The Irony behind NPLs and Lending

This post could actually be summarized in one sentence: If you want Non-Performing Loans (NPLs) to fall, then you have to increase lending. Still, I don't really hope that I will be able to convince many just by stating this. Thus, what follows is an exposition of why the amount of loans (and more so of new lending) matters when it comes to NPLs and, in addition, when bank regulatory capital requirements are concerned.

NPLs are loans for which "payments of interest and principal are past due by 90 days or more". There is nothing more rational than to think of the rise in NPLs as an outcome of the crisis. This, nevertheless, is where most stop their arguments; the problem is that asking "why?" matters the most when it comes to policy. The answer is again so simple everybody has thought about it: it's because people lose their jobs and cannot repay their mortgages or other consumer loans, because there's no investment and no consumption forcing businesses to default and putting more people on the dole. 

The correlation is obvious as can be seen in the case of Greece:

Source: CEIC Network

NPLs as a percentage of total gross loans. Source: Index Mundi

The additional problem here is that crises usually come around when banks are already contracting their balance sheets, so the hit in consumption and investment is even harder: less consumption, less demand and less money to go around as well. As a consequence, firms face serious trouble meeting up with their obligations. If they cannot make ends meet, then their loans enter the NPL category. When more NPLs are created, then the bank is more constrained by its regulatory capital needs as bad loans are assigned a higher risk weight than before. Thus, the higher the NPLs the lower the banks' ability to lend out more money.

The problem resembles the one of austerity: we need a government budget surplus but we cannot do it since by cutting expenses and transfers (e.g. pensions) we are reducing consumption and thus government income. Similarly, we want smaller banks, but we cannot do it without retracting money from the economy. As money is reduced, consumption and investment become more scarce and business struggle for survival; many go bankrupt. Driven by this lack of funds, unemployment rises resulting in even more NPLs.

How can we get out of this mess? The solution (ironically) is not that banks have to decrease their exposure. It's that they have to increase their lending in order to get the economy going again. If the economy does not have enough funds to pull itself out then countries experiencing these issues will face Greece-like situations: prolonged measures to make things better, but only making them worse (here's looking  at you austerity!). When lending is increased then more investment is created; subsequently, more jobs and more consumption, leading to an increase in income and a decrease in the loans which cannot be repaid. When people have more money, loan payments which could not be paid before are met now. Nobody wants to lose their house, and no bank want to be stuck with one. In addition, less NPL's actually mean less capital needs, thus more funds to lend, thus more profit for the firm. Still, instead of lending and preventing this from happening, banks are forced by regulators (and themselves as well) not to lend out funds.

As said before, there is a time and place for everything. Just like it wouldn't make sense to continue expanding fiscal policy in a boom (see the UK experience), or performing QE operations when times are good, it does not make sense to use austerity measures when times are bad (Greece, Spain, Italy, Portugal, Ireland). Similarly, banks should not be pressured to reduce their credit exposures during downturns. Yet, unfortunately, policymaker decisions do not appear to be counter-cyclical.

Policy and Self-Fulfilling Prophecies

I've been raging about confidence for a while now. Since any other form of stimulus is either unproductive (e.g. monetary policy due to the ZLB) or infeasible (e.g. QE or government spending), the only way we could actually see growth in the region is via an increase in confidence, which basically means an improvement in our current expectations about the future. Simply put, if I am going to either spend or invest more, I have to know that I will continue to have a job in the near future or that the overall situation in the economy will be better than now.

The problem is that many of us (especially journalists) take a particular liking to bad news; it appears that they sell more than good ones and that is why we tend to emphasize on that (disclaimer: I may have fallen into that trap myself at times). This wouldn't necessarily be hurtful to the economy if we did not live in a world where we somehow create it ourselves. In physics, bad news about a specific group of atoms would not cause all other atoms to stop obeying natural laws. In economics though, bad news about some may cause others to react badly as well.

Think for example what happens when austerity measures on the public sector are imposed: although it may be right that some workers in some countries are overpaid, lowering their wages in a recession comes at a cost. As civil servants lower consumption, the private sector sees its demand fall and reduces investment, causing unemployment to rise. Then, until we adjust to the situation, the economy moves in cycles of reduced demand and investment, causing unemployment to rise and incomes to fall. In the Eurozone, we are now experiencing the time where most of the adjustment has already taken place and even though demand is weak and investment is low, we are much better off (expectations-wise) than a year ago.

