The Great Debate UK

Geithner’s fudge won’t kill the euro zone debt Ouroboros

The frosty reception given to US Treasury Secretary Timothy Geithner at the ECOFIN meeting in Poland last week tells you all you need to know about what is wrong with the EU. The hostility was directed not at the feebleness of the advice he had to give, but at the right of an American passport-holder to offer any advice at all to the policymaking elite of Europe, who are so obviously capable of handling the crisis themselves without any outside assistance.

As far as I can tell, Geithner’s proposal amounts to leveraging the EFSF so that it can be inflated to a level sufficient to assure the markets that it has the resources to do the enormous job it has been given: bailing out Greece, Ireland, Portugal,  Spain, probably Italy and maybe even France at some point.

So, as ever, the American solution to the problem of excess leverage is… even more leverage. Financial wizardry is what Europe needs now – after all, it worked so well last time around… Risks? What risks? The additional borrowing will be guaranteed by the ECB, whose credit is cast-iron, so problem solved. Why did it take them so long to come up with an answer? If only it were so easy. Ask yourself: why is the ECB so creditworthy in the first place?

Not, in the final analysis, because its borrowing is backed by the governments of Greece or Portugal or Spain or Italy, nor even because it is backed by the Netherlands or Finland – however fiscally responsible they may be, they are simply too small to stand behind Europe’s central bank. In a crunch (and if we ever doubted that crunches happen, we know now that they do) even French support could be inadequate, given that it is currently running a sizeable budget deficit and faces a presidential election in a few months.

No: there are two meaningful levels of support that give the ECB its pristine credit status.

Firstly, the backing of the German government was, until recently, enough to preserve the ECB’s status as Son of Bundesbank. The trouble is that Germany itself has a debt-to-GDP ratio comparable to that of Britain, and the ratio would be a lot higher if it included commitments already made and about to be made to support weaker euro zone member governments. Moreover, even if they still have the capacity to do so, it is hard to see why the Germans would want to shoulder the bailout burden in this barely-camouflaged form when they are apparently so wary of entering into a more explicit transfer union (as they call the nightmare scenario of a Europe in which they are doomed to subsidise everyone else in perpetuity).

There is a second-level backstop for the ECB, and it is the one which I suspect will be called upon in the end. Although it is subject to all sorts of nominal restrictions on its freedom of action to reflect its multinational character, which have served to prevent it ever being free to behave like the Fed, the ECB is ultimately a central bank and, as such, it can always be given the green light to print Euros in whatever quantity is required to pay its debts or simply to cover the cost of more loans. The Geithner proposal amounts essentially to freeing the ECB from some of its existing constraints and preparing it to monetise Europe’s fiscal deficits, a policy similar to that which the Obama Administration itself has pursued vigorously so as to fund massive bailouts of Fannie Mae, Freddie Mac and other basket cases, with results that have been at best extremely mixed.

A make-or-break month for the euro zone

By Kathleen Brooks. The opinions expressed are her own.

For over a year now people have been calling for the collapse of the euro zone. Either one of the bailed out nations would leave, or the more fiscally sound northern European states would form their own version of a union. Regardless of what the outcome would be, the harsh reality was that the Eurozone’s massive floor -  allowing countries like Greece to borrow for nearly a decade at German-style interest rates without some limit on spending or enforcement of fiscal rules – meant that it could not survive.

But after 18 months of stop gap solutions, emergency weekend summits and hastily constructed bailout plans it feels more and more like September may be the swan song for the currency bloc.

Event risk is piling up: Greece is due to receive its sixth tranche of bailout funds from the EU and IMF at the end of this month, Germany is scheduled to vote on the legality of the extension of the European Financial Stability Facility (EFSF) and now the region’s banks look like they are being sucked into the crisis. Added to this, various governments are trying to pass austerity budgets and Italy has more than 60 billion euros of debt to finance during the month.

The EU’s response to the crisis so far has been littered with errors, but we are rapidly reaching a point where there is no more margin for error. Already there have been gaffs and we are only at the start of the month.

