Friday, 5 October 2012

Terrible Calculations and Crisis History

In Thursday's article I gave some of the views Nobel laureate Joseph Stiglitz had on Europe. Notably, that austerity measures are causing the crisis and not the other way around. Who could disagree with that? A simple logical deduction will lead us to that. Let's see now the order things happened in the EU:

1. Sub-prime lending crisis in 2008, led by US banking and investment firms, and marked by the Lehman Brothers collapse in North America and the Northern Rock bankruptcy in the UK. (other financial institutions also failed in the EU, yet no-one was large in size). The sub-prime lending crisis had nothing to do with the now sovereign debt crisis. (it may have been the thing that pushed Greece over the cliff but this was not the cause that brought the Greeks at the brink of disaster. The Greek economy was unstable for years)

2. Greek scandal concerning the size of debt, deficit and GDP of the nation. (debt and deficit had been deflated while GDP inflated. Curiously, nobody was ever sentenced for this fraud) Greece opts for a bail-out from the EU and the IMF and the first austerity measures were put forward in the country.

3. Seeing that the debt-to-GDP ratio of Greece climbed even higher, regardless of the austerity measures (again, think about this: 100 debt with €100 GDP makes a 100% debt-to-GDP ratio. €100 debt with €80 GDP makes a 125% debt-to-GDP ratio. Unfortunately this was too much mathematics for the Troika and the expert economists to understand) the EU policymakers and Troika decided to give the Greek debt a haircut. The haircut consisted of 30% of the face value at first (i.e. for every euro the borrowers held they were going to get 70 cents) and then another 70% of the remaining later (i.e. instead of the 70 cents they were holding they were going to get just 21 cents).

4. This led to a significant shrinking of assets for the banks exposed to Greek debt (many of the Cypriot, Spanish and Italian banks as well as many German ones which curiously managed to sell most of their bonds), and with the new regulation raising capital reserves from 8% to 9%, banks were is serious need for money. 

5. Since many banks did not have sufficient capital reserves to allow them to function, they opted for a government bail-out. As banks are not really like any other firm (look here for more details) the nations had little option but to try and save them. However, the banks' needs being large, and the nations' debt being high made it more difficult for them to refinance. Thus, nations themselves needed to opt for a bail-out since their banks were dragging them along to the bottom.

Had the Greek haircut not occurred in such extremity (for an alternative read here), banking needs would have been lower and nations would not be in such a difficult state. Thus, the rough austerity measures could have been milder and with a longer time-span than now. This would have allowed nations to increase their GDP slowly, while simultaneously reducing their deficit and debt, which would mean that none of the current events would be happening. Although I am an advocate of the austerity measures in order to rationalize the budget, having too much too rapidly will only cause trouble in an already troubled economy.

P.S. The new idea now is that politicians and policymakers will offer more austerity with different measures than the ones the Troikans are proposing. Case study: Cyprus. The counter-measures proposed by the Cypriot government include a 9-11% cut in public servants wages (nothing of the kind was mentioned in Troika documents) in order for the Troikans to agree for the non-abolishment of the 13th salary (a bonus salary paid at the end of each year). Again simple maths: €1000 monthly salary is €12000 a year. A 9% cut would mean that 1080 euros are cut from the worker's salary each year. (provided that the 13th salary does not suffer the 9% cut as well). So in essence, the worker is giving up €1080 to receive €1000. (€1170 if the 13th salary suffers cuts as well). You may imagine what happens at the 11% level. 

Clear case of stupidity and obsession with an idea: the 13th salary should not be abolished, thus we are offering extra cuts, so that the 13th salary will remain but the overall hit would be larger than the one proposed by Troika. Hmm, one wonders who it is the officials work for. Troika would be much better in running Cyprus than its politicians.

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