Tuesday, 5 February 2013

The misunderstood effects of a default: A Guide to Politicians and Policymakers

Although I had thought that the issue with Cyprus was very similar to the one with Greece, Portugal and Ireland it appears that it isn't so in the eyes of some. From what I can see on some websites, it appears that the case is not so clear for one reason or another. For example, denying aid to the island has been an issue in the German parliament over the past few weeks. Notably, Angela Merkel's coalition partners the FDP have raised their voice in opposing a bail-out scheme. Even in Merkel's own party (the CDU) there appears to be some hesitation. Yet, it appears that they are not so against it as they used to be, if we believe Spiegel.

From my point of view, it appears that some politicians are not really thinking this through. For their sake, let's take a walk through this once again. Just to make it simple for them I will not even use country names so that it will be easier to be used as a formula in the future.

We have two options:
1. We give money to [insert nation here]
2. We let them default

Consequences of Option 1:
The nation receiving the aid would have to be very careful with its public finances. Thus it will inevitably have to make some budget cuts, including cuts in wages and salaries. However, these cuts will have to be implemented slowly. If they are rapidly employed on the economy they will cause a severe contraction (for a simple thought experiment on fiscal multipliers have a look at this) and thus increase the debt-to-GDP ratio significantly, making the debt unsustainable. This would mean that a debt haircut must be implemented which will mean that either private investors (with banks being the majority) or assisting nations (or both) would lose money. If a haircut is to be avoided then further assistance in the form of extending the debt period and significantly lowering the interest rates is to be given. Yet, this would also mean money lost and since losing money is not good for reputation we can agree that the best way to deal with option 1 would be to give the nation the money it needs but make gradual fiscal corrections in order for its debt to remain sustainable. In addition what would be an even better idea would be to directly bail-out banking institutions and force them to invest these money in their government's bonds, but that might be too much thinking. So let's stick to what is easy: If we give money then we have to be sure that change is being done gradually if we do not want unnecessary losses.

What should be mentioned here is that the ECB could also be given the authority to deal with the issue of financial aid. As it has large quantities of money available it can readily assist any ailing nation without any other nation's assets being in danger.

Consequences of Option 2:
If the nation does not receive any aid then it will survive for as long as it can with what money it has left and then declare bankruptcy. The issue is what happens next. The definition of default is when a nation cannot pay the interest on its debts. Then, sooner or later this will also mean that it will also cease to pay its debt (the technical term for that is insolvency). What happens then: well first a debt restructuring for foreign creditors occurs, which means either debt restructuring or debt cancellation. This is in essence a haircut which ends up in loses for the nation's creditor. Then after this huge mess where the state itself has to decide which creditors to ignore and which to honour, another issue arises: how is the nation going to get new money to finance its needs (including the needs of its banks)?

There are only two options for that: either receive money from external sources or print more of its national money. For a country which is in the Eurozone, however, the latter cannot be done. So other countries have to decide again whether to lend it or not. If they do decide to lend the nation then they would be inconsistent to the decision they have made before (when not choose Option 1 instead of Option 2, and suffer the complications of these decisions if you are going to give money after all?) so they will most likely choose not to lend it money again. To which, the already defaulted nation has to respond with exiting the Eurozone in order to print its own money.

Thus, choosing not to lend money to a nation in danger of default leads to their exit from the Eurozone. 

Is this bad? Well it depends. First of all we cannot have conflicting policies: either we assist all nations in need or we do not assist any. So if we assist one we have to assist all the others as well. Second, we have to figure out whether we want to preserve the Eurozone or not. David Cameron stated that the UK should have a referendum on whether it would prefer to stay in the EU or not. If one country exits the euro then it will only be a matter of time before every country which faces the dilemma of inane austerity and a Eurozone exit will choose the latter over the former.

When we analyze it deep enough it boils down to whether we want to maintain a common monetary union or not. If we do then the only solution is to assist all countries needing a bail-out. If we do not then why do we bother having this discussions at all?


