Felix Salmon

The Economist’s Charlemagne was unimpressed by my euro fantasia this morning: apparently I was the BBC’s second choice for the spot, and was approached only after they had been turned down by more sober journalists.

There is enough noise out there about Anglo-Saxon newspapers talking down the euro without dragging The Economist into a spoof about the death of the single currency… the whole idea felt unworthy of the BBC. …

The British media is handling this crisis with unusual complacency, tinged with a certain glee.

Charlemagne even manages to call the Times (of London) “criminally irresponsible” for writing about a break-up of the euro.

All of which represents a level of hypocrisy in the Economist that I’d previously suspected, but not noticed due to highly evasive skills.

Exhibit A:

I had a little three-minute fantasia this morning on Radio 4 in the UK; if you prefer text to audio, here you go. The idea was to give an idea of one way in which the euro might fall apart, but I had no idea, when I recorded it, that markets would plunge again today.

August 18, 2010:

Markets around the world plunged on Wednesday, after Spain announced that the cost of bailing out its beleaguered mortgage lenders would amount to more than 250 billion euros. The country was immediately downgraded by both Standard & Poor’s and Moody’s, triggering fears of default or devaluation in both Spain and Portugal. Stocks fall by more than 5% in all major markets, including the US.

August 19, 2010:

Chancellor Angela Merkel of Germany, in an unprecedented joint public appearance with Jean-Claude Trichet, the head of the European Central Bank, railed against “speculators and hedge funds” who were damaging European unity and threatening the viability of the common currency. She said that Europe would provide up to 500 billion euros in support of Spain, Portugal, and Greece, to help them bail out their banks during a period when investors have simply stopped lending them any new money.

August 22, 2010:

In the largest set of coordinated demonstrations since the run-up to the war in Iraq, angry voters and opposition parties across Europe came out in their millions, protesting the hundreds of billions of dollars being spent on southern European countries, and the painful austerity measures being demanded of Greece, Spain, and Portugal by the IMF.

Opinion polls show that an overwhelming majority of Eurozone members oppose the current bailout plans, both in northern European countries like Germany, which don’t want to see their money spent abroad, and in southern European countries like Greece and Spain, which refuse to be told how to run their countries by Brussels bureaucrats and the IMF.

The riot photos from Greece are becoming depressingly familiar, but now we’re seeing riots across Germany, too.

August 23, 2010:

As markets continued to plunge around the world today on civil unrest across Europe, governing coalitions across the continent broke apart, with no parties seeing any political upside in supporting the most unpopular policy that has ever been implemented in European history. Even Angela Merkel started backtracking from her earlier statements, saying that no democracy could unilaterally act against its citizens’ wishes.

August 24, 2010:

A solution, of sorts, was found to the European crisis today, when the governments of Greece, Spain, Portugal and Italy announced that they would no longer accept EU or IMF funds as part of the bailout program, and would solve their problems on their own. The joint statement was taken by markets as tantamount to default, since none of the four countries has access to the liquidity needed to roll over their debts.

August 25, 2010::

Greece has announced a debt restructuring that will push back the maturity of its bonds by three years.

It will swap existing debt for new bonds denominated in New Drachmas, which the Greek government is introducing at a 1-to-1 exchange rate but which are already trading in the “grey market” at just 50 euro cents each.

September 13, 2010:

Markets were shocked once again today as France joined, at the last minute, the joint restructuring offer from Italy, Spain, and Portugal. All four countries are offering to swap their old euro-denominated debt for new obligations denominated in a currency they’re calling “neuros”. Other eurozone countries have indicated that they, too, will leave the euro for the neuro, cutting their debt at a stroke. In the grey market, the neuro is already trading at 75 euro cents, while the new drachma is holding steady at 45 euro cents.

Today was the last day of the euro as we knew it for a decade: Europe is returning to a system of multiple floating currencies. And that means that political ties are much weaker, too. With the death of the euro, the future of the European Union itself looks very uncertain.

This is not a prediction, it’s just one way of many in which things could go wrong. There’s always a worst-case scenario. And although I didn’t have time to spell things out here, this really is a worst-case scenario, and would cause legal chaos with respect to the redenomination of assets and liabilities in what might be called the neurozone.