Yet, some still point out to the bad things; while, for example, the outflow of deposits from Cyprus appears to be stabilizing with the overall amount registering ups and downs in the past couple of months (compared to huge decreases before), some focus on the downs. The problem of over-focusing on the bad news is that it creates another cycle of uncertainty, one which, on its own, can cause more damage than policies can. You see, if I am bombarded with constant emphasis on how bad the economy is doing (it's not doing good by the way but it does certainly fare better than last year) then I will be more than skeptical to invest or spend. The cycle, as described in the previous paragraph, is indicative of what will happen when confidence falls; the issue here is that over-exposure to "bad" news means that these will turn out to be true if people believe them to be. It is the equivalent of fiat money: it works just because you trust it, nothing more and nothing less.

This kind of over-emphasis can actually derail many of the countries already in a bail-out agreement. Biased information about Greece is what made Greeks believe that they are faring worse than expected, pushing the vicious cycle of austerity deeper into the economy. Now that they are faring much better, biased information and vastly exaggerated opinions are still appearing on popular websites. While I am certainly not a fan of irrational optimism (remember I was one of the first to note that the Cypriot economy was badly in need of a rescue package in 2012 and that Spain is not really out of its trouble) I do think that we should really think before we offer an opinion, especially if it is bound to affect millions.

The bottom line is simple: be very careful of the information you use to make decisions. Emphasis on what could go wrong never really helped anyone; and neither  it will in the future

P.S. As far as forecasts are concerned here are my own (obviously biased) ones: Greece will need no more loans after 2014, but she will most probably not exit the bailout programme by year-end as the Greek PM has predicted. Cyprus will have a tough year but it may actually show us some quarter-to-quarter growth in late 2014. Spain will be rather stable with a slight increase in GDP compared to last year but the big question is what will happen in Italy and whether Slovenia will opt for a bail-out. On the latter two we just wait and see.

Road Plans for Privatizations

Probably the most discussed issue in bail-out agreements is that state-owned organizations in the countries receiving the Troika money should be privatized. The issue was first presented in Greece, where the country had to present a plan to fully privatize, among others, the state-owned post-office  (ELTA) and the water and sewage (EYDAP) companies. The same has been asked for Cyprus, and in order to avoid a bail-out, Slovenia is planning to privatize many of her companies in 2014.

There have been many arguments against these actions, most of them pondering about the job security of the companies' employees once they have been privatized or whether natural monopolies (such as EYDAP) should be privatized. Yet, even though these questions are obviously of great importance (especially since they both affect the welfare of the citizens), the biggest question comes when the decision for a sell-off has been made: at what price should these companies be sold off so that the state will not lose any money as a result of the distressed sale?

For example, consider the following (very simplistic) scenario: a state-owned company is currently (year 0) earning 200m per annum and is expected to earn the same ad infinitum. If the discounting rate is, say, 2.5% the price for that organization would be 8 billion (200/0.025). Yet, if the earnings are now depressed because of a recession (as is the case in most countries forced to sell-off their state-owned companies) or next year (year 1), due to increased marketing efforts or less competition increase to 230m a year, with the discount rate at 2.75% and are expected to remain at that level for years to come, then the company is worth 8.363 billion, which if brought to year 0 is 8. 16 billion, resulting in a loss of 160 million for the state (obviously depending on the amount of shares it sells).

In order to avoid this situation, the state will have to take specific measures, meaning that it should impose a clause which will entitle it to any profits over and above a threshold which will be considered as hurting state finances. For example, let's assume that the threshold is set at 4%, meaning that a fluctuation in permanent earnings under 8 million in the example of the previous paragraph, will cause no claim of funds from the state and that the state sells off 40% of the firm including management. Yet, if profits in year 1 rise to 220 million, then the discounted value is at 214 million (220/1.0275) and the excess of 6 million should be paid to the state, over and above the required dividends of the 60%.

