Tuesday, January 27, 2015

Prof. Paul Krugman Discovers The Importance of Cash Flows in Greece!

It's good to feel vindicated from time to time. With all this hype that has been going on for years over the sustainability of Greece's debt, leading to the self-conviction of many that the most important thing which Greece needs is a haircut --- I have always said that the level of Greece's debt doesn't really matter. What matters the most is how much debt service flows through the budget. The level of debt is totally irrelevant when it carries a zero interest rate and when it has no maturities. That's also called equity.

As I have written before, Greece currently spends about 4,5% of GDP on debt service (actually not a high percentage) and that percentage goes down to about 2,5% when considering ECB interest rebates. SYRIZA can't touch the debt owed to private creditors at this stage, so they can never get the debt service down to zero. But with some touch negotiations with the Troika, SYRIZA ought to be able to bring the overall percentage of debt service (net) down to 1% or even a little less.

And now witness what Prof. Krugman writes in this blogpost: "Most discussion is framed in terms of what happens to the debt. But at this point Greek debt, measured as a stock, is not a very meaningful number. After all, the great bulk of the debt is now officially held, the interest rate bears little relationship to market prices, and the interest payments come in part out of funds lent by the creditors. In a sense the debt is an accounting fiction; it’s whatever the governments trying to dictate terms to Greece decide to say it is". Put differently, the message is: "It's the flow, not the stock, stupid!"

I once argued that Greece's decision point would come when a primary surplus was reached. As long as there was a primary deficit, Greece paid interest not out of its own resources but out of new borrowings. With a primary surplus, Greece has to decide what it uses that surplus for: for domestic investments or for paying interest to foreigners.

So I guess Prof. Krugman, who has been a fierce proponent of idea that Greece's debt is not sustainable, now agrees with me (Sorry! I agree with him!) that there should be two major negotiating points with the Troika: How to get the debt service close to zero and how to use much or most of the primary surplus for domestic investments.


  1. Well, somewhat right, but you folks forget one thing: This wasn't money just suffed up under the mattresses of EU governments, that's borrowed money that actually has to be paid back! So, it's rather real, and not simply an accouting fiction at all. At least indirectly, taxpayers outside of Greece have to pay for that!

    1. No, there are situations where borrowed money does not (have to) get paid back. They are called bankruptcies. When a person or company declares bankruptcy, creditors typically take losses and after the conclusion of bankruptcy proceeding, there no longer exists a borrower.

      A sovereign state cannot go bankrupt because there are not bankruptcy laws for sovereign states. A state can never disappear. A state hardly ever pays back debt but it must be able to service the debt.

      Take a market rate for Greece and apply it to 320 BEUR in debt. Before you know it, you come to an annual debt service of 15 BEUR. If Greece does not have the surplus to make that debt service, it needs to borrow and the debt goes up.

      So it is clear: at market rates, Greece's debt is unsustainable. Of course one could tell Greece that, since you can't declare bankruptcy, you have to stay on the hook for all this debt forever. But when you think that through, you come to the conclusion that it doesn't make sense because it would be like drawing water from a dried-out well.

      So you have to recognize reality that debt is unsustainable at market rates. There is a loss to be taken. The trick is to spread that loss over several decades instead of taking it all at one time.

    2. Sorry, but you totally miss the point. I am not talking about the (increasingly likely) bankruptcy of Greece, but the money that the Troika/IMF/EZ rescue fund used for bailing out the country (about 75% of the Greek debt, it's said). That was borrowed, too, has to be served with interests, and eventually be paid back! How about THAT cash flow issue? This will burden those institutions for a long time! Thus, I find the lighthearted attitude Krugman and you show towards the issue to be rather inopportune, sorry.

    3. @ Gray
      I did get your point; perhaps you missed mine. Take Germany as an example. Assume that all rescue loans were booked at the KfW (which I am not sure of).

      Thus, the KfW would have made about 60-70 BEUR loans to Greece and would have funded them just like they fund all their other loans. Whether that 60-70 BEUR was lent to Greece or to the USA would not have made a difference. And – the Inc. guaranteed those loans.