Which means that questions like this one, which I got via email this morning, are simply unanswerable:

What happens to the euros which I have in my travel wallet (or under the mattress or where ever) if the euro splits into various neuros? More importantly, what happens to euros held by a British bank? Answer needed!

Most likely, in this kind of a scenario, the euros would transform themselves into the currency of whatever country they’re on deposit in. You can see where the flight-to-quality trade comes from: cash flows away from euro-periphery banks and into German banks, and away from euros and into dollars, lest it end up forcibly converted into something else. Physical euros should be pretty safe: you could probably convert them into neuros at an advantageous exchange rate, assuming that it’s the weaker countries which leave the eurozone, rather than Germany and a few others deciding that they’re going to create a smaller, stronger, super-euro.

Returning back to reality, the euro itself could still fall further, especially if questions over its long-term survival continue to be raised. And all this uncertainty is bad for assets generally around the world. Expect lots more volatility going forwards.

Note the circular reasoning in Martin Wolf’s latest column:

Greece is likely to restructure its debt at some point, as John Dizard has argued in the FT. That would not be the worst outcome. Once a country is in the “junk bond” category, no reputation is left.

Or, to put it another way, Greece got downgraded because it is likely to default, and it is likely to default because it got downgraded. This is yet another reason to start ignoring credit ratings.

The main point of Wolf’s column is a very good one:

European orthodoxy is that the crisis is, at root, fiscal. Marco Annunziata of UniCredit summarises it in a recent note: “In hindsight, it seems obvious that the flaw in the eurozone’s institutional setup is both extremely serious and extremely simple: first, a currency union cannot work without sufficient fiscal convergence or integration; second, the eurozone has been unable to create incentives for fiscal discipline.” Mr Annunziata’s chart shows that this view is wrong. Just consider the frequency of breaches of the rules requiring fiscal deficits of less than 3 per cent of gross domestic product. Greece is a bad boy. But Italy, France and Germany had far more breaches than Ireland and Spain. Yet it is the latter that are now in huge fiscal difficulties.

The fiscal rules failed to pick up the risks. This is no surprise. Asset price bubbles and associated financial excesses drove the Irish and Spanish economies. The collapse of the bubble economies then left fiscal ruins behind it.

It was the bubbles, stupid: in retrospect, the creation of the eurozone allowed a once-in-a-generation party.

This, in hindsight, was the biggest weakness of the Maastricht rules, capping debt at 60% of GDP and deficits at 3%. It’s not that the rules were broken: it’s that they were insufficient to prevent the kind of debt-fueled boom which leads inevitably to a fiscal crisis. As Wolf points out, the countries in fiscal trouble, like Spain, aren’t necessarily the ones with the highest sovereign debt ratios: they’re the ones with the highest debt ratios overall, including private debt. (Spain’s public debt is just 56% of GDP; its private debt, however, is 178% of GDP.) And private debt was never included in the Maastricht rules.

In a way, Greece has it easy: a sovereign default and devaluation solves a lot of its problems at a stroke. Spain, on the other hand, has a much tougher task ahead of it, since private-sector defaults won’t make the country any more competitive. And it’s already got unemployment over 20%. Only tough structural reforms have any chance of working, and those will take a long time, and face enormous political opposition. As Andrew Eatwell says:

Having squandered the opportunity to embark on unpopular economic, labour and pension reforms when his popularity ratings were relatively high after the 2008 general election –a period in which he fervently denied that Spain was facing an economic crisis– Zapatero now faces the prospect of tackling those issues while trailing the main opposition centre-right Popular Party in the polls and with a string of potentially tight regional elections around the corner. Necessary but unpopular measures may therefore be put on the backburner or at least kept to a minimum for fear of a voter backlash that could cost the governing Socialist Party dearly in regions such as Catalonia, where the Socialists lead a coalition government and elections are due this autumn. Zapatero also faces a general election in early 2012.

With regional governments accounting for 57 percent of total public spending in Spain, there is a serious risk that national interests and the economy as a whole may find itself subordinated to entrenched regional interests, crowd-pleasing promises and partisan politics.

All of which is different only in degree, not in kind, to what we’re seeing in the US right now.

Tim Duy has a provocative thesis: the Europe crisis is good for the US economy, at least for the next few quarters.

