Thursday, June 6, 2013

IMF is courageous and admits the obvious!

Well, the IMF now has spoken and it was a remarkably straightforward assessment, indeed! Above all, it didn't shy away from a critical self-assessment. It is certainly surprising that the IMF would have come out with such a critical self-assessment. The content of what they have now put on record should not surprise at all!

Everyone who has ever been involved with external payment problems of a country knew by early 2010 that a 'run on the country' was in the making in Greece. The run had actually started back in 2008 when foreign banks began calling their short-term lines for Greek banks. In other words, they began reducing their Greek exposures. By late 2009, it only required a spark to turn this into a real run, and that spark was the new government's accouncement that the budget figures needed to be restated. By early 2010, it had obviously become a case of 'game over'.

Everyone knew that. Everyone, I should add, except EU-elites.

A run on a country cannot be stopped by strong expressions of support by politicians; or by a 110 BEUR financial commitment. By year-end 2009, Greece's foreign debt was close to 400 BEUR. To stop that run, the financial commitment would have had to be for 400 BEUR plus a commitment to finance all further cash needs of the country.

Barring such a financial commitment, a run on a country can only be stopped if it is stopped in its tracks. That would have entailed an immediate stop on all foreign debt service and the initiation of negotiations to restructure the existing foreign debt of the entire country (not only the sovereign debt). When Angela Merkel announced that 'if Greece fails, the Euro fails and if the Euro fails, the EU project will fail', she irreversibly opened the door to the unfortunate development which has taken place since then. I once wrote an article that the EU-elites would deserve a Nueremberg-trial for that irresponsible decision.

The IMF now admits that Greece's debt should have been restructured right away. This is mistakenly interpreted as meaning that Greece should have been forgiven a substantial portion of its debt right away. A debt restructuring and a haircut are two separate things. A debt restructuring can involve a haircut but it doesn't have to. In the case of Greece, an EU-member and thus a country of the First World, a haircut should never have even be considered at the time.

To make a haircut on sovereign debt at the outset of a crisis, particularly if it is a First World country, is a terrible precedent of gigantic proportions whose long-term effects cannot be foreseen. If there had been a one-time catastrophy, it might have been different but Greece was not a case of a one-time catastrophy. Such a haircut may be considered after 10 or 20 years of unsuccessfully battling an economic crisis but not at the outside. Among other reasons, because there are better ways to accomplish the same effect.

Thus, what the IMF calls a 'restructuring' should have been a straightforward 'rescheduling' of debt. As the Chief Economist of Citibank later stated in an interview: "The Europeans did not know that, outside Europe, debt reschedulings of sovereign debt with existing creditors have come a dime a dozen in recent decades”. Citibank is probably the most experienced player in the field of sovereign debt reschedulings.

The overriding principle of a debt rescheduling is that 'risk takers must remain risk carriers'. I. e.: every creditor must keep the risk which he already has. All he does is to extend the maturities of debt and interest payments.

What about the issue Greece's debt not having been sustainable back in 2010? Well, one takes the amount of debt which is deemed to be non-sustainable; for example all debt over 50-60% of GDP. And then one refinances that non-sustainable debt with a very long-term bond (at minimum 30 years) and with interest capitalization. Put differently, Greece would have not have had to make any service on that debt for at least 30 years.

Why would creditors have accepted that? For a very simple reason: because it is far better than a haircut! Once a haircut is made, the creditor has forgone all his claims. When he accepts a new 30-year bond with interest capitalization, that bond may trade near zero at the outside but the creditor retains a legal claim (and the bond might increase in value if Greece were to turn into an economic miracle in the next 30 years).

Who would have been the beneficiaries of that? Not really Greece because the country's debt wouldn't have changed (only much of its service would have been deferred). The beneficiaries would have been the European tax payers! Instead of sending 247 BEUR to Greece (which they have done since then), they would have had to send only 40-50 BEUR. Why? Because that was the part of the 247 BEUR which actually stayed in Greece. The rest was immediately recycled for foreign debt service.