What happens if things go bad one might ask. In the case where permanent decreases in earnings are made, then these will be offset by any future proceeds until one exceeds the other by some extent at which both are satisfied with. An additional issue which often arises is who should purchase these companies. My take is that their employees should have the first take in purchasing these shares, either directly through personal accounts or indirectly through provident/pension funds. This is mostly a sign of trust: if an organization's employees do not trust that their company is worth something, then nobody else will. In addition, these companies should be made publicly traded in the country's exchanges, allowing the markets to reflect their own valuation in the stock price, indicating whether the increase in profits has been considered as a permanent or a temporary situation.

Summing up, it is imperative to safeguard the state's interests when it comes to selling off assets. The fact that the timing of the sale occurs in a recession means that the price will be less than what it is really worth and the state will stand to lose a significant amount of money. Under the proposal described above (even though many details still have to be spelled out), the state will be sure that it leaves no money at the table, while at the same time the interests of the buyer are only harmed by little.

CEO compensation and Worker Job Security

That CEO's are earning big money is nothing we didn't know about. Yet, the size of their paychecks is at times enough to make those who are not earning 6-figure salaries furious. In the list of the top 15 earners for 2013, the lowest CEO compensation is at $36 million. It is true that their earnings fluctuate with the earnings and general performance of their firms. In fact, they have done a wonderful job tracking the S&P 500 especially since the 1990's:

As the reader may observe, CEO compensation was not following stock market development right from the start. In fact, for the first 10-15 years since the 1960's, the upward trend in compensation was not an outcome of a strong stock market; the S&P was on a long downwards trend during that time. Yet, in modern times, CEO's more than made up for their losses. In 1978, the CEO-pay-to-worker ratio was 26.5-to-1; in 1995 it went to 136.8-to-1 and in 2012 it was 202.3 times the typical worker's salary as the EPI reports (the peak of this ratio was in 2000 when it reached 411.3-to-1).

The difference is astonishing. Most of us would (rightly) think that we have overemphasized the importance of a CEO: she/he may be worth a lot and have much more worries than the average worker, but try working a day without him and another without 200 typical employees and see which is more important for the firm. Still, what is more interesting is not that, since the 2000 peak, the ratio of CEO pay to average worker has decreased, but the timing and reason behind that. For example, look at the following table from the same publication:

Note the two highlighted numbers: CEO compensation has actually decreased in 2011-2012, by approximately 7.1% while the decrease for workers has been a much lower 0.6%; the ratio of earnings during that period narrowed by about 6%. The problem here is worker wages are also falling during a crisis. Thus, even though CEO compensation is falling, the fall is reduced from the worker wage reduction (this is the same as debt-to-GDP ratio analysis where if GDP falls even when debt falls the ratio may remain unchanged). This isn't just the case for the US mind you; the same gap (albeit not so exacerbated) also exists in Spain (where higher salaries continued to grow through the crisis, with 2009 being the only exception) and most likely every other EU nation. As the article on Spain notes, there are two possible explanations: either CEO salaries were the first to go down so the first to go up, or firms are focusing on people who, in their opinion are bringing the greatest value in the organization.

Defendants of CEO pay might argue that since their compensation varies widely through time, indicating more risk, it makes sense that these people get more money in return. Yet, when there is mostly an upwards trend, a few points indicating a decrease hardly matter. In fact, Kaplan notes that the historical average of CEO compensation is in the mid 1990's: the figure for 1995 is 6,303 and the ratio at 141.1-to-1. Thus, even though CEO compensation has been falling since 2000 the fact remains that at its peak it was much higher than expected. Just like the dot-coms at the time, it was a bubble itself.

A more important point is that their compensation, although decreased at times of recession (contemporaneously as the data show; see 2007-2009), the value of their money was not reduced by as much, given the deflationary pressures of the time. Yet, the defendant might comment that worker wages increased during that time. This is the most interesting part of the analysis: it appears that, in 2007-2010, worker wage was increasing (a total increase of 5.6%), while CEO compensation fell by 11.8%. In contrast to what many might believe, it appears that worker compensation declines only long after the event, indicating that wages are sticky (for details see this). The bad part here is that unemployment isn't.