Firstly, Greece was forced to deny reports that it had hired a US law firm to manage its exit from the Eurozone. Who knows if there is any truth to the story, but it caught my attention as it suggested what a process for exit might look like, something I hadn’t really considered before. If as a member of the currency bloc you decide to leave, then you hire a law firm and they sort out the nitty-gritty for you: how to change back to your original currency, what would happen to any outstanding euro debts, etc.

And that wasn’t all from Athens. The Finance Minister was forced to claim that a report circulating around the Greek Parliament that said Greek debt dynamics were out of control was based on inaccurate information. This is hardly the stuff that engenders confidence in the currency bloc.

from Felix Salmon:

The long-term implications of a US downgrade

David Boucher, of The Economic Word, asks a very good question via email, about the implications of the US losing its triple-A rating:

I was wondering if the state-level impact of a debt downgrade would be different, more severe.

From my understanding, Illinois and California have the two lowest ratings of the US states; if the US were to be downgraded and so would a couple of trouble states, would it have an impact on the ability of the Federal Government to lend a hand to those in trouble? And as a result create a Euro-ish type of debt crisis within the US?

There's certainly a general understanding, in the markets, that California is too big to fail: if push came to shove, the federal government would bail it out rather than let it default. But David raises a good point: is the moral-hazard trade going to get weakened if the US loses its inviolability?

The way that credit ratings work, any municipalities which currently have triple-A ratings would almost certainly lose those ratings were the US sovereign to be downgraded. As far as I know, there's no precedent for a sub-sovereign entity to have a higher rating than the sovereign, except in extreme cases where the sovereign is actually in default.

That said, I don't think there's much of a trickle-down effect. When you get to states like California or Illinois, which have single-A ratings and are therefore many notches below triple-A already, a downgrade of the sovereign does not mean an automatic downgrade of the state. California and Illinois are being rated on their own merits, or lack thereof -- they don't just have a rating x notches below the sovereign.

So if the sovereign downgrade hurts the likes of California and Illinois, it will be where it hurts, in the markets, rather than immediately in their own credit ratings. There's some number between 0 and 1 which is the probability of the existence of an implicit federal guarantee on each state's debt. That number will almost certainly fall when the US gets downgraded. And the lower that number, the more expensive it becomes for either state to borrow money.

When the federal government is strong and can step in to save the day with little harm to itself, it's wont to do so. But the lesson of countries like Ireland is that you have to be very careful whom you bail out, lest you hurt your own creditworthiness. And the message of the US sovereign downgrade is very much that the government can't just spend as much money as it likes without worrying about the effect on its own creditworthiness. A bailout of California would be extremely expensive, and would also set a very dangerous precedent for other states which might run into trouble.

from Felix Salmon:

The curious Greek bond price chart

Many thanks to Van Tsui and Scott Barber for putting this chart together for me. We're all used to seeing yield curves -- charts which show the yield, for any given credit, at various points along the maturity spectrum. This chart is different: it's a price curve. It just shows the price at which Greek bonds are trading, plotted according to their maturity.

And it's really odd.

To understand just how odd this chart is, it's important to realize that in the Greek bond exchange, there's only one menu of options for anybody holding a Greek bond. It doesn't matter if your bond is maturing in six months or if it's maturing in 26 years, the instruments you're given the choice of swapping into are all exactly the same.

The way that the bond exchange has been structured, the new Greek bonds are all going to trade at roughly the same price, at least in the first instance. If they didn't, then everybody would simply pile into the most valuable instrument. We won't know exactly what price they'll be trading at until they start changing hands, of course, but I've marked a range between 62 and 75 cents on the dollar in the chart. At 62 cents on the dollar the bonds would be trading at an exit yield of 13%; at 75 cents on the dollar they would be trading at an exit yield of 9%. Chances are, when the bonds start trading, they'll be somewhere in that range.

For the bonds which are trading at or near that range, the exchange makes sense. You swap one bond for another bond worth pretty much the same amount, and Greece gets a bailout at the same time. Net-net, you're better off.