      Should those loans be 100% forgiven, the KfW would initially take a loss of 60-70 BEUR. It would immediately become insolvent and the Inc. would have to recapitalize it. That, however, would not be necessary because the Inc. had guaranteed the loans. So, what happens is that the KfW call the guarantee of the Inc. and the Inc. has to come up with 60-70 BEUR to fulfill its guarantee obligations to the KfW. At the end of this exercise, the KfW is as healthy as it was before.

      Where does the Inc. get the 60-70 BEUR from? Correct! It has to borrow the money by issuing bonds. And the transfer of 60-70 BEUR to the KfW flows through the budget. And that is when the tax payers discover that someone had made bad loans to Greece with their money.

      Now, “extend & pretend” means that the KfW keeps the loans on the books at nominal value of 60-70 BEUR. Since it has the Inc. guarantee, it has not problem with the 100% valuation of this asset. If the interest rate is cut to zero and the KfW’s funding cost is 1%, the KfW has an out-of-pocket funding loss of 600-700 MEUR annually. It depends whether the Inc.’s guarantee covers only the actual funding loss of also the opportunity cost of not having a margin. If it is only the funding cost, the Inc. has to transfer annually 600-700 MEUR to the KfW under its guarantee. And these 600-700 MEUR flow through the budget annually. A lot less than 60-70 BEUR.

      You say I have a lighthearted approach to debt. Well, the more appropriate word would be realistic. Since independence in 1832, I believe, the Greek economy has had only one year of positive cash flow from operations (current account surplus) and that was 2013 (2014 will be the second year). In order to truly repay debt, the country’s cash flow from operations would have to be positive. Suppose Greece could sustain a current account surplus of 5 BEUR annually, a very optimistic figure when considering the track record of almost 200 years. Still, Greece, with a debt of 320 BEUR, would have to, for 65 years, use ITS ENTIRE EXTERNAL SURPLUS for debt reduction. This is totally unrealistic.

      So, the loss is already there. If politicians had been honest, they would have admitted that back in the spring of 2010. As long as they “extend & pretend”, they do not have to admit it and the tax payers won’t feel very much how much they have lost.

    4. What do you mean with insurance? Who allegedly insured those papers, and how do they expect to cover a 70 billion loss? How can Greek treasuries be hedged, who would bet against a default? And how high would the premiums for such a risky insurance realistically be? Sorry, but this somewhat sounds like the same phony guarantees given for US real estate CDO's to me. You may remember that their insurer, AIG, went bankrupt.

      Also, you sure the KfW is allowed to do such phony bookkeeping, after the toughened banking regulation of the last years? Don't they have to account by "mark to market" prices?

      Anyway, no, your response doesn't convince me at all that it won't be the taxpayer who will have to face the big bill.I accept that as part of the failed edeavour to help the Greeks to stay in the Eurozone, but what annoys me very much is the cynical disregard Krugman and you show towards that sacrifice by the Germans (and other European taxpayers, just ask the Fins for their opinion!). Some words of empathy would be in order, imho. We had the best intentions, and we actually, evidently, did help other countries to get through the crisis. Only Greece turned out to be a hopeless case, and we'll have to pay for that, sadly.

    5. @ Gray
      There is no insurance à la AIG. There is the unconditional and irrevocable guarantee of the Federal Republic of Germany. (Haftung). That's good enough for KfW and its auditors to keep the loans on the books at 100% value. Not to mention that Basel-2/3 considers sovereign risk of Eurozone countries as risk-free and no risk provisions need to be made. There is no mark-to-market on these bonds. There is no phony accounting. And I don't think the Federal Republic charges a fee for its guarantee, but I am not sure.

      You don't seem to have read my comment. There is no question that the bill will ultimately hit tax payers of Germany and other countries. Not only the bill for Greece; for other countries as well. It's just a question of when and how much at one time.