In fact, unemployment in the US soared to 10% from less than 5.5%, in 2008-2010. It was only after unemployment peaked, at the start of 2010, that firms decreased wages. This brings out a more important topic: that after all, worker wage is not only volatile, but workers also face the extra uncertainty of becoming unemployed. For the CEO's higher pay means that the cost of being replaced is accommodated, as is the cost of higher volatility. The problem is that the cost of being replaced isn't covered by the wage increases of the average worker.

This doesn't just happen in the US though; it is also the case in Spain, and Greece and other countries. The point is that we compensate CEO's for the higher risk of getting fired or higher volatility in earnings. Still, the wages they earn are sufficient enough for their children to live in luxury. The average worker not only does not earn that much, but also faces the increased probability of being fired at a time when it is most difficult to encounter another occupation, just because of wage stickiness.

What we have been arguing basically reduces to one of two options: either we start thinking that we are overpaying CEOs or that we are underpaying workers. I'll leave it up to you to decide. But if you ask me, lowering the ratio to the early 1990's levels would be much better.

Jean-Claude Trichet's "apology" and responsibilities

Yesterday, Jean-Claude Trichet apologized at a European Parliament hearing concerning the role of the “troika” of international lenders (which managed bailouts in Cyprus, Greece, etc), with his response surprising many, as he blamed Member-State governments for the situation the EU is currently facing and basically washing his hands off the subject.

What caused some to wonder about Trichet's behaviour was that he did not admit any mistakes made by the Troika (and in essence the ECB, even when the IMF admitted to have under-estimated the GDP projections) and showed no remorse whatsoever. A prevalent idea is that Trichet did not do much during his stint at the ECB. Yet, he claims that without his actions, Mario Draghi's "whatever it takes" speech wouldn't have mattered much. 

To be fair, he deserves some credit. Trichet was head of the ECB during 2003-2011 and with the crisis beginning to show its teeth in 2009, the following table shows monetary policy actions since 2009 (even though the policy rate fell by more than 125 basis points in 2008 as a response to the sub-prime lending crisis).

As the reader may observe, the ECB's deposit facility rate fell dramatically in 2009, after new evidence on Greece showed that the country was sitting on a huge pile of debt; in fact both the main refinancing operations and the marginal lending facility rate were reduced during the year. This was actually more than most observers believed the ECB would do at the time. The rate remained unchanged during 2010 while, in an irrational change of mind, it was raised during 2011. As you may remember, the Decision to appoint Draghi was taken in June 2011, while the official inauguration date was in November 2011. Now, the only reason I am bothering you with the dates is that both the rate hikes in 2011 occurred while Trichet was heading the ECB. In fact, just 8 days after Draghi took over, the ECB rate was reduced by 25 basis points. 

In addition, have a look at the European Interbank Overnight (EONIA) Rate in 2010 and 2011: as it appears, the interbank cost of lending rose significantly in those two years (and only began to its fall after November 2011), at a time (after the first Greek PSI in late 2010 and just before the second PSI in Autumn 2011) when confidence about the banking sector had reached its nadir, with the whole situation forcing huge losses on periphery banks. During the same time, daily open market operations were reduced by approximately 38% from 775,559 to 483,141, while liquidity based on the Covered bond purchase programme more than doubled from 2010 to November 2011 (albeit in absolute numbers it was much less than the reduction of open market operations).

Source: http://www.global-rates.com/interest-rates/eonia/eonia.aspx

Yet, Trichet (or the ECB if you prefer) did something else in order to assist the then ailing European economy: bought large amounts of Irish and Greek government bonds as early as 2010, a policy which well continued in 2011. Had there not been the ECB buying bonds the crisis would have evolved much faster and with greater severity, as it has been a combination of both banking and sovereign trouble. Yet for some countries (Spain, Cyprus, Ireland), the former sector was the one which caused the latter to face problems, while for others (Italy, Portugal, Greece) it was mainly the latter which imposed its burden to the former. 

The ECB's reaction was one to "save the sovereigns" and somehow ignore the banks. This was justifiable at some point: the last three countries, of which Greece got the most publicity during the Trichet presidency, would have gone down spectacularly had the ECB not intervened. As for Ireland, the government was "forced" to guarantee the banks to avoid total collapse, thus forcing the ECB to "guarantee" the state. It goes beyond logic to suggest that the ECB did nothing for Ireland (or other countries in the EZ) during the crisis; yet it is equally illogical to suggest that the ECB did everything it could.