  1. The Germans are now having a debate that is tangentially economical. Indeed if the strategy heretofore has been to bail out governments, then it should apply to all. Whether bailing out countries ought to be the approach is another issue. I will not enter into the discussion of how good or bad the political system of Cyprus is; for while I certainly have my opinion, I believe this is something the domestic population should deal with (also known as democracy).

    Concerning the fiscal multipliers—a hypostasized notion I am highly skeptical about—, I think that apart from wage cuts, you should make mention to two effects (which I am sure you already are well aware of):

    1) Tax hikes: It is no secret that governments resort to tax increases as a last-ditch effort to balance their budget, without reducing their spending. With a national currency this can be done with the less obvious method of currency devaluation (inflation), but in the case of the euro, the only option is via tax increases in both direct and indirect taxes and also in the broadening of the tax base. Whatever the modalities though, the fact is that in the face of diminishing demand, of rising uncertainty and of negative expectations brought by political instability (e.g. disputes on euroexit, rise of extremists etc.), an already bad situation is greatly exacerbated.

    2) Favoritism: The support for some sectors of the economy at the cost of those who are not supported, is something that should merit our attention. There basically are two kinds of favoritism that are usually observed in our case. One is direct bank recapitalizations, which in plain terms means putting the cost on the public (sovereign debt) to shore up a failing private entity (whether this is benign or not in gross economic terms is irrelevant to favoritism per se). Secondly, we have the neo-mercantilist rhetoric of “increasing our exports”. This can happen in two ways: (i) force people to decrease their imports, with wage cuts and rising taxes (capital controls are not allowed in the EU), or (ii) support with various legal, economic and political means, the export sector (again whether this is good or not is irrelevant to the fact that favoritism applies).

    As for Cyprus exiting the euro, I think this is no way to address any of the (numerous) structural problems, though it will certainly help to paper over existing debts/deficits.

  2. I realized I forgot to comment on the debt restructuring issue. Apart from what you said, I wish to touch upon another aspect of the issue. From information I had, in the months prior to the loan from Russia, the Cyprus government managed to finance its deficits by borrowing from the internal market. Much of this demand came from the cooperative banks and, one may assume, from pension funds.

    While my data on this fact is somewhat incomplete, and therefore I am cautious, I believe that if it is true it can pose a few problems on the haircut, since the creditors happen to be locals and maybe the effects on the real economy and lower-middle parts on the income distribution will be quite severe (though the state will indeed reduce its debt, though not necessarily its spending given that unemployment may rise and so may come the concomitant need of bailing out yet more financial institutions/pension funds).

    I repeat my data is not very reliable on this, so I am just probing in search for more information (in case you may have something). So the last thing I would consider is the structure of Cyprus' sovereign debt holdings: how much of it is held domestically and by whom.

    In saying so I am not trying to provide any justification on bailouts whatsoever, but am only wondering if a forced haircut is a priori a solution to a problem.

    1. With regards to your first comment:
      You are right about the tax hikes and favoritism. I did not mention them in the post not because I believe that they are unimportant but because when I think of austerity measures they are all united in my mind. I should perhaps be more clear about this in the future.

      The political system in Cyprus, as well as the one in Greece or Spain and Italy are obviously suffering. It is a situation which Alex Ghita cleverly dubbed Democratic Masochism and I have subsequently written an article about it. Yet, the political system should (in theory) have nothing to do with the bail-outs although it would be a good idea for something to change.

      For example, Greece now has a government which is much more credible and much more efficient than almost every other in the past. This did not come without a cost though. Unemployment is the highest in Europe although Spain is unfortunately catching up.

      By fiscal multipliers I mean all the changes which have an effect on a country's real economy and output. Transfer payments (i.e. pensions and welfare payments) for example, are not considered in the calculation of GDP. Yet, one cannot say that they do not have an indirect effect on it, through fiscal multiplier.

      I would even be as "radical" as to propose direct funding by the ESM/EFSF funds since that is why they were built up in the first place. And I do not mean just for Cyprus...

      I could also not agree more concerning exports and imports. First of all it is impossible for every country to have a positive balance of payments. Yet, no-one seems to understand this!