Bottom Line: The European crisis, by keeping US interest rates in check and oil prices low, may do more to help the US recovery than hurt it. In the process, however, we would expect the flip side of the resulting capital inflows into the US to emerge – namely, a rising external imbalance. Arguably, this simply shifts the ultimate adjustment to sometime in the future. Again.

Is this really true? Interest rates can hardly be any lower than they are, so for the time being they’re exactly where they would be even if there wasn’t a European crisis. The situation in Europe might at the margin make the Fed slightly more reluctant to start tightening, but it’s not going to make any real-world difference for a while yet, if ever.

As for the price of oil, again I think the influence of European news is marginal, and only secondarily due to fundamentally lower demand from Europe. Mostly, I think that the option value embedded in the oil price — the idea that you might be able to buy now and then sell in the future at a profit — has fallen, as the prospects for serious oil-price appreciation have eroded. In other words, the fall in oil is financial, rather than fundamental. Which still helps US growth: the price of oil is the price of oil either way. But I think the connection with Europe is a second-order effect.

More to the point, if the European crisis really does end up delaying and therefore exacerbating the way that the US is going to have to deal with its twin deficits, that bodes ill for future interest rates, and is likely to keep the yield curve steep for the foreseeable future. If global liquidity embarks on another flight-to-quality trip to the US, that’s a nice short term boost on this side of the pond. But it’s not at all sustainable, and I’m not even sure it can reasonably be considered a “net positive” if it only increases the likelihood of a W-shaped recovery.

Jim Surowiecki today looks at the flipside of the moral hazard trade: if you can’t count on governments to bail you out in extremis, then you’re likely to have volatile and unpredictable markets.

Political risk is hard to manage because so much comes down to the personal choices of policymakers, whether prime ministers or heads of central banks. And those choices aren’t always going to be economically rational—witness Merkel’s recent tergiversations. Similarly, the U.S. government’s failure to bail out Lehman Brothers in 2008 seems to have been in part the result of Treasury Secretary Henry Paulson’s desire not to be seen as Mr. Bailout. Investors, then, are being forced to read the minds of policymakers—not something they’re good at. Markets work best when there’s lots of information available and a historical track record to go on; they excel at predicting things like horse races, election outcomes, and box-office results. But they’re bad at predicting things like who will be the next Supreme Court nominee, as that depends on the whim of the President.

Surowiecki is saying not only that Merkel should have bailed out Greece with alacrity and that Paulson should have bailed out Lehman: he goes on to praise successful interventions in the markets such as the Clinton/Rubin bailout of Mexico, Hong Kong’s successful 1998 intervention in its own stock market, and the Obama Administration’s decision to preserve as much equity and debt value of the banking system as it could.

In all these cases, government intervention was used to prop up market prices — of Mexico’s bonds, of Hong Kong equities, and of US bank stocks and preferred debt. And yes, when there’s a government put, volatility goes down. But that doesn’t mean that government puts are a good idea: after all, it’s not the job of government to reduce market volatility.

What’s clear is that governments — and I’m including central banks here — have much less ammunition now than they did pre-crisis, even if they still have the willpower to intervene to save markets from themselves. And the willpower is evaporating rapidly, to boot. The result is that the moral-hazard play is becoming increasingly dangerous, and that volatility is sure to stay high.

The only thing keeping markets from plunging on worries surrounding European finances is faith in the political credibility of the European Union and the ECB. And on that front, there’s a lot more downside than there is upside, since we’re leaving a world of very high European cohesiveness and entering a world of much greater uncertainty. It’s already clear that the UK is going to be absent from the European project for the foreseeable future; the big risk is that the Germans will follow suit.

A lot of investors have made a lot of money from the moral-hazard trade over the past 15 years or so. When that trade comes to an end, expect the losses to be just as big, if not bigger.

Is everybody overstating the consequences of a Greek default and/or devaluation? The Economist points out that Europe has seen quite a few defaults in recent decades (Russia, Poland) and also break-ups of currency unions (Czechoslovakia, Yugoslavia) — and that none of these events caused a lot of lasting damage.