Summing up, the idea that Trichet did nothing, as well as the idea that his actions were what the Eurozone needed at the time are both nonsensical. Trichet should have lived up to his role as the ECB President and stand up against the PSI (if he was really against it). In addition, blaming others for their mistakes and not acknowledging that you could have done much more is not a sign of strength. Yet, the same holds for the MEP's: they are free to judge anyone for the outcome of their actions, but they should not forget that they are also liable for notorious inaction during the crisis. We all know that it's easy to judge in retrospect but it appears to be much easier to do nothing and then judge others about their actions.

P.S. A note to those who suggested that the PSI came back with a vengeance in Cyprus: the "bail-in" is much different from the PSI. In the latter the bank loses capital by experiencing losses in invested funds (in this case government bonds) while in the former it gains capital by effectively seizing deposits. And yes, the latter is better.

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.

The 1920's all over again: The Greek Transfer Problem

Germany in the 1920's: The Transfer Problem
Keynes, in 1929, stated that the problem of German reparations after World War I could be reduced into two issues: the Budgetary Problem (i.e. how to extract the necessary amount from the country) and the Transfer Problem (i.e. converting the German money received into foreign currency). The fact that Germany had been borrowing abroad for domestic capital purposes temporarily solved the problem, yet the situation could not hold for ever. Thus, the only potential resolution of finding the funds to cover for the Budgetary Problem would be to increase exports by a significant amount; a feat that could only be achieved by shifting factors of production from other employments to the German export industry.

The only reasonable explanation for Keynes was that Germany had to reduce her costs of production first, as supply of labour was more than enough at the time. Using this rationale, solving the Transfer problem would mean that German gold-costs of production relative to such costs elsewhere would have to be reduced either through increased efficiency, lowering of interest rates or lowering efficiency wages. As the first two did not appear to be available for change (efficiency was high at the time and lowering interest rates, i.e. cheap money for Germany, was not an option) a reduction of the efficiency-wages in Germany was the only alternative left.

However, such a reduction in efficiency wages would make the extraction of the funds needed for reparations (i.e. the Budgetary Problem) much more challenging. In addition, lowering money-wages would be to no avail if:
i.   Output could not be exported
ii.  Demand elasticity for Germany’s goods was less than one
iii. Germany’s competitors reduced their efficiency wages pari passu
iv.  Foreign customers imposed tariffs on German goods

This lowering of money-wages would not mean that real-wages would be reduced by the same amount as home-goods prices are expected to fall. On the other hand, efficiency could also be reduced in response to the wages which could trigger an even larger decrease in money-wages and so on.

The mechanisms which would provide for such a decrease in wages were two: the fall of the German Mark’s exchange rate (which was prohibited by the Dawes scheme) or by allowing the Reichsbank to enforce deflation, which would curtail the activity of business and throw people out of employment, so that when sufficient amount of workers are out of employment they would accept a reduction in their money wages. In Keynes's own words "Whether this is politically and humanly feasible is another matter".

Greece in the 2010's
On May 2nd, 2010, the IMF and the Eurozone authorities (Troika) agreed on a bail-out loan of €110 billion. The influx of funds, which was mainly employed in bank recapitalizations and debt restructuring, came with the need to increase government revenue, while simultaneously reducing expenses so that future installments could be met. Given that Greece did not possess a national currency to devaluate (much like Germany in the 1920’s) the additional three options had to be assessed; greater efficiency, cheaper money or lowering the money-wages.

Blue line: Corporate Lending Rate. Orange line: Mortgage Lending Rate

Although interest rates decreased slightly, they remained a relatively high level compared with the rest of the Eurozone, perhaps indicative of the fact that Greece is still at risk. Issuance of sovereign bonds was not an option for the country since she had been out of the markets since April 2010, thus, no opportunity for cheap money was not available. Increased efficiency was an issue considered in the country, yet, due to over-crowding in the government sector, lay-offs were implemented, both as a measure to increase efficiency as well as a measure to decrease government spending. Thus, the only remaining alternative was a reduction in money-wages.

