debts, it would also be a legal nightmare, as every contract turned into a fight between creditor and debtor over which currency it should become. The creditors, of course, would all want the contract to become Deutschmarkized, while the debtors would probably all want their debts to be converted to drachmas at that one-to-one rate. Given that the whole point of European monetary union was that it would become a single monetary union, trying to break it up into 17 component parts is certain to be a legal and logistical nightmare.
Would it be easier, then, to come up with a clever way of keeping the eurozone together? Because Jed Graham has one of those: he calls it Safeguard bonds, which is actually an acronym: Sovereign Approvable First-loss EFSF-Guaranteed Upfront Automatically Recallable Debt.
Graham’s idea is not that easy to understand, so I called him up and asked him to explain it to me. Basically, if countries signed up for a fiscal austerity program, they would be allowed to issue a certain quantity of Safeguard bonds, which would be guaranteed by the EFSF. Then, if at any point they broke free of their fiscal constraints, they would have to pay down 10% of the bonds, immediately, in cash. If you held €1,000 in Italian Safeguard bonds and the country ended up borrowing too much money one year, then Italy would automatically pay you €100 for 10% of your holding, and you’d be left with €100 in cash and €900 in Safeguard bonds; failure to do so would constitute an event of default.
The idea is that this would act as a real fiscal constraint: if a country were to avail itself of this facility, it would then be in a position where any fiscal slippage would be very expensive — because it would have to borrow at a very high rate to make the bond payment. Meanwhile, the EFSF-guaranteed bonds would trade at much lower yields, because of that EFSF guarantee, and because, under Graham’s plan, the ECB would step up and guarantee all Safeguard bonds in the event that EFSF monies ran out.
Because Safeguard bonds would be long-dated and very cheap, countries would have every incentive to use them to fund their current deficits — and thereby lock in fiscal constraint for the next 30 years.
It’s an intriguing idea, but technically extremely difficult to put together — these things are a bit like reverse CoCo bonds, in that they actually punish the issuer when the issuer gets into trouble. And, of course, as such they’re extremely pro-cyclical, if they ever get triggered. If a country suffers a nasty recession and sees its tax revenues fall a lot, the Safeguard bonds would get triggered and it would have to find a lot of extra cash just when it could least afford it.
I’m reminded of a clever idea that the World Bank had in the between 1999 and 2001, called the Rolling Reinstatable Guarantee. It was meant to be a way for the countries that used it — Thailand, Argentina, and Colombia — to reduce their borrowing costs by putting in place a World Bank guarantee which would cover the next coupon payment. In the event of a default, the World Bank would have to make the coupon payment, the country would have to pay the World Bank (because the Bank is a preferred creditor), and then the guarantee would get reinstated. Rinse and repeat.
When put to the test in the Argentine default, however, the mechanism didn’t work. And in general whenever people attempt to solve deep economic problems with the application of clever financial ideas, they fail. The eurozone might break apart, or it might stay together. But either way, financial innovations like these are not going to make much of a difference.