Put differently, European tax payers could not have been misled that Greece needed 'hundreds of BEUR'; European electorates would have shown much greater understanding for supporting Greece. European tax payers might still have had to come up with the remainder of the money to bail out their banks but that would have had two very favorable consequences: European tax payers would have had transparency as to what they were really financing and, secondly, they would have received something in exchange, namely equity in those banks which would have had to be saved.

Instead, what happened was: the EU used Greece's balance sheet to bail out its banks and they called that 'help for Greece'.

Does that have anything to do with the infamous austerity and the collapse of the Greek economy which it allegedly caused? Not really! I do not accept the argument that Greece's pain would have been diminished if there had been less austerity. An economy does not work based on scientific rules where it can be projected what happens, if... An economy works very much on the basis of expectations. If less austerity had lead to more optimistic expectations on the part of Greeks, less austerity might indeed have done the trick. However, I argue that it was expectations which 'killed' the Greek economy. The Greek economy had become such a basket case by 2009 that expectations for a turn-around simply weren't there. Not internationally; neither domestically.

Greece had a budget deficit of 15% in 2009 and a primary deficit of 10%. Now, if that is not a fiscal stimulus, then I don't know what is. And yet, Greece's GDP declined by a little over 3% in 2009! How much more stimulus than that could have stopped the decline which occurred when expectations fell apart?!?

The IMF is very vague when it comes to suggesting how Greece's pain could have been diminished. They insinuate that if structural reforms had been implemented, etc. etc., then private sector growth would have come about automatically. Well, that sounds like an illusion because when expecations work against it, there is no hope.

I have always been very clear on what should have been done. With unavoidable austerity in the public sector, there would have had to be an enormous push for growth in the private sector. For example: an immediate long-term economic development plan for the Greek private sector. If for no better alternatives, the implementation of the Greece Ten Years Ahead plan proposed by McKinsey. Who would have had to finance the implementation of that plan? My answer was/is: private foreign investors.

If offered a good Foreign Investment Law and if offered security that the Foreign Investment Law would be honored by Greece at all times (i. e. an EU-guarantee for the political risk, including the risk of a Grexit), foreign investors would undoubtedly have come.

Accompanying measures would probably have been some form of special taxes on imports to stimulate domestic import substitution ('infant industry protection'), some form of export promotion and, in all likelihood, at least temporary capital controls. All violations of EU-treaties? Yes, indeed. But considering how many EU-treaties have been violated in the past 3 years at enormous cost to all, this would have been a fairly acceptable violation because it would have supported a long-term plan. And, an EU-guarantee for the political risk would have cost the EU but a few signatures.

Short of a bold new private sector initiative, one would be inclined to agree with Prof. Paul Krugman when he says 'in that case you have to wonder whether it was worth trying to keep Greece in the euro at all. “Grexit” would have been ugly, and will still be ugly if it eventually happens. But compared with what has actually taken place?'

The IMF’s Ex Post Evaluation (EPE) has been generally interpreted as a complete mea culpa on the part of the IMF with a complete culpa assigned to the EU. Greece was said to come out of it as the victim of having been used as a ginny pig. Against this background, it is noteworthy to pay attention to the following quotes from the EPE.

From the Executive Summary
“Competitiveness improved somewhat on the back of falling wages, but structural reforms stalled and productivity gains proved illusive”.

“The depth of ownership of the program (on the part of Greece) and the capacity to implement structural reforms were overestimated”.

From the Report
“Some argue that Greece was the country that gained most from euro adoption. Government interest expense dropped from 11,5% of GDP in the mid-1990s to 5% of GDP in the mid 2000s. These savings were more than swallowed up by increased spending on wages and pensions. The general government deficit reached 15,5% of GDP, up from 4% in 2001 (i. e., ceteris paribus, without the direct fiscal dividend of lower interest expense, the deficit comparable with 2001 would have been 22% in 2009!)”.