Reduced government spending meant reduced state stimulus in the economy; thus, the Budgetary problem had to be resolved as less available money would have to compensate for the same amount of state revenues (to meet debt repayments). The challenge was no less tempting than the one faced by Germany in the 1920’s and the necessity to create additional income to compensate for the increased installments which had to be paid in the following periods, drove the economy to the only other alternative: deflation.

Not possessing a national currency (much like Germany could not devaluate hers) meant that the nation would either be forced to borrow from abroad to repay her current installments (which was infeasible for Greece) or increase the trade balance in favour of exports. In Keynes's mind, this could only occur if money-wages were reduced; as we have seen before indicate that before, money-wages in Greece decreased, although they were much stickier than most expected.

The shift of factors of production in Greece the borrower’s price of Imports relative to Exports is consistently rising over time, which leads to decreased export prices and increased import ones. This is consistent with the Keynesian premise that factors of production need to shift from industries which focus on domestic goods to ones which focus on exports, consequently decreasing export prices as a result of lower efficiency wages.

Import over Export Prices

Conclusion
Since Greece was unable to devaluate her currency to accommodate for the flow of goods in her economy after the first bail-out, the transfer problem deteriorated the nation’s finances, which promoted a shift in the factors of production from home-goods to export-goods, albeit at a significant cost to the country’s economy: unemployment has exceeded 26%. Consequently, the Budgetary problem of extracting a significant amount of funds from a reduced amount of wages in an economy, arose; this in its turn provided the need for debt restructuring, both in the sense of reducing the debt burden as well as making debt terms more lax. 

Why should we pay attention to this? Simply because this has been largely ignored by most economists when the design of the Greek restructuring plan took place (and every other EU bail-out before or since, to be fair) and led to consequences econometric models were unable to project. In addition, since none of the countries which received a bail-out has been able to come out of it successfully yet, (although Cyprus has some hopes since new bank loan offers have already began) the matter presented here should be of extreme interest both for any future bail-outs that may be needed (Slovenia is likely candidate for example) as well as for re-examining where policy went wrong in the Eurozone. Past experiences with austerity when countries had their own sovereign currencies had nothing to do with what was (and is) asked of the bailed-out member: a depreciation of the exchange rate when there is no exchange rate to depreciate. This is what has mainly been the cause of the severe contraction of the Eurozone economy has been the inflexibility of the economy (see also here) which is a result of stickiness in the short-run and the lack of sovereign currency to depreciate. In its turn, this forced the shifting of factors of production from one sector to another while at the same time created an army of unemployed.

To paraphrase Keynes, it appears that such policies were deemed as politically and humanly feasible in the 2010's EU. Unfortunately, the costs were both miscalculated and neglected.

Are labour costs all that matters in reducing prices?

A month ago, Eurostat published the 2012 data concerning labour costs in the EU. Attention should be drawn to the following graph:

(Click to Enlarge)

As the reader may observe, of the crisis-ridden countries, only Ireland is (barely) over the EA-17 average, while the rest of the countries, although they have been accused of high labour costs and the need for a more competitive economy are facing much lower costs than the "stronger" economies of Europe. Then, in the following chart we can see the change in labour costs compared to the change in real GDP for 2012.

Although not many data can be seen above, it is the case that a decrease in labour costs and a decrease in GDP go hand in hand, although labour costs appear to be lagging with respect to GDP change (see Italy or Cyprus). Economic theory states that for a nation to become more competitive, it either has to decrease its costs of production or depreciate its currency. In the Euro Area case, the second option is unavailable, thus the "need" for the first. Nevertheless, too much emphasis on the reduction of labour costs does not yield good results. 

It is doubtful that anyone would dare state that Greece or Portugal or Spain are more competitive than Germany. Yet, German labour costs were €30.4 per hour compared to €14.2, €12.2 and €21 respectively. If a person knowing just the economic theory described above and the labour costs per nation was told that Germany was the leading exporter in the EU then he would be rightly confused. It is not that Germany has a weaker currency either. In theory, a euro is a euro anywhere in Europe (well, other than Cyprus, that is).