I’m not convinced, if only because the Russia default caused the collapse of LTCM and a serious crisis; if it weren’t for tough arm-twisting by the Fed and billions of private-sector dollars from America’s biggest banks, it could have been much worse. And the end of the koruna and the dinar also meant the end of the Czechoslovakia and Yugoslavia, and the worry is very much that if Greece or anybody else were to exit the euro, then the whole currency union could fall apart, endangering the EU itself.

More generally, financial markets are good at taking the collapse of risky assets in their stride: what they’re bad at is dealing with the collapse of assets they thought were safe. And until very recently, Greek bonds were considered to be an interest-rate play, not a credit play. As a result, the institutions owning them can ill afford to see big losses on them.

The euro was designed to be a super-safe currency; as such, the repercussions of it falling apart would surely be many orders of magnitude greater than anything we saw in the wake of the collapse of the unlamented Yugoslav dinar.

Mike Kinsley also notes, in the North American context, that if you don’t have an economic union, then other issues tend to get worse — like illegal immigration.

All of which is to say that the great euro experiment seems to be unwinding, the Estonia news notwithstanding, and no one knows where it’s headed over the medium term. If economics and politics become fractious and nationalized across Europe, then within the region only Germany will any longer provide the kind of safety that investors are currently looking for; everybody else is going to start returning to their pre-convergence trade levels, which were a long way away from where we are now.

So anything which threatens the unity of the eurozone or the EU is surely going to have market consequences much worse than a single day drop of a few percentage points on European stock exchanges. And right now it’s far from clear that the political will to keep the union together is going to be sufficient.

Ronan Lyons is unimpressed by the now-viral NYT graphic showing the web of debt within Europe. It’s particularly unfair to his native Ireland, he says:

Because they didn’t look behind their statistics, however, the graphic is about as informative as CNBC’s now infamous unveiling of Ireland as the world’s most indebted country, with debts worth 1300% of GDP! The point that both miss is that you can’t look at debt liabilities without looking at corresponding assets.

That is why the markets are worried not about all debt. They are worried particularly about government debt, because typically there is no corresponding asset.

It’s true that Spain and Ireland — particularly the latter — have much less of their debt at the government level than, say, Greece. And Lyons helpfully provides a little chart showing how much of each of the PIIGS’ external debt is government debt.

But we’re still a long way from the point at which markets are more worried about government debt than about corporate debt, at least if you’re measuring such things using credit spreads. Investors still believe in the concept of the “sovereign ceiling”, and it’s still extremely rare for any corporate, including a bank, to be able to borrow more cheaply than the government of the country it’s in.

Writes Lyons:

For Portugal and Spain, it’s only one fifth of all debt. In the case of Ireland, just five percent of all its debt is general government debt.

The reason is hardly a secret: Ireland is a major international financial services centre. The international financial services sector plays such a large role in the Irish economy that it even gets its own set of statistics from the Central Statistics Office. At the end of 2008, the sector had debts of almost €1,650bn. Don’t worry though – it also had assets worth about €1,660bn.

Don’t worry? Of course we should worry. We’ve all seen what can happen to bank “assets” in extremis: Lehman Brothers and Washington Mutual both had assets greater than their debts before they collapsed, and then suddenly they didn’t. And in case Lyons has forgotten, the Irish government is still providing an unlimited guarantee on $600 billion of deposits and interbank debts at Ireland’s banks.

Or, to boil it all down into one word: Iceland. Government debt was never much of a problem in Iceland: the problem was bank debt. But bank debt has a habit of becoming government debt when there’s a crisis. And I’ve never seen a sovereign default where the banks of the country in question all happily continue to pay all their debts. When a country defaults, its banks default too.

So I’ll side with the NYT over the FT here: the original graphic is just as informative as it is striking, and it’s important to look not only at direct government debt, if you’re examining a country’s finances, but also the total external indebtedness of the country in question. Which actually helps Greece, a country where a huge swathe of the population owns their home outright, and where credit-card debt and other personal indebtedness never had the kind of bubble seen in places like the UK.

It’s not all that easy to tell, but it looks very much as though most of today’s market rally is a function of the ECB deciding that it can start buying bonds in the secondary market after all. The trillion-dollar announcement from the EU looks big and grand, but ultimately is so vague that few market participants would place much stock in it.