      Your last paragraph, sorry to say this, defies reality and description. Todate, there was no sacrifice by the German tax payers for Greece (Finland is a bit different because Finland had no exposure to Greece before the bail-out). Roughly 85% of rescue loans have gone right back to the private banks. Banks like BNP, Deutsche, etc. were bailed-out via Greece's balance sheet. The bail-out so far was one massive transfer of risk from private lenders to tax payers. An irresponsible decision by Merkel & Co.! Germany indeed had the best of intentions if the intention was to save its banks and the Euro. If the intention was to really help Greece, Germany & Co. failed miserably so far. Germany's risk share in the bail-out loans is 27%. The bail-out loans replaced, among others, loans of German banks where Germany had 100% Greek risk. Thus, by shifting the risk from private banks to Troika loans, Germany as a country reduced its risk on those loans from 100% to 27% (of course, it increased its risk by assuming 27% of the risk of other countries). Because of the problems in the South, there has been a flight to quality in capital markets. This is why Germany can nowadays raise funds at zero interest cost. Conservative estimates have calculated that this saved Germany at least 40 BEUR in interest expense so far. The Null-Defizit was made possible. If one wants to be cynical, one can be cynical about those who spread lies like "there is not alternative"; or "we have really helped Greece". Etc.

      From 2010-12, rescue loans totalled 247 BEUR. Of that, 206 BEUR went straight back to the lenders and only 41 BEUR stayed in Greece to finance the budget, etc. Real help would have been if 84 instead of 41 BEUR had stayed in Greece and if some of the private lenders had shared a bit in the cost as well.

      I am sorry to tell you that you are a victim of brainwashing of those who have to deny reality because that would mean admitting (HUGE) mistakes!

  2. Well argued, both you and Paul. A follow up question though: why do you think that Syriza (people like Varoufakis for instance) keep demanding a new haircut (not personally of course, Varoufakis is quite bald). Is it for political and psychological reasons only?

    1. Because otherwise Greece will be under Troika budget supervision forever. This is not compatible with Greece sovereignty, and so is much too politically risky.

    2. Well, even if an amount is written off (and nobody will write off all of it), there still would be supervision.

    3. @ crf
      Please keep in mind that every EZ-country, also Germany, gave up an important part of its sovereignty when it joined the EZ. No EZ-country, not even Germany, can print the common currency. There are only 2 ways for Greece to restore complete sovereignty: (a) return to a local currency or (b) find a rich sponsor who commits to finance Greece without limitation and forever.

    4. Mr. Seukel,

      In my humble opinion, Tsipras on the matter of debt, is simply posturing and he would accept a solution of extension, BUT, as long as he has no troika and he is given moratorium and free hand to do "anti-troika" reforms. It is obvious that Tsipras is trying in haste to build: a) a "confident profile" for the exterior, b) a popular profile for the interior. For the exterior, he is trying to show that he isn't afraid and that he is prepared to go all the way to default. To the interior, he is trying to gather popular support by doing things that weren't even promiced before the elections, but go a long way in being pleasing to many voters (like the abolition of zero deficit clause or the changes in school/university). Also he is trying to gather people behind him, using Germany as the common foe. His protest that the EU didn't ask him before issuing a warnint to Russia, because he is against it, is also part of the posturing, to show to the EU, that he isn't afraid to go against them.

      Tsipras, is also in great haste to "trap himself". Day 2 and you have all ministers running to the televisions to say what their immediate laws for the next 14 days will be, like they had fire in their pants. Again, Tsipras wants to "de facto" cancel memorandum laws, so that he can then go to negotiations, from a position that will be "impossible to retreat from". He will say "i already passed laws, i can't take them back and put the memorandum laws again, my goverment will fall".

      Tsipras is doing a semi-bluff. He knows, that time works against him. He knows that all these new laws he is about to pass, cost money he doesn't have. He knows that if he bows to memorandum and Troika, he will be politically finished. He knows that if he defaults to internal payments, he will also take a big blow.
      So, he tries to rally public support, hoping that if it comes down to a default, the public will support him "against Germany" and he burns the bridges behind him, to show to Merkel that he has no way of retreat and make his threat more credible. Effectively, he leaves only 1 escape route for himself, a referendum.

      It's the same strategy Andreas Papandreou used in the 1986 crisis with Turkey. In Greece, this is the "madhouse dogma", where madhouse has a literal meaning, of a facility for insane people. It goes like this "don't open the door of the madhouse, because i won't hesitate to cross it and take you with me".