Thus, since Germany is the leading exporter of goods it does either of three things:

1. Buys raw material at cheaper prices

2. Has a better reputation and creates better goods

3. Sells with less profit

Better reputation and quality of goods is not a thing that can be attributed to labour costs. On the contrary, when workers are paid better, it is to their best interest to create better goods. Thus, decreasing labour costs would not assist in neither better reputation nor better quality. Selling with less profit may be an issue, yet it is one we will never find out, as finding out what the profit margin of every company in Greece or Germany is, appears impossible. Then, all we are left with is producer prices. According to Eurostat, Germany's industrial producer price index (which indicates changes in the ex-works sale prices of all products sold on the domestic markets of the various countries, excluding imports) stood at 108.4 compared to 112.9 for Greece, 111.8 for Spain and 111.1 for Portugal. 

The producer index signifies that the German producer is able to purchase goods at lower prices than his Spanish or Portuguese counterpart. Rising prices do not have to do just with labour costs though. If we assume that raw materials are bought at the same prices (i.e. oil, ferrous and non-ferrous metals, etc) given a world-wide market, then all we have left are procedures, costs and productivity. Thus, of the constituents of prices, the only one which is influenced by the state of the economy is costs; which at the end does not even matter that much. 

Productivity is wholly different subject though. Eurostat calculates labour productivity per hour worked per year and the results are impressive. Germany's stands at 42.3, while Portugal's at 16.8, Italy's at 32.5, Spain's at 31.3 and Greece's at 20.3. This means that a German worker actually produces more than double of what a Greek or a Portuguese one does. As a result, the labour cost of a worker in Germany is approximately the same as for a Greek worker if we account for the fact that the former produces more (with the added advantage that the German firm produces more). 

Thus, the issue is not how to decrease wages, but how to to make workers produce more. This is not an easy subject. The main issue here is what makes a worker produce less. Is it because he is just lazy or because the whole system does not allow for more production? If obsolete equipment and stagnant procedures are to be blamed for this (again, as economic theory states), then a renewal of equipment and less bureaucracy would benefit the economy more than any reduction in labour costs would. If all workers in a country were lazy then we would not have any production at all, thus, although it is true that some people are lazier than others, the case is that if you have to work, you will eventually become as productive as your job requires you to be or as productive as it allows you to be.

We can all agree that a contraction in GDP leads to lower labour costs. Yet, we should not forget that it also leads to lower demand and thus less income for any firm. In addition, increasing productivity is a much better way to lower labour costs, increase production and subsequently income. Thus, although the current focus is on decreasing everything that may be decreased, the state of events indicates that this approach has been on the wrong: if productivity is increased then any periphery country may be able to sell more goods, both in the domestic as well as the international market, at a much lower price with much greater profit.

The quick lesson is this: if productivity is increased via increased investment in new and better equipment, then both effective labour costs will be lowered and the country's output as well as the firm's profitability will be increased.

Contagion, Capital Controls and Too Big To Fail: Outcomes of the Cyprus agreement

Corralito Protests in Buenos Aires

Just when I thought that nothing more would have to be said about the Cyprus experiment, a literature over capital controls, whether Cyprus should leave the Eurozone and if potential contagion is something to be feared in the future arose. Economists have been evaluating every one of the aforementioned issues and just as they always do, they could not agree on anything.

Capital controls have been in Cyprus for four days now and apart from the mess at the banks as a result of the 12-day "holiday" no significant flight of capital occurred (and no bank run, to the delight of everyone, even journalists). Although the ECB does not publish real-time Target2 balances, it appears that the capital controls have done their job (if one excludes the stupid decision to close down all banks and leave branches in Russia and Romania open). Probably every article online condones the measures taken by the Cypriot government, yet, some of them agree that there was no other option. Fellow blogger Protesilaos Stavrou commented that if controls persist even after the first tranche is paid by the Troika, then the whole programme was a fiasco; a statement I partially agree with.

Abolishing capital controls cannot happen over a day. The strict regulations applicable now should be transformed to more lax ones over time, with the aim of completely abolishing them until the end of the year (at the very extreme). Why the end of the year? Simply because anything that lasts more than 9 months should be considered as permanent no matter what the authorities may claim. Receiving the first tranche from the Troika does not really mean anything unless the ECB is willing to increase the ELA funding for the Cypriot banks, whose reputation has sunk over course of this deal. If €10 or €20bn of deposits exit the island will the ECB be ready to accommodate the lack of liquidity? 