      Regarding your second comment:
      From what I can see at the Cypriot Public Debt Management Office about 25% of the country's debt is held by foreign governments (including the 2.5 billion Russian loan). Of the privately held loans, more than 60% is being held by domestic investors, which will of course face losses in the even of a haircut.

      From my point of view, a haircut is not a very clever way to deal with the problem. Cancelling interest payments and increasing the debt maturity date would be much better both in the short-run as well as in the long-run.

    2. Yes, good. I agree. Just two short notes:

      Concerning fiscal multipliers I know what you mean, but I am just saying that this is Keynesian/macroeconomic notion I am skeptical about, especially because it cannot really be determined with precision on an ex ante basis.

      On haircut: Thanks for the link! I guess we could speak of a debt re-"profiling" then :), i.e. of maintaining the face value of all bonds, but renegotiating coupon rates + maturities.

    3. You have a point on the ex ante issue. Can we know with precision what would occur if we change government spending? Of course not (this is sometimes dubbed as the Lucas Critique although I believe it has been widely misunderstood).

      Still, it would be fair to say that it is just an accounting equation up to a point: GDP=G+C+I+NX. Thus if you reduce one of the 4 it is obvious that (ceteris paribus) GDP will be reduced. And we are not even considering the interconnections between the variables here.

      I can prove the fiscal multipliers without using mathematics but I do not think that such a proof would be welcomed in the economic world!

      Even so, think of the Great Depression. What ended it was not austerity but an influx of money. It is not just Keynesian although it was fully articulated by him first. Irving Fisher published a paper in 1933 where he presented the debt-deflation theory which is essentially what we are witnessing nowadays(very interesting read if you have the time, and thankfully with no mathematics if my memory serves me right!).

      Nice term, (re-profiling that is) I think I will use it in the future :)

    4. On national accounting: I will not go into Lucas because much of the debate there is couched in terms of general equilibrium and all closely related assumptions that I simply do not agree with epistemologically (at least not on a strict macroeconomic level).

      My point in general on all economic data (statistics) is that these are historical facts that apply to acting individuals who are (1) 'unpredictable' in a narrow interpretation of the term, (2) who operate on "expectations" (Keynes' theme but also a core idea of radical subjectivists), (3) who are not omniscient (perfect knowledge) nor 'rational' in the sense economists use the term.

      Thus in short: What happened in the past, in the specific context that it did, may not necessarily happen again in the same way or pattern etc. (and by "context" I go well beyond the economic magnitudes, into political institutions, culture etc.–I know these cannot be modelled, but they also cannot be disregarded as irrelevant).

      Hence when speaking of the impossibility/imprecision of the 'ex ante', I am predicating it on a broader skepticism of the "prediction" approach, which may be good for physics, but which is problematic for the real human world. It certainly, like the concept of fiscal multipliers, has its merits, but all I am suggesting is to be a bit more eclectic with it and with all other theories in general.

      On the debt-deflation, I will not speak on Fisher's (and the post-keynesians') theory here. All I wish to say is that I do not think we have such a phenomenon today, at least not in Europe. There are some cases where we witness deflationary pressures, but on many sectors/markets we have inflation (and we also have general price inflation, though relatively low). Debt-deflation can be bad, but debt-inflation in the milieu of a depressed economy, of political uncertainty and of negative expectations is even worse (I think).

      The case of the Great Depression is very useful to understand many things, but I believe that in Europe we also need to consider the specific politico-institutional context of the EU and its member states (again this relates to my note on the 'facts' above).

      Finally, on re-profiling, I think I have heard this somewhere before but cannot recall right now :-)

  3. Concerning Lucas that is why I thought it is misunderstood... DSGE models are not at all good.

    Keynes was a subjectivist actually. A look at his "Treatise on Probability" confirms that he did not really enjoy playing with odds. And true, the perfect knowledge (especially with the addition of a perfectly forecastable future) is one of the worst ideas in economics and shows a true lack of understanding of the working of real people (as opposed to the strange beings economists think we are).

    Mark Twain said it better: "History does not repeat itself; but it does rhyme"

    Yet, I agree that prediction should not be considered sacred. They are just a means to an end, like a street lamp-post which would light the way coming next but after you have moved you have to adjust your views and ideas of the next one. This is what the IMF was not doing and what I commented on a previous post.

    I think we are witnessing a debt-deflation phenomenon on the sovereign level, i.e. with the inane effort to reduce debt at all cost. Yet this does not seem to hold in the economy. Only yesterday was I reading that prices in Greece have only now began to fall. This is contrary to all economic theory thus far: expectations were that inflation would be low (if not deflation), people were spending less, they had less money and yet prices were much more sticky than what any economic theory would have predicted. You have a point here: debt-inflation is much worse in a declining economy and this is what Greece was witnessing.

    The Great Depression is a good example but a still greater is what led to it. For example strong adherence to a rigid rule (then the Gold Standard now austerity or debt reductions) has catastrophic results.

    You again have a point when discussing the specific EU context. We cannot employ tactics which were successful under other regimes until we have seen how they would work under ours. The only problem seems to be that we have not yet found out what our context is!

    1. Yes Keynes was a subjectivist (one of the reasons I draw a line between Keynes and 'keynesianism').

      On Lucas we agree. I like the quote and would also add: "The future is unknowable, but not unimaginable", Ludwig Lachmann.

      Also agree on the IMF.

      On debt-deflation. What you say about sovereigns is true, at least in as far as the hardly-pressed governments who ask for bailouts are concerned. But what about the sovereign bonds market? I am thinking for instance how the LTRO was in large part channelled there and how some states in the euro area (and elsewhere) are enjoying strong demand and near-zero-to-negative interest rates. This is a complex phenomenon to be sure.

      Agree on the disastrous effects of the gold standard and of all such rigid rules (see fiscal compact for instance which follows that same logic).

    2. Nice quote. Yours reaches more in the philosophic region as expected :)

      I think the relative failure of the LTRO in some countries can be attributed to two issues:
      1. The fact that countries differ greatly. We cannot obviously compare the risk of an investment in Greek or Cypriot bonds with the risk of investing in Finnish or Austrian. Although theoretically the risk of an EA17 country should be the exact equal of the risk of the whole region collapsing, this does not appear to be the case since
      we are not yet as united as we could have been. It is a case of federalism here as you have stated on your second-to-last post as well.

      2. Sovereign bonds are also traded by many non-banking institutions. If an investment fund is eager to buy safe asset (which would its strategy otherwise it would have no point in investing in low return bonds) then the fund would be better off with Germany. This is more of a matter of reputation and credibility rather than pure economics.

      I think the LTRO should just be focused on increasing liquidity in banks as it would be impossible to lower bond yield in this manner. That is why Draghi announced the OMT mechanism over the summer.

      Yes the fiscal compact is a great example. And Germany still insists on austerity... "Let He Who Is Without Sin Cast The First Stone"

    3. Agree on everything.

      Just on the risk issue with respect to the LTRO: domestic banks bought domestic debt (especially in Spain) or "hoarded" it, not because of increased certainty in the sustainability of the sovereign's finances, but in part due to expectations of continued support from outside ("moral hazard" more or less).

      On its liquidity aspect, I assume you refer to furnishing credit to the 'real' economy, where I think it did not achieve as much as it could/should, for reasons that were also mentioned above (expectations, uncertainty etc.).

      The true challenge for OMT is, I think, its conditionality clause and how that will relate to the ESM, austerity, domestic politics etc. (and to prejudices...)

    4. You are right on the point. Institutions like the ECB should be careful on the specific incentives they are promoting when implementing programs like the LTRO.

      Regarding liquidity I was just referring to banks being able to obtain money so they could finance corporations and citizens (i.e. the "real" economy as you have said) and not "hoard" them. Again, if incentives were correct the banks should have been able to boost the economy through the liquidity injection from the LTRO. Yet, it appears that bankers are more afraid of lending than seeing that without such action the economies would still be very fragile.

      You are right about the OMT and I hope we will never be given the chance to find out whether or not its implementation will be successful or not.