“Tax administration reforms encountered setbacks due to political resistance and capacity constraints. There were few signs by the end of the first program that collection efficiency was being improved on a permanent basis”.

“Labor market reforms were initially judged to be progressing well, but a more critical view was taken in later reviews. The absence of early actions to reduce private wages may have aggravated the job losses from the economic downturn”.

“The product markets and the business environment failed to generate critical mass necessary to boost growth. Progress was disappointing and militated against realization of the productivity gains that had been hoped for”.

“Confidence was badly affected by domestic social and political turmoil. Some of the adverse political developments followed from limited ownership of the program”.

“The burden of the program was not shared evenly across society. Specific plans to downsize the number of civil servants were limited to a commitment to replace only 20% of those who retired. The state enterprises also remained generously staffed”.

“Ownership of the program was limited. Vested interests had fiercely opposed structural reforms in the past. Little progress was made with politically difficult measures such as privatization, downsizing the public sector and labor market reforms”.



    The above NYT editorial jumps to the conclusion that Europe should admit its mistake and act accordingly. True, but what mistake should Europe admit to?

    The mistake was not to have rescheduled debt upfront. A terrible mistake! It cost European tax payers hundreds of BEUR. To those tax payers Europe should apologize.

    Greece only got 40-50 BEUR out of the 247 BEUR which Europe has disbursed to Greece so far. Would it haved saved pain for Greeks if Europe had disbursed maybe 20-40 BEUR more? In the short term, yes. In the long term, no.

    I repeat: Greece started getting into trouble once the tsunami of foreign funding came into motion after the introduction of the Euro. The public sector covered up problems by hiring people who would otherwise have been unemployed. This was still ok until about 2006. But from 2006-09, the public sector went totally off the chart in terms of hiring people and increasing their wages and pensions. Still, it could not get unemployment below 10%.

    In 2009, spending went through the sky with a deficit of 15%. And yet, GDP declined by over 3%. When things get so much out of control (as the Greek Central Bank wrote in a confidential report in early 2009), it is like a mosquito looking for a windshield, and that windshield came in the form of Papandreou's restatement of the deficit.

    The only thing which could (or can) reduce the pain of Greeks is significant growth measures for the private sector. There, Europe has been silent and deserves blame for it. But Greece has also been silent as to plans for growth in the private sector.

  2. Hmm. I recall at the very onset of the crisis -- that is, just as Papandreou was elected -- most economists I spoke to in Greece were emphasising the importance of protecting the European banking system. This same mistake was adopted by Europe's politicians -- where implicitly the "saving of the banks" was done simply by cutting off debt-financing for the weaker eurozone economies and sacrificing the real economy in the process.

    That mistake cannot exactly be undone; nor can the eurozone admit it, else they may as well resign en masse. Moreover, the previously suppressed IMF staff hostility to the strategy is now open knowledge, and all that the EU can do is complain about the IMF and its refusal to continue with the charade of mistakes.

    Nor is state-sector subsidy of the private sector (as intended by the Greek government and the political leadership of the European Commission, via the European Social Fund) a sensible idea. The reason is that the ESF is designed for active labour market measures, in order to support the employment/skills needs of the private sector. When the private sector is actually shedding labour, then those policies are redundant. It looks to me as if the current Greek government wants to abuse the ESF for job creation, regardless of the current state of the private sector. The result will be useless jobs, replicating within the Greek private sector all the past mistakes made with employment in the public sector.

    Basically, neither Greece nor the Troika has any sort of strategy to deal with the crisis. So long as northern Europe's banks remain viable, they seem to be moderately happy. Collapse of the real economy in most of the eurozone, and very high unemployment, is a price apparently worth paying in order to keep banks afloat. Until this policy position is reversed, Europe (and Greece) will simply continue along this disastrous road to ruin.

    1. I am definitely not talking about state-sector subsidy for the private sector. I am talking about foreign private sector investing in Greek private sector. That could easily be done by having the export agencies (such as Coface, Hermes, OeKB, etc.) issue guarantees for political risk at very low or zero cost. Or better yet, have the EU issue such guarantees.

      The touchy issue is the definition of the political risk which is guaranteed. There I suggest that a new Foreign Investment Law of constitutional rank is implemented which spells out everything which the foreign investor is offered before he makes his investment. That would be the economic framework for his investment (everything that makes it easy for him to do business competitively) and it would certainly include protection against a Grexit.

      The EU would definitely be in a position to assure that the Foreign Investment Law is observed. For example, if a future Greek government wanted to unilaterally fiddle with it or even eliminate it, the EU would simply threaten to cut off all support. The only thing which the EU cannot control is a Grexit but the more foreign investment there is, the less likelihood of a Grexit.

      The foreign investor knows that he has the guarantee of attractive and competitive business conditions. If anything happened which would change the commitment under which he had made his investment, he could call the EU guarantee.

      Again, the guarantee would cost nothing and would not require any public funding. It would only assure that private funds come to Greece's private sector for investment

  3. I did not intend to imply that you would support this sort of state subsidy for the private sector. My point is that this foolish approach is being touted by Samaras and the EU Commissioner (but not the Commission staff). That is the same sort of story as the gap in the IMF between staff and political chiefs -- with the politicians making terrible decisions.

    I agree about the idea of a Foreign Investment Law; actually one should be drafted as a model for use across the EU. Of course, the idiot national politicians will never agree to a common approach on something so important.

    In the case of Greece, there is still the problem of implementation of law and the useless and corrupt legal system. There is no point in having a law if it actually has no effect.

    1. I agree that the implementation of laws is a problem when they affect the entire country, for the simple reason that one cannot change an entire country from A-Z in a reasonably short period of time. That takes a generation, at least.

      It is different when a new law affects only specific situations (like a foreign investment and/or a special economic zone). There it can easily be implemented, monitored and controlled. If Greece couldn't handle that on its own, the TFGR could easily assist.

      Since the EU would be guaranteeing compliance with the new laws, it would have all the rights in the world to closely audit compliance. Such auditing of compliance would also assure that correct corporate governance is being adhered to.

      Put differently, if the EU discovered that "Greek ways of doing things" had entered the dealings of foreign investors, they could immediately cancel their guarantee. That would motivate foreign investors to make sure that "Greek ways of doing things" will not enter their business practices because they certainly would not want to lose protection under the EU guarantee.

  4. "Greece had a budget deficit of 15% in 2009 and a primary deficit of 10%. Now, if that is not a fiscal stimulus, then I don't know what is. And yet, Greece's GDP declined by a little over 3% in 2009! How much more stimulus than that could have stopped the decline which occurred when expectations fell apart?!?"

    The budget deficit was indeed too small, when taking into account that private credit started contracting (which was the primary driver of the economy in the 00's).

    I know that it must sound shocking to a liberal to say that a 15% budget deficit was too small, but that's how it is.

    As for rational expectations (and other dubious theories in the vein of the Ricardian Equivalence), they don't really count for much when it comes to aggregate demand. Income counts, not expectations.

    1. Yes, it is indeed shocking that you would argue like that. Bear in mind that Greece's borrowing cost in the late 2000s was about 7% lower than 10 years earlier. So, if you were to factor that in, Greece's deficit in 2009 would have been about 22% on a comparable basis with 10 years earlier. Not a big stimulus?

      I think the extremely low level of interest rates misleads people as to what the issue with debt really is. It's not so much the level of debt. It's the level of interest expense which it triggers in the budget.

      Japan will be an interesting example because it seems to have become the role model for deficit spenders. True, they can print the currency of their debt and that makes things easier. But I recently wrote that if interest rates were to rise by 2%, interest expense in Japan's budget would rise to 80% of current revenues. Think about that!

      I guess Greece's sovereign debt is around 350 BEUR by now. Suppose Greece were going strong and had no problem raising new debt. And suppose Greece could borrow at, say, 4%. That would be 14 BEUR in interest expense. Just think how many roads, schools, hospitals, etc. etc. you could get for 14 BEUR which roads, schools, hospitals, etc. etc. you now have to forego!

      You will probably argue that it makes no difference because if we need more money for roads, schools, hospitals, etc. etc., we'll just print it. My friend, I have lived in Argentina when they did that. At its peak, inflation reached about 30% PER MONTH!

      I agree with you on the importance of aggregate demand but there has to be at least some level of aggregate supply to meet that aggregate demand if an artificial increase in aggregate demand is to serve a sustained purpose. What good does it do Greece longer term if the increased aggregate demand goes right into imports?

      There is such a thing as 'potential utilization' in an economy (Krugman writes about that a lot). If there is potential to be utilized by new demand, increasing aggregate demand artificially will work without inflation. That is Krugman's argument for the US. Now you may say that as soon as there is new aggregate demand, the Greek economy will respond and create new aggregate supply. Almost 200 years of modern Greek history are not really a proof that it works that way in Greece!

    2. Perhaps you will find this article interesting.

    3. I'll answer indirectly.

      First of all, Japan isn't a role model. It suffered two lost decades because of an asset price bubble. That's no role model. In fact, for a country with Japan's industrial capacity, it is an outright failure, although it did far better than the Eurozone.

      On to Greece.

      So, let's say that Greece reverts to the drachma, and it "prints" drachmas (that is it borrows from it's central bank) in order to kick-start the economy.

      This would be internal debt, so no biggie.

      The question is, what can Greece achieve with this internal debt?

      Obviously, it can't achieve import consumption, but then again it shouldn't.

      So, can it achieve (through policies that target specific activities) not only to kick-start the economy, but also to turn it around from an unproductive to a more productive model (a weakening of the currency would be helpful in that aspect)?

      It can. The question is whether Greek politicians can pull it off. I'll be a realist and say that they can't. But it is a better scenario than the current one.

      Simply put the loss of one economic tool (competitive devaluations, although Europe has a long history of meddling with one-size-fits-Germany policies, perhaps you remember the ERM) needs to be substituted by another (a redistributive taxing authority on the Eurozone level). If not, then at some point a country is going to be forced to leave the euro, just like they left the original ERM.

    4. You are changing the scenario. My scenario was Euro; yours now is Drachma. In your scenario, I would agree with everything you say. Unfortunately, I would also agree with your assessment that Greek politicians wouldn't be able to pull it off. This is why I am still a defender of Greece's remaining in the Eurozone even though I have to admit that, for some time now, this is no longer based on conviction but, rather, on wishful thinking.

      From the beginning, one of my major points has been that Greece's challenge is not only the Euro but, at least equally importantly, the Euro in combination with 2 of the 4 EU-freedoms: the free movement of goods & services and the free movement of capital. These 2 freedoms expose the Greek economy to competition for products & money which it can't handle (yet) and the Euro puts oil on this fire.

      When I started writing about Greece, I argued that a return to the Drachma would lead to social revolution because of all the damage it would cause. Well, if someone had told me that unemployment would exceed 25% a couple of years later, I would also have predicted a social revolution.

      I argued that Greece couldn't make it within the Eurozone as it is but a return to the Drachma would be the worst of all evels. Thus, I suggested that Greece should remain within the Eurozone but simulate a situation, for several years, as though it had returned to the Drachma: special taxes on imports accompanied with special incentives for import substitution; special incentives for exports (such as SEZ); an EU-sponsored foreign investment drive (to substitute for deficit spending); capital controls; etc. etc. You can read it here:

      To this day, I am convinced that this could have worked well for both Greece and the Eurozone. However, it would have required significant EU-initiatives and significant initiatives on the part of Greece to allow and implement the rules of the game necessary for such a plan.