The Original Sins: EU's entry decisions

Once upon a time there was a continent, which was made up by 50 countries. One day the countries decided they would benefit from being united instead of fighting each other thus they formed a Union which they soon thought would be able to issue its own currency; one which would work in all of these countries and become one of the leading currencies in the world. But who would enter? They couldn't just let anyone in so some rules had to be made. Thus, they thought of the easiest task: you wouldn't be able to join the currency area, unless your public debt was less than 60% and your government deficit was less (or very close) to 3%. They even formalized this by signing a treaty in a smallish town somewhere North.

The problem with this treaty was that it was too rigid for its own good. By the time the new currency was brought to the markets, many of the countries wanted to join the whole charade and play with the big boys but couldn't. The reason was that they were constrained by 3-60 rules of the treaty. Why should they want to enter ans lose the enormous power of issuing their own currency one might ask. The reason was simple: it was better than the one they had until then and it opened the door to numerous opportunities for growth. Up until the initiation of the common currency the countries which wanted most of all to enter the Union and could not grappled with high inflation and perpetually-depreciated currencies. For example, three of the countries wanting to join the currency Union had an exchange rate of 166.386, 353.101 and 1,936.27 to one with the common currency*.

However, those countries really wanted in. But what could they do? Their public debt was more than the 60% limit and their deficit exceeded 3%. There was no real way to reduce the debt by issuing new money as that would mess with the exchange mechanism they were tied to, given their willingness to join the Union. Thus all there was to reduce was the deficit; but which politician would be willing to and announce a reduction in spending and risk sacrificing his chair to the altar of joining a Union? The stakes were too high for such actions. Still, they had promised their voters (and their voters really wanted it) that they would join the Union.

Being mostly politicians and bureaucrats they had no idea of what they could do. Thus they invited the big investment bankers for advice. The latter, known for their quick wit, eagerness to solve a problem they will receive a big compensation and willingness to find loopholes in legislation found a simple solution: they would be able to reduce the deficit using a Swap. In a swap, two counterparts change cash flows, usually in order to reduce risk. In this case, the supposed risk was the exchange rate since there was a bond issue in Japanese Yen. The following graph shows how a swap should look like. Note that these sort of swap transactions were legal and approved both by the sovereign's central bank as well as the Union's.

Source: ZeroHedge

Yet, this is not how the transaction went on. What the investment bankers did was increase the one-off final payment and make the payment coming from the sovereign borrower negative. In simple words, the country was receiving the fixed payments in yen and was again receiving payments at the time it was supposed to pay. The following graph illustrates what happened:

Source: ZeroHedge

Why would they do this if the payment in the end was huge the reader might ask. Remember that the country had no intention of reducing its debt since it could not do it in short notice; it was aiming at reducing its deficit. Using the above swap, the country was receiving two payments from the bankers which meant that first it wouldn't have to pay any interest thus reducing the government deficit and second it was getting money back and it could either repay outstanding loans or use it to show further budget improvement. The country did both. And this is how it fared:

The bond was issued in 1995 and the swap took place in 1996. Note the impressive decrease of government deficit as a percentage of GDP from 1996 to 1997 by 4.3% to within the limits of the 3% rule; something which lasted until 2002, the year when the common currency was introduced to the public (although to be fair, the specific swap expired in 1998). The strategy was so successful that it soon found imitators: others sought to find the magic deficit-decreasing swap. In 2001, Greece tried the same and somehow it worked in allowing it to join the Eurozone:

But things didn't work out as planned by the Greeks: by the time they signed the deal, they were already 600million more in debt than the originally planned 2.8 billion to be repaid. The perils of secret negotiations and under-the-table agreements came up in 2009, forcing the country to require a bail-out. Not that Italy is doing any better now but having a stronger economy can assist in overcoming recessions faster.

The author of "Derivatives and Public DebtManagement", Gustavo Piga (the person who unearthed the story about Italy) suggests that secret treaties are just a way of exploiting the taxpayer. The problems in the Eurozone have not arisen because of some secret agenda or as a result of a global conspiracy. They were there to begin with. Neither Greece's nor Italy's debt management practices were ideal and those who allowed them in the Eurozone knew about this (even Eurostat was to to blame since it had knowledge of the fact according to ZeroHedge) and chose to close their eyes. Evidence of mismanagement were there: just look at the exchange rates of the three countries mentioned earlier. 

The accumulated sins of the Eurozone structures were bound to come and haunt us. They just did sooner than anyone expected. If there is a moral to this story it's that in economics, when you do something bad it will come back and hit, just like a boomerang. But that was not what the Italian and Greek authorities thought when they made the swaps. Too bad; for their taxpayers that is.

*Spanish peseta, Greek Drachma and Italian lire respectively.