      Tsipras can't just go out and say "i want debt extension", because he has been sneering at the notion for 4 years and calling "Merkel's servant" or "coward" former minister Stournaras who was mention it. So Tsipras will accept it, but as part of a package, that will secure that he can end austerity and do as he pleases. Otherwise, he is saying to Merkel: "If i don't do this, i am politically finished, so i may as well take you with me".

    5. Mr. Seukel,

      To add to my above, long post, there is also a very interesting, yesterday's claim from the italian "La Repubblica" newspaper, which is the biggest center-left italian newspaper. According to this, in November 2014, the EU Commission already accepted a secret agreement with Samaras, for debt extension on the base that Greece will continue to be under a memorandum. The terms of said secret pact, were:
      - Moratorium up to 2020.
      - Payments towards EFSF will start in 2023 and will end in 2057.


      According to the article, The pact remained secret, because:
      - Merkel, didn't want to tell the German public that they money won't be coming back any time soon, even more when Samaras wasn't certain to remain in power, facing the election of President of the Repubblic.
      - Samaras didn't want to say it either, because it would pale in comparison during the electoral campaign next to Tsipras' position of "haircut of the majority of the debt".

      I don't know if such pact really exists or whether it is a result of journalistic fiction, but, if it does exist, i doubt it was much secret in Greece and Tsipras must know about it. If he knows about it, Tsipras has even more reason, to think, that he can squeeze more out of an agreement, conceeding him "troika free" ruling.

    6. Syriza want to be able to borrow more money. They can only do that if there is a write down.

  3. Herr Kastner -

    This is unrelated, but the IPSAS chimera has reared its head once again in the pages of the New York Times: http://www.nytimes.com/2015/01/21/opinion/greeces-accounting-problem.html?emc=eta1

    Thought you might be interested in that, even though you already covered it last month.

    1. No, the rescue loans are not on the books of Germany Inc. They are at subisiary levels like the state-owned KfW, etc. The same thing probably in all other countries. So if the loans were priced below funding cost, the funding loss would be booked by KfW and would not flow through the budget. Only when KfW requires a capital increase and/or if agreements force the Inc. to reimburse the KfW for losses, then it would flow through the budget.

      The whole idea of the "extend & pretend" strategy is to hide losses by not taking them at once but, instead, spreading them out over decades. If the world's financial system would stop extending and pretending, there would soon no longer be a world financial system.

      I can only say over and over again: the level of debt (stock) is irrelevant in the case of Greece. What matters is who has control of the primary surplus.

    2. Sorry, but your downppaying of the issue doesn't convince me at all. The KfW isn't a central bank creating money out of a vaccuum, it does have to borrow it like every other bank! The large stock of Greek papers in the books thus is balanced by huge loans. Once the papers have to be written off as worthless, the KfW may become bankrupt. Undoubtedly necessiting lots of taxpayer Euros to be spend on damage control! So, pls don't make it look as if the billion Euro rescue operations benefitting Greece are simply "peanuts". Most people won't agree with that cynical banker view, and rightly so. There is no free lunch, this DOES come at a cost for the Troika governments, and the utter disregard of the Greeks for these efforts is embarassing.

  4. Seukel has left a new comment on your post "Prof. Paul Krugman Discovers The Importance of Cas...":

    Well, even if an amount is written off (and nobody will write off all of it), there still would be supervision.

    1. Yes, there will always be supervision, not only of Greece. Either supervision by the Troika or supervision by markets and rating agencies. Given the choice of two evils, I would still prefer the Troika-evil over markets and rating agencies.

    2. Tsipras' issue isn't with supervision. It is with imposition of specific measures from outside, like it was happening with Samaras. SYRIZA's position is "we commit to a primarily balanced budget, how we do it, is our business".

  5. An emotional statement by DEI's Mr. Fotopoulos, supporting the goverment:

    "As the president for 7 consecutive years, of DEI's trade union, i publically express my satisfaction and i call upon the employees and upon the greek population, to unite and support the policy of the goverment for DEI. The new goverment, made justice to the struggle of one generation of workers, that didn't hesitate to resist to corruption and interests, despite the persecutions and targeting that has suffered".