Many compare Cyprus with Iceland. I beg to differ. First of all, Iceland was not part of the Euro-Area, which means that it had to create its own liquidity. If the ECB agrees to provide ELA funding for the Cypriot banks which may need it (so far only the Bank of Cyprus appears to be in need), then Cyprus can abolish the controls (again, over time) without any more harm to its reputation or economy. In addition, Cyprus banks only account for 10% of GDP and the economy receives a strong boost of foreign money in the form of the 2.5 million tourists who visit the island every year; not be rude to Iceland but we have to admit that their tourism is much less than that. Even without that amount of tourism, Iceland, having imposed capital controls for about 5 years now, exhibited a 3.1% growth in GDP in 2011 with an unemployment rate of less than 5% in mid-2012. Thus, although most economists discern capital controls they have really benefited the country's economic performance. Having capital controls is not bad per se; it's how long you keep them and how harsh they are that makes the difference.

Let's move on to contagion issues. A New York Times article stated that the Bank of Cyprus is no bigger than Indy Mac Bankcorp, a savings and loans institution in the US, which failed five years ago and needed a bail-out. The author misses a little detail though: the US has a GDP of $15 trillion while Cyprus's is about 1,000 times lower. Thus, Indy Mac was approximately 0.0018% of GDP (it had $27bn in assets), while the Bank of Cyprus is approximately 1.5 times as big as the Cypriot GDP. The difference between the two was that Indy Mac was NOT too big to fail. As stated before, there would be no severe contagion in any monetary terms from Laiki bank failing. Neither Bank of Cyprus for that matter. What made the two banks systemic was there strong presence in Greece. After selling that for the cheaper price they could get, they now pose no danger to the European economy (bad move for the Cypriots). 

What makes a difference though, are the psychological effects this issue has had. The banking union, planned for 2014, now appears to be a vague dream; no predictability of institutions exists in any form. If someone thinks that the situation is not so bad and people still trust their banks then why should Wolfgang Schauble have to tell us that the savings in euro are safe? Ordinary citizens have no other viable option in the EU but to place their savings in a bank account. Yet, the less-than-100k accounts do not amount to much. For example, in Laiki bank, only €4bn out of a total of  €20bn will be saved, i.e. 80% of deposits belong to large depositors. These are the people who have the ability and knowledge to transfer funds from one country to another at the click of a button. It is, unfortunately or not, the big depositors that the EU has to reassure to the small ones. In addition, it is not just depositors that have to be persuaded. It is also emerging economies or other countries who use the euro as a reserve currency. The Economist observes that countries in the developing world are drastically reducing their reserves in the Euro, with reserves being at their lowest in a decade. The Euro is as strong as its weakest link and we do not even know who that link is.

Uncertainty is running wild in the Union, as the Eurogroup does not appear to understand the decisions it is making. Another outcome of the Cyprus experiment is that a brand new Too-Big-To-Fail bank has emerged in Greece. Pireaus Bank, after securing €16.2bn of loans at the ridiculously low price of €524 million, has become probably the largest bank in Greece controlling 28% of loans and 27% of deposits. With no agenda on being pessimistic isn't market concentration in the banking industry a big issue, especially in an economy in recession? Time will tell. Yet, it now appears that Greece is being dominated by 3-4 banks, which is almost never good for competition and always never good for the economy if they face trouble. If the Eurogroup decided to reduce the Cypriot banking sector the EU average by making one bank default and make the other less systemic why isn't it doing the same in Greece? Oh, I forgot: we are only looking for solutions AFTER the problem has hit us over the head with a baseball bat. 

This is has been a great week for euro-skeptics. A Euro-exit appears to be less distant know that ever before. The question is who will take the first step. The outcome of Italy's elections will dominate the Euro-Area over the next few weeks, while all of us will keep an eye in France, whose fiscal deficit was still very high in 2012. If the austerity cycle resumes then we are all in big trouble; especially Germany.

GDP is falling down...

Eurostat published its latest statