On the mis-diagnosis of the Eurozone's crisis

According to S&P, EU leaders have misdiagnosed the euro-zone crisis. They have focused too much on tackling the increase in governments’ budget deficits, which is only part of the problem. As a result, they did not pay enough attention to the deeper causes of the crisis: the divergence in competitiveness between the euro-zone’s core of strong economies and its struggling "periphery" as well as the huge cross-border debts that stem from this gap. Reforms based solely on fiscal austerity could easily become self-defeating, notes S&P.

So writes The Economist, and thus confirms the writings in this blog of the last many months. Let me restate my point: the budget deficit and sovereign debt are not Greece's foremost problems. Greece's foremost problem is her foreign debt caused by her current account deficit! Or rather: her foremost problem is the continued requirement of significant funds inflows from abroad because of the continued current account deficit!

A budget deficit can, theoretically, be financed domestically (Japan finances much of its budget deficit domestically; so does the US). A current account deficit can only be financed with money from abroad.

A budget deficit tends to stimulate the domestic economy by pumping money into it. A current account deficit withdraws money from the economy by paying for imports and it de-industrializes the domestic economy (unless the imports are primarily capital goods for investment purposes).

A country's foreign debt represents the savings of other countries which those other countries have lent to the country. If Greece were not using about 500 BN EUR of other countries' savings, there would be much less hectic between Paris-Brussels-Berlin today. If Greece had zero savings of other countries (i. e. zero foreign debt), I doubt that many other countries would care very much how Greece handles her budget deficit.

It is clear by now that other countries no longer want to lend their savings voluntarily to Greece. Furthermore, Greeks are transferring their own savings abroad (capital flight). Thus, while the present financial squeeze on the state may be painful, it is very manageable when comparing it to the horrrendous financial squeeze which Greece will find herself in once the funds flow from abroad comes to a halt. No more cars, motorcycles or smartphones? Not quite, but quite a bit less!

The necessary medicine has been outlined here many times before, and I repeat the most important steps:

1. Reduce dependence on foreign funds by reducing the current account deficit.
2. Substitue imports of consumption goods with new domestic production.
3. Promote exports by allowing Special Economic Zones where exports can be produced competitively.
4. And, finally: attract foreign investment, attract foreign investment and, again, attract foreign investment so that the need for loans from abroad can be reduced.

Greece, if she acts cleverly, could transform herself into the role of a trendsetter who explains to the surplus countries that the best way to help the Greek economy is to help it to develop on its own (instead of killing it with exports to Greece). The price which the surplus countries would have to pay for that is less exports to the Periphery. That would appear to be a very reasonable price to pay when comparing it to the alternative of losing 3-digit BN EUR loan amounts.

Does Greece want to go down into history as the country where the collapse of the Eurozone began or would she prefer to become the country which served as the prototype for the solution of the Eurozone's economic imbalances?

If I were Greek, I would opt for the latter!

The sickening behavior of Capital Markets --- promoted by politicians!

Much is being written these days about the Greek PSI. One reads about investors' playing games such as not wanting to participate in the PSI in order not to forego CDS-insurance. Or about investors' confidence in the continuing stupidity of EU-politicians by buying up Greek bonds maturing in March at enormous discounts (hoping that they will be paid in full with tax payers' money). None of that has anything to do with the real problems confronting Greece and possible solutions for them!

First of all, a PSI which is based on the premise that private creditors have to forego claims against a sovereign state after only a couple of years of crisis is doomed to fail. Unless there are one-time devastations, one simply does not foregive sovereign debt after such a short period of crisis! One reschedules it!

A PSI in the case of sovereign debt has 2 principal aspects: (1) existing creditors must keep their existing exposure; they should not be called upon to increase it but they should not be allowed to decrease it (“risk takers” must remain “risk carriers”); and (2) creditors must be flexible in the structuring of interest rates and forms of payment (cash payment versus capitalization of interest). That is all which should be required of creditors (and it is quite a lot!).

A PSI is not "a small part of the overall solution". Instead, it is THE starting point for an overall solution! Debt negotiations have to start between borrower and its private creditors. Governments do not come in at the start; they come in at the end!

Why will private creditors be prepared to negotiate reasonably if they are involved from the start? Because they know that by negotiating reasonably, they can preserve the value of their assets (and that they lose that value if they don't negotiate reasonably).

Why will private creditors no longer negotiate reasonably once governments have jumped forward? Because, like in any game, once the opponent has blinked one knows that he will blink again.

There have been many sickening reports about ongoings in Greece such as continuing corruption, rip-off's by parties and politicians, etc. Those things must, of course, be changed but changes of culture cannot happen overnight. They will take time and perseverance.

The sickening behavior of capital markets could be stopped overnight if politicians had the nerve to do it. All they would have to do is to announce that "We will no longer lend money to Greece for the sole purpose that Greece uses that money to pay off private creditors".

Would that be a problem for Greece? Not at all, as long as the EU continues to finance the Fresh Money needs of Greece (primarily the budget deficit). In fact, the EU and Greece could form a real alliance against the blackmail on the part of capital markets by the EU saying to Greece "We will finance the Fresh Money you need provided that we can both agree on a reform plan for Greece" and by Greece responding to the EU "That sounds like a fair deal; we will cooperate fully!"

Bond prices will collapse and create havoc? Who cares? During the Cold War, the real fear of the West was that if they played hard ball with a sovereign borrower in the West, that borrower might seek refuge in the East. In simple terms: a country like Greece could say to the West "If you don't help us with new financing, we will go to Moscow and they will help us for sure". That game collapsed with the collapse of the Soviet Union.

There could be a new game, however. A game where the EU and its members in crisis form alliances against capital markets. As long as a country is assured of financing for its ongoing operational needs, it has nothing to fear. Capital markets have to fear a lot because if the bluff is called in a confrontational way, financial assets in gigantic amounts will be destroyed irrecoverably. At the end of the day, tax payers will have to pay for some of that destruction, too, but then it would not be an expense but, instead, an investment into a better financial system.

The point is that it would never get so far. Why not? Because investors will become reasonable before they lose their assets (and their existence).

An anecdote from Soviet times
An American Ambassador talks to his neighbor, the Soviet Ambassador, over the garden fence. The American Ambassador laments "Why are they doing this kidnapping etc. only to us and not to you?" The Soviet Ambassador replies "Because they know what would happen to them if they did it to us!"

Conclusion
One country alone may be helpless against the forces of capital markets (or only against the force of one investor like the battle Soros/UK has shown). But there is no way that capital markets can prevail over the united political actions of a large economic zone like the EU (or the US, for that matter). The individual banker says "I will be happy to negotiate an extension of loan maturities and perhaps even a lowering of the interest rate if that means that I will eventually get my loan back". Capital markets have to be forced to think exactly like that.

Economic freedom in the world, in Europe and in Greece

The Heritage Foundation has published its Annual Report on Economic Freedom covering 179 countries. Switzerland is the highest-ranked European country (position 5) and Greece the lowest (position 119). Like with all such analyses: one may disagree on the definition of economic freedom and one may disagree whether or not economic freedom leads to greater national wealth. However, one cannot disagree that this is interesting information!

Link to full report
http://www.heritage.org/Index/pdf/2012/book/Index_2012.pdf

Link to highlights of the report
https://thf_media.s3.amazonaws.com/index/pdf/2012/Index2012-Highlights.pdf

Get rid of the fixed-income people!!!

If all of Greece’s sovereign debt were in the form of bank loans (instead of public debt instruments), we would have a totally different situation today. Why? Because bank loans are made by bank lenders (with the banks’ own money!). Borrowers and lenders know each other and when they have a problem, they normally sit down and talk to each other about how those problems could be solved.

Public debt instruments (like bonds) are typically handled by the fixed-income departments of a bank. “Fixed-income-people” do not think in terms of customers. They think in terms of “assets” and in terms of “fair value of assets”. They know the accounting rules for valuing those assets by heart. They structure assets and distribute them. They even hold them if they represent a good fair value.

But fixed-income-people have no interest in a customer relationship. Their only interest is “the market” and however that market prices the value of their assets. To them, a Greek bond is an asset on the shelf. As long as there is turnover, they replenish assets for the shelves. If turnover stops, they get rid of the remaining assets as quickly as possible (or insure them via CDS).

One of the foremost principles of banking is “know thy customer!” The foremost principle of fixed-income people is “know thy market!”

When commercial lending divisions present credit proposals to board committees, they present analyses of the borrower. When fixed-income people request position limits from those committees, they present public ratings. The term “borrower” does not appear in such requests. Instead, one talks about “counter parties”.

Transfer all the Greek bonds from the books of the fixed-income departments to the books of the commercial lending departments of banks and you will quickly see a difference in the handling of the debt crisis!

Eurozone - the strongest economic region of the world?

This article by Daniel Gross refers to some of the key macroeconomic indicators of the Eurozone, which are:

Current account - balanced in the Eurozone; US deficit over 5% of GDP
Fiscal deficit - 4% for the Eurozone; close to 10% in the US
Sovereign debt - around 80% of GDP in the Eurozone; around 100% in the US
Exhange rate - EUR buys about 10% more USD than at inception of the Euro

Now, if that is not a near-perfect score card, I don't know what is! A visitor from Mars would have to conclude that the Eurozone is the strongest business region and the Euro the strongest currency in the world.

Questions about Greece's foreign debt (including update!)

The Bank of Greece has recently published the external debt figures per Q3/2011.

The foreign debt of Greece is now at its lowest level since over 2 years ago. At Q3/2011, it stood at 405 BN EUR compared with 413 BN EUR at Q3/2009 (in between, it peaked at 434 BN EUR).

How is that possible? During this time, over 73 BN EUR were transferred as new offshore loans to Greece under the rescue plans. If foreign debt still went down, that would mean that all the new money from offshore (and more) was used to pay off existing loans, i. e. nothing left for Greeks.

What is really confusing is that sovereign bonds owed to offshore investors declined from 206 BN EUR to 101 BN EUR during this period. Since that is far more than the bonds which matured during this time, it would suggest that domestic Greek investors bought Greek bonds from foreign investors. And it seems that the whole thing was financed by the Band of Greece by taking new loans offshore (ECB?).

I hope my analysis is not correct because it would almost sound like the ECB saying to Greece: “Look, we have too many of your bonds on our books. We lend you the money so that you can buy them back from us”.

And here is the million-Euro-question: if foreign funding of Greece actually declined in the last 2 years, how was the current account deficit during this time (46 BN EUR) financed? How was the capital flight during this period (estimated well over 50 BN EUR) financed? How was the budget deficit financed?

I have posed these questions to the Bank of Greece and I look forward to their answers!

SEE UPDATE BELOW!

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My thanks to Mr. George Zambanakis at the Bank of Greece who replied - overnight! - to my questions. And the answer is ---

Following IMF-guidelines, the Bank of Greece publishes the foreign debt based on market values and not based on nominal amounts. Details on the valuations were not provided but it would be fair to assume that only public bonds were revalued in such a manner (there is no "market value" for private loans). This would mean that sovereign bonds placed offshore did not decline from 206 BN EUR to 101 BN EUR nominally but were, for the most part, revalued in that amount. Put differently, the foreign debt of Greece would be about 100 BN EUR higher than published in the Bank of Greece statistics. Put differently: if a miracle happens and Greece manages a complete turn-around; it the economy booms; if the budget is in surplus; if the rating goes to AAA; well, then Greece's foreign debt will increase (through revaluation) by 100 BN EUR as a reward for that!

A default is not automatically a Euro-exit!

I fail to understand why a possible default of Greece is equated with an exit from the Eurozone. I would argue that those are 2 separate issues.

A default by Greece may very well happen; a Euro-exit cannot happen, at least not very easily (and certainly not automatically). EU-treaties provide neither for the expulsion of a country from the Eurozone nor for a country’s voluntary retreat.

Greece might be better off today if she had never given up the drachma and she might be better off if she returned to the drachma at some point in the future when stability has returned. However, a Euro-exit at this point, particularly an uncontrolled one, would bring havoc upon the country.

A default is not the end of the world if one deals with it properly and responsibly (Greece has been in default for more than half the time since her independence). The major difference with the present rescue effort is that the debt rescheduling following a default is no longer voluntary; it is mandatory and it has to be negotiated with existing creditors (risk takers remain risk carriers).

Large European banks will be in trouble? Perhaps, but that is not Greece’s problem. CDS-traders will be in trouble? Perhaps, but that is not Greece’s problem.

The Greek banking sector will collapse because of a run on banks? Not if deposits are frozen for the duration of the rescheduling negotiations.

Greece won’t be able to pay salaries and/or pensions in case of a default? I doubt that very much. First, the government will certainly have “put aside” enough Euros to finance day-to-day operations for some time and, secondly, if Greece negotiates a rescheduling in good faith, she will probably receive bridge financing from the EU in the meantime.

The major problem with a default is that it wrecks a country’s creditworthiness and makes it impossible for a country to return to capital markets for quite some time. Well, Greece has already paid that price.