But for bonds trading significantly above 75 cents on the dollar, there's a lot of reason to stay out of the exchange. We're talking the bonds maturing in the next year or two here -- for them, you'd be much better off holding them to maturity, or even just selling them on the secondary market.

from Felix Salmon:

Larry Summers’s inadequate plan for Europe

Larry Summers reckons that "with last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase"; he's right about that. But his prescriptions for what must be done, laid out in the second half of his column, are a mess. For one thing, they're impossible to implement from a political perspective. For another, they contradict Summers's own diagnosis of what the problem is, as laid out in the first half of his column. And in any case they're a textbook case of too little, too late: even if implemented they wouldn't actually fix the problem.

Summers is quite right, in the first half of the column, to write this:

The approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative.

It's hard to see how he can square that with his prescription in the second half of the column:

First, for program countries. Interest rates on official sector debt will be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated so there is no reason to charge a risk premium, since charging a risk premium needlessly puts the success of the whole enterprise at risk.

Somehow, Summers has magically gone from "the debts incurred will in large part never be repaid" to "default to the official sector will not be tolerated so there is no reason to charge a risk premium," without ever explaining how he got there from here.

It seems, here, that Summers has gone effortlessly from "you can't just extend and pretend that there won't be any default to the official sector" to "let's extend and simply declare that there won't be any default to the official sector."

from Felix Salmon:

How Ecuador sold itself to China

When a country is a serial defaulter, two things happen: it regularly writes down the value of its own debts, and it can't borrow money anywhere else. The result looks something like this:

The implication of this chart is that Ecuador is finally, perforce, living within its means -- something you have to do, if you have no ability to borrow.

Except there's something the chart doesn't show: China.

Ecuador's government on Monday signed a loan for $2 billion with the China Development Bank Corp., Ecuador's Finance Ministry said, as China deepens its financial ties with the South American nation...

Currently, China's loans to Ecuador exceed $6 billion, including $1.7 billion to finance 85% of Coca-Codo Sinclair, a hydropower plant to be built by China's Sinohydro Corp. in Ecuador, which will supply about 75% of the country's energy needs.

In a country the size of Ecuador, these numbers are huge. The latest newsletter from Ecuador's Analytica Investments puts them in perspective:

Since the 2008-9 default, which chopped the government’s foreign debt to $7.01 billion, debt has surged 54% to $10.78 billion with the latest deal...

Newspaper El Universo reported that the loan from China’s Development Bank is tied to another 72,000 barrels per day of oil deliveries, citing a memo from the negotiations. That would make Ecuador owe 75% of its oil exports to China, the paper cited opposition legislator Vicente Taiano as saying...

Ecuadorian bankers report that Ecuador wants a $10 billion credit line from China. If that were to happen, Ecuador would owe the Asian giant an extraordinary 24% of GDP.

Could Italy go the way of Greece?

Italy has hogged the headlines in recent weeks mostly for political reasons rather than financial ones. But in a few months we may be concentrating on its fiscal woes and unsustainable debt burden.

Last week credit rating agency Moody’s announced it was putting Italy on review for a possible downgrade to its Aa2 credit rating. These reviews typically last three months or so, and although a downgrade would still leave Italy at the higher end of investment grade, it is not good news to be sliding down the scale, especially when a sovereign debt crisis is raging further along the Mediterranean coast.

The reasoning behind the move by Moody’s was firstly challenges to economic growth, and secondly difficulties in bringing its debt levels down. A lot of attention has focused on a Greek default hitting Portugal and Ireland hardest, but Italy has a public debt-to-GDP of close to 120 percent of GDP, thus it is extremely vulnerable to investors dumping its debt, which would push up interest rates and make its debts too expensive to service.

Nearly a quarter of all debt issued by the euro zone comes from Italy and yet its growth remains stubbornly sluggish. Its average quarterly growth rate since 2000 is just 1 percent. Italy now risks becoming a long-term low growth/high debt economy.

Although its budget deficit is at a manageable level just below 4 percent of GDP, it has more than €300 billion of debt maturing this year and needs to get access to the capital markets in order to fund these bond redemptions.

So what is Italy’s problem? It is mainly an issue of low productivity and rigid labour laws. Its labour laws are some of the stiffest in the developed world. Article 18 of the Labour Code states that after a short probationary period, an employee fired from a company with 15 or more employees can bring a lawsuit against their former employer. Although they have no right to reinstatement, they would be entitled to compensation ranging from 2.5x to 6x monthly pay. That explains the low unemployment rate, since firms can’t fire inefficient or sub-par workers without a hefty cost.

Its work week was also shortened in 1997 to 40 hours from 48 hours. Italy’s competitive record is dismal and it is already trailing in the wake of fast-growing, innovative emerging markets. If there was a crisis in Italy’s sovereign debt market it’s easy to see how its economy could stagnate for a generation or more.

Units and unities: can currency change really resolve the Greek tragedy?

As the Greek tragedy goes into what looks like its final act, there is increasing talk of the country leaving the euro zone and refloating the drachma. Perhaps the Athens street mobs favour this “solution”, but what would it involve, and would it work?

It is a bizarre situation, without precedent as far as I am aware (though I am no economic historian). Usually, new currencies are introduced to replace old ones which have become discredited (typically after hyperinflation), whereas here we are talking about the absolute opposite: abandoning the euro because it is too strong, in favour of a new drachma, which will be a weak currency by design – rather like launching a ship, in the hope it will sink!

Equally bizarre is the fact that many people seem to think this course of action will somehow be less painful for ordinary Greeks than the austerity measures being demanded by the IMF, EU and ECB. But just consider what is involved.

The immediate problem would be the changeover mechanism. New currency launches take time, normally many months or even years, so even if this reversion to the drachma can be rushed through at Olympic speed, we must surely be thinking of January 2012 at the very earliest. But what happens in the interim? The situation could be completely unmanageable.

In the first place, Greek savers are not going to wait around while their cash, bank deposits and other assets are forcibly converted into drachma (and their banks go bust too). Instead, they are going to do everything in their power to put them beyond the reach of the Greek monetary authorities, which may simply be a matter of moving their accounts to foreign banks, if they haven’t already done so, or possibly something more sophisticated or devious. (In any case, you can be sure middle-class Greeks will already have had years of practice at hiding funds from the taxman).

In fact, since, legally or illegally, euros will continue to circulate long after a new currency is launched, the only feasible way to refloat the drachma is in a dual-currency regime in which, at least initially, drachma are only used for transactions involving the government and nationalised industries. So, for example, civil service salaries and welfare payments could be paid in drachma, which would then be accepted by the government-owned utilities, and presumably by banks, which would have to be nationalised, de facto if not de jure. The private sector would then use drachma alongside euros, which would for the foreseeable future remain the currency of choice for all their big-ticket transactions.

Post-hyperinflation experience in Latin America, Israel and Eastern Europe suggests that this sort of dual-currency scenario can be as stable and durable as any other type of regime in the unstable world of international monetary arrangements.

from Felix Salmon:

Could the EFSF engineer a Greek restructuring?

We're now close enough to a Greek default that the likes of Daniel Gros are coming up with schemes for how to avoid such a thing:

The European rescue fund -- European Financial Stability Facility, or E.F.S.F. -- should offer holders of Greek paper an exchange into E.F.S.F. paper at the current market price. Banks could be "induced" by regulators to accept the offer.

The E.F.S.F. could then be the only remaining creditor of Greece and propose a bargain to the country: “We write down the nominal value of our claims (say, 280 billion euros) to the amount we paid (say, 150 billion euros) and extend all maturities (at unchanged interest rates) by five years provided you (Greece) agree to additional adjustment efforts (and asset sales)."

This should be too good of a bargain for Greece not to accept since it avoids default and saves the country 130 billion euros. While the E.F.S.F. exchanges the stock of Greek bonds, the International Monetary Fund could finance the remaining deficits in the usual way, with bridge financing until the fiscal adjustment is completed.

Greece would then be left with some I.M.F. debt and the 150 billion euros it owes to the Europeans. Together, this would be about 85 percent to 95 percent of its gross domestic product, which is not far from that of France. It would be high but manageable.

The losses that would be taken by Greece's private-sector creditors -- €130 billion or so -- would be small enough to avoid large-scale bank insolvencies, at least outside Greece itself. (What would happen to Greek banks is far from clear.) But it's not at all clear how this regulatory "inducement" could work.

One problem here is that unless they're Goldman Sachs, banks don't mark all their assets to market every day: the current secondary market price might be a more reliable guide to value than anything else, but that doesn't make it infallible or even in the right ballpark. And of course the minute that the EFSF or anybody else starts treating the market price as some kind of holy benchmark, you can be sure that the market price will start rising dramatically.

A bigger problem is that the market price is a marginal price, being set between a relatively small group of speculative investors with pretty short-term time horizons. (That's why it's fine for Goldman to mark to market: when it holds securities it does so on a speculative basis and with a short-term time horizon.)

There's an enormous group of investors who would never buy Greek debt for anything near the current price, and there's an equally enormous group of investors who would never sell it at these levels. Those investors, obviously, don't trade with each other: they simply don't participate in the market for Greek debt. But Gros's idea is to drag them into the market against their will, tell them that they're wrong to stay out of it, and force them to sell at a price they would never normally agree to. Regulatory strong-arming can be effective, but this would be a very tough sell indeed -- and indeed would violate the very spirit of markets, where trades are voluntary and done in the knowledge that most investors aren't actually interested in trading at the current market price.

The point here is that Gros's plan would never work if the EFSF simply bought up Greek debt in the secondary market -- it could never buy enough to move the needle, and if it started buying extremely aggressively, then the price would necessarily rise sharply. So it's the element of coercion here which is central to the Gros scheme.

Nuclear plants aren’t the only meltdown worry in Germany

Having just got back from a couple of days in Hannover, I couldn’t help but be struck by the dominance of the local news agenda by two topics – and the almost complete absence of a third. Taking the British media at face value, I might have expected a city in near-panic, with people nervously scanning menus for safe dishes to order and maybe antiseptic handwashing facilities being hurriedly installed in public places. In fact, the town looked exactly as I remembered it from my last visit a few years ago, with E.coli rarely mentioned either in conversation or on the 24-hour TV news channels.

In fact, apart from endless replays of the goals from Tuesday night’s football (Germany versus Azerbaijan, a real clash of the Titans that must have been!), the news was all about the remote risk of a meltdown in the country’s nuclear power plants, and the anything-but-remote risk of meltdown in what is left of the Greek economy.

As far as the first is concerned, it seems that the sight of one of the reactors at Fukushima succumbing to a tsunami generated by the second biggest earthquake ever recorded has convinced Germans that they are better off counting on their neighbours in France and Czechoslovakia for their nuclear power than on generating their own. As the Americans say: go figure.

If there were ever any doubt, Frau Merkel has made it clear that, after all the tough talk, Germany is going to cough up for Greece. The arguments are simply about how to package the donation so as to make it look as penny-pinching as possible, and accompanied by the maximum pain that can be inflicted on the recipients – after all, the Bundeskanzlerin is elected by Germans, not Greeks. But there are clearly limits to how much austerity can be imposed on a country where standards of governance have been sliding for 2,500 years, and when Greece’s debts are finally restructured/reprofiled/rolled over or whatever euphemism for default is finally chosen, German voters are bound to overestimate the cost to themselves and underestimate the pain for the Greeks.

(Question: why don’t they offer a cash prize for the best euphemism for default? What about Negative Asset Investment Value Elimination?)

How will it all play out? I have no idea, but so far I see no reason to change the forecast I made back in 1998, when this ship of fools was launched amid so much fanfare on an ocean of Euro-rhetoric. I thought then that the most likely outcome was that the “savers” – the Germans, Dutch and Austrians (I wasn’t aware then of the Finns) – would get tired of being taken for mugs and, realising their prudence was ultimately futile, would loosen their belts and join the party. After all, in the euro zone, they can’t beat ‘em, so they may as well join ‘em.

Although this still seems to me the most likely outcome, it is probably some way off yet, though I would not be surprised if this or the next German Government lost enthusiasm for its current campaign to rein in its relatively modest overspending.