If you have 16 central banks all announcing that they will buy both government and private debt, that’s going to provide a one-day boost to markets, which are going to price in all that future demand. But if all that yesterday’s announcements achieved was a one-day rise in stocks and bonds, that counts as failure. What’s important is that markets are so impressed by the trillion-dollar fund side of things that they don’t even bother selling the debt of countries like Spain and Portugal, since they know that a solid safety net exists.

That’s not going to happen. Just like Hank Paulson’s TARP bazooka had to be pulled out and used, the markets are going to push the Eurozone periphery to a point at which the new bailout mechanism needs to be activated. And right now, nobody knows how or whether that mechanism is going to work. Does it need to be ratified by every individual country which is providing a guarantee? How cheaply will the SPV be able to borrow? Will it just borrow at floating rates overnight while lending at three-year terms, thereby essentially becoming a bank? How much faith will the markets place in the fragmented set of guarantees which is meant to reassure lenders to the SPV that they will be paid back in full? If one country fails to make its pro-rated payment, what happens then? Does the SPV have seniority over private-sector bondholders and even bilateral lenders in the way that the IMF does? Can any of this work in the absence of a formal international treaty setting it up? There are simply too many questions and too many uncertainties for anybody to be reassured at this point that the eurozone’s fiscal problems have found even an intermediate-term solution.

Well done to the ECB, then, for saving the day — at the cost of its own independence. Let’s hope that it saves at least the rest of the year as well. Otherwise the cost was surely too much of a price to pay.

Thanks to Johannes Bruder of Hamburg University for sending me this intriguing chart:

I suspect that the pattern would continue were you to include non-European countries as well; what’s interesting to me is the way in which there’s much more variation among eurozone countries than there is at the bottom of the scale, between Germany and countries like the UK and Switzerland which set their own interest rates.

As for trades, I wonder whether the chart might be pointing to a long-Ireland, short-Italy relative-value trade here. That trade has a positive carry, and if the two countries even so much as converge, you end up making a nice profit. Ireland has already shown that it’s politically grown-up enough to be able to implement tough fiscal austerity. I don’t think anybody really believes that of Italy.

On Monday, I looked at Germany’s attitude to Greece from a nationalist/tactical perspective, and promptly got slapped down by dsquared: “Congratulations,” he wrote, “you’ve proved the impossibility of not only the 2004 and 2007 accessions, but also of the Common Agricultural Policy.”

But the fact is that the Europe which grew in 2004 and 2007, and the Europe which came together to create the CAP, now looks as though it is falling apart. Philip Stephens has an essay in today’s FT which diagnoses this well, and which captures the sudden shift that we’ve seen of late, from the “reassuringly ineluctable” EU of a couple of years ago to something much more precarious today:

Europe no longer carries the stamp of inevitability. Quite suddenly, it has become almost as easy to foresee a future in which the Union fractures…

Germany relishes instead the chance to become a “normal” country, separating what it sees as its national from the European interest. Helmut Kohl’s historical insights are forgotten in the insistence that German taxpayers should not be asked to remain the continent’s paymaster. So too are Berlin’s long-term interests in European-wide political stability and in open markets for its exports.

France struggles with the dynamics of a Union in which more Europe no longer necessarily means more France. Nicolas Sarkozy’s admirable energy is unconnected to strategic purpose. Britain, as ever, stands half on the sidelines. Italy, led by Silvio Berlusconi, has removed itself from influence.

There have been moments of stasis before. But the rules have changed. The fall of the Berlin Wall and the collapse of communism have turned an enterprise of necessity into one of choice. If the Union falls into disrepair everyone will still be the loser; but the threat no longer seems an existential one…

The response of Europe’s politicians has been to sacrifice the strategic to the tactical.

Stephens diagnoses this as a failure of leadership, and narrowly he’s right; certainly it’s impossible to imagine today’s European heads of state making the collective decision to adopt the euro.

But Paul Krugman takes the opposite tack: the failure of leadership, he says, was encapsulated in the decision to adopt the euro in the first place.

The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro, the governments of Greece, Portugal and Spain denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.

And when crisis strikes, governments need to be able to act. That’s what the architects of the euro forgot — and the rest of us need to remember.

I’m probably closer to Stephens than to Krugman on this one, but it’s true that the architects of the euro assumed that it would foster political unity, in much the same way as some couples think that having a baby will help to save their marriage. Certainly the stakes were raised, but if Germany and Greece never really got on very well in the first place, it was with hindsight far too optimistic to assume that joining together in monetary matrimony would suddenly make them sovereign soul-mates. When they were just cohabiting in the EU, their differences were manageable. But now they’ve had the euro together, that’s not true any more.

Charles Forelle and Stephen Fidler have a really good front-page overview of the eurozone’s fiscal situation in the WSJ today. There’s not a lot of new news here, but as a lucid explanation of how we got to our present sorry state (and possible future even sorrier state), it’s vastly superior to sensationalist conspiracy theories about euro-shorting hedge funds.

So in the wake of the latest announcements from Greece promising fiscal rectitude in present and future — announcements which the market seems to like quite a lot — it’s worth bearing in mind two questions. The first, on which the market is currently fixated, is whether Greece can roll over its maturities in the next three months or so, tapping some combination of public bond markets, state-owned European banks, and EU loan guarantees. On that front, things are indeed looking pretty hopeful, partly thanks, as Sam Jones notes, to those very hedge funds which shorted Greece a few months ago, are making substantial profits by covering those shorts, and are now driving spreads tighter as opposed to wider.

The second question, which is much less tractable, is whether we can have any faith in eurozone government finances more generally, and this is where today’s WSJ article is so helpful, showing clearly that the truth has a tendency to come out very slowly and unpredictably, and that currency swaps through the like of Goldman Sachs are the least of the problem: governments hide much bigger debts by doing things like excluding defense expenditures or reclassifying subsidies as equity investments.

It’s worth remembering the famous convergence trade of the 1990s, whereby the wide spreads on what we now think of as PIGS debt all converged to something near zero as the euro approached: the idea was that simply adopting a single currency would mean an end to idiosyncratic credit risk between countries. In hindsight, that doesn’t make a lot of sense, since it was based on what Willem Buiter calls the “paper tiger” of the Maastricht treaty — the idea that somehow, after signing that piece of paper, sovereign governments would change the habits of decades or even centuries.

Of course it didn’t seem that way at the time. Because the PIGS were funding themselves in domestic currency, their credit risk pre-euro was very low, since they could and did always just print money to repay their debts. The result was high nominal interest rates to make up for high expected future inflation and/or currency depreciation. When those countries moved to the euro, the risks of inflation and currency depreciation were massively and credibly reduced — but no one seemed to worry overmuch about the fact that those risks didn’t simply disappear, they were just being transformed into medium-to-long-term credit risk.

Even at 400bp over German sovereign bonds, Greece’s nominal borrowing costs today are much lower than they were in the era of the drachma: the markets are requiring less compensation for Greek credit risk than they ever did for drachma depreciation risk. Maybe that’s because they have more faith in Greece’s fiscal rectitude today than they did in the early 1990s. And maybe that faith is well placed: the Greeks certainly seem pretty serious, these days, about cutting spending and increasing revenues. More serious than they ever were in the 90s.

But the fact is that the changes in nominal PIGS funding costs are not perfectly correlated with the fundamental faith that markets have in those countries’ fiscal sustainability, especially now that they’ve spent the past decade with no real control over monetary policy. So while the ouzo crisis might be waning, I’m sure that we’ll see more, similar, crises in future. Because southern Europeans can’t become Germans just by signing a treaty in Holland.

The first thing you have to know about the Greece-Goldman story is that the definitive account was published by Nick Dunbar of Risk magazine in July 2003. He kicked off by saying that the deals he was writing about “are likely to prove controversial” — he probably never guessed just how controversial they would end up being, nor how long it would take them to achieve that status.

The details of the deal are more or less what I suspected, and indeed the Spiegel story hews so closely to Dunbar’s account that the Risk article was clearly a primary — if not the primary — source. Here’s Dunbar, explaining what went on:

The cross-currency swaps transacted by Goldman for Greece’s public debt division were ‘off-market’ – the spot exchange rate was not used for re-denominating the notional of the foreign currency debt. Instead, a weaker level of euro versus dollar or yen was used in the contracts, resulting in a mismatch between the domestic and foreign currency swap notionals. The effect of this was to create an upfront payment by Goldman to Greece at inception, and an increased stream of interest payments to Greece during the lifetime of the swap. Goldman would recoup these non-standard cashflows at maturity, receiving a large ‘balloon’ cash payment from Greece…

It seems the total credit risk incurred by Goldman Sachs was roughly $1 billion. Effectively, Goldman Sachs was extending a long-dated illiquid loan to its client.

Dunbar also goes into a lot more detail about the fees on the transaction than the NYT does. I think it’s reasonable to accuse the NYT of being unfair to Goldman when it writes that Greece “paid the bank about $300 million in fees for arranging the 2001 transaction”. The point here is that because this is a cross-currency swap rather than a bond deal, the interest payments are going the wrong way: Goldman is sending Greece a steady stream of payments over the course of the deal, and then being repaid with a big balloon payment at the end. Essentially, Goldman is continually lending Greece money, and getting no interest payments in return, until maturity a long way out.

So the fee associated with the deal isn’t a fee for arranging the transaction, as the NYT would have it: instead, it has to cover all of the credit and market risk that Goldman Sachs is taking on in lending the money to Greece. What’s more, a very large chunk of the fee was immediately paid to Depfa, which sold Goldman a $1 billion 20-year credit default swap on Greece to hedge its credit risk. And for what it’s worth, Dunbar’s article puts Goldman’s total charge for the transaction at $200 million, not $300 million: I have no idea which figure is more reliable.

It’s also a bit disingenuous of the EU to start saying now that Eurostat was not aware of the transaction. Put aside for one minute the fact that Eurocrats have been known to read Risk; Dunbar’s article actually goes into some detail about how the Eurocrats knew exactly what was going on:

The drafting of ESA95’s section on derivatives was the subject of fierce arguments between the government statisticians and debt managers of certain eurozone countries.

The statisticians wanted derivatives-related cashflows to be treated as financial transactions, with no effect on deficit or interest costs, and with the derivatives’ current market value stated as an asset or liability. The debt managers opposed this, insisting on having the freedom to use derivatives to adjust deficit ratios. The published version of ESA95 reflects the victory of the debt managers in this argument with a series of last-minute amendments.

In particular, ESA95 states in a page-long ‘clarification’ that ‘streams of interest payments under swaps agreements will continue… having an impact on general government net borrowing/net lending’. In other words, upfront swap payments – which Eurostat classifies as interest – can reduce debt, without the corresponding negative market value of the swap increasing it.

In other words, Eurostat knew that Greece, Italy, and others were planning this kind of deal even before they happened, thanks to their successful lobbying efforts with respect to ESA95, and it was inevitable that they would structure deals with investment banks doing exactly what they did.

So while it’s entirely fair to blame Greece for trying to hide its debt, and to blame Eurostat for letting it do so, I think that blaming Goldman is harder. It was surely not the only bank involved in these transactions, and the swaps were simple enough to be shopped around a few different banks to see which one could provide the best deal. Structuring swaps transactions is one of those things which investment banks do. If countries like Greece buy swaps in order to hide their true fiscal status, then that’s the country’s fault, not the banks’. No self-respecting bank would decline such a transaction because they felt it was unfair to Eurostat.

Yes, I’m sure that Goldman put a team of people onto the Eurostat rules and made that team available to the Greeks. But let’s not blame the advisers here, for structuring something entirely legal and which the Greeks and Italians clearly wanted to be able to do all along. This is a failure of European transparency and coordination; Goldman is a scapegoat.

Faisal Islam does a great job explaining the problems facing Greece, and why Germany is likely to come up with some kind of bailout:

This so-called ‘ouzo crisis’ has emerged from a witches’ brew of concern about 1 Greece’s shaky political economy, including dodgy statistics and historic default record, 2 the short term nature of Greece’s debts and 3 the fact that a large proportion of its creditors are easily-spooked foreign investors…

It would be a total humiliation if this problem could not be sorted out within the single currency area. Besides, what will the IMF tell Greece to do with its currency, which is controlled by the ECB in Frankfurt? So the IMF is not going to happen.

So all along we have been waiting for the point at which the possible systemic damage, the contagion to the other countries would be so acute, that Germany and France would step in. We are here now.

Will Greece be giving up fiscal independence in return for bailout funds or German guarantees? I’m sure it’ll agree to stringent conditions, while claiming that it would have kept to such a plan in any case. The question is what happens when — inevitably — it ends up breaking its fiscal promises, or trying to play silly games to get around them. What will Germany be able to do, in that case, to snap Greece back into line? And do the Germans really want to play the role of Europe’s fiscal disciplinarian in any event?

It probably doesn’t matter: Greece is the Bear Stearns of Europe, seemingly too big to be allowed to falter or default, and therefore it must be bailed out somehow. Of course this sets an important precedent for when Spain and/or Italy find themselves in a similar situation — and it’s likely to make countries like Latvia feel a bit miffed, seeing how much fiscal pain they’ve inflicted on themselves with no bailout to show for it at all. The hazard here is that countries, seeing the Greek precedent, refuse to take tough fiscal steps unless the path is sweetened by Germany and France. This isn’t the end of the euro crisis: it’s only the beginning.

Marco Annunziata has a diagnosis of what ails the PIGS:

Germany has been relying on an export-led growth strategy: With virtually no wage growth over several years, it has rapidly gained competitiveness against most of its European partners, running a substantial current account surplus, which stood at 6.5% of GDP in 2008. As two-thirds of German exports go to other EU countries, it is not surprising that some of them ended up with huge external deficits. With a sharp rebound in international trade now leading the global recovery, Germany sees no reason to change strategy. But Europe, like the U.S., is a relatively closed economy—the bulk of growth for the area as a whole has to be generated by domestic investment and consumption. If Germany continues to compress wages and hence consumption, there are only two possibilities: Either other euro zone members follow suit, in which case the continent will stagnate, or they lose competitiveness, in which case imbalances will be exacerbated. It may seem absurd to suggest that Germany should somehow favor more generous wage dynamics, thereby losing competitiveness, but the alternative at this stage is an unpalatable choice between sustainable stagnation and destabilizing imbalances.

I think that Annunziata has the effects right here, but I do take some issue with his identification of the causes. Yes, Germany is growing through exports, and yes, those exports are mainly to the rest of the EU, and yes, that strategy is succeeding for Germany, if not for the rest of Europe. But no, I don’t think that the key variable here is wages.

It’s true that German wages have not risen over the past few years, but I don’t think that lower wage inflation is the reason for Germany’s export-led success. Germany’s wages are not low, by European standards, and its exports are not cheap. Similarly, “more generous wage dynamics” in Germany would hardly be enough to rescue the PIGS from their plight . Yes, they would mean that German exports get a bit more expensive, but the fact is that German manufacturers aren’t competing with Greek manufacturers in the global market.

As Martin Wolf says, Germany is “the world’s foremost exporter of very high-quality manufactures”, which means that the demand for its goods is highly inelastic. If you want a high-precision medical-equipment component, or high-end music-production software, you want what the Germans are selling, and, within reason, you’ll pay whatever they’re charging — especially when the euro is weak. State-of-the-art optical components aren’t olives, and more expensive machine tools don’t make Mediterranean beach holidays any more or less attractive than they were before.

All of which is not to say that a bit of wage inflation in Germany wouldn’t be a good thing. It’s just that the chief beneficiaries would be the Germans seeing their wages increased, rather than anybody on Europe’s southern fringe. Germany may or may not end up bailing out the PIGS in one way or another. But it can’t do so just by paying its own workers more money.

Warren Mosler has an interesting and provocative remedy for Europe’s current fiscal woes: the European Central Bank should simply print 1 trillion euros, and hand it out, on a pro-rated basis, to all the Eurozone states. This is a per-capita payment: it would be based on population, not on GDP, with the highest-population countries getting the most money.

Mosler reckons that spending would be unaffected, because the Eurozone countries are already up against their Maastricht limits, and that therefore inflation wouldn’t be affected either. More importantly, he says, the Eurozone debt ratios would come down, by say 5 percent of GDP across the board.

The interesting thing is that given recent weakness in the euro, something along these lines — if not quite as explicit — seems to be already priced in, to some degree. I don’t think anybody in Europe is particularly worried about inflation right now; if anything, deflation is more of a problem, especially in the PIIGS.

The big question, of course, is whether and how anybody at the ECB would ever let something like this happen, given its much-vaunted independence. Deflation worries might have to pick up quite a lot before it happens, and even then it’ll be a very tough sell among the European central-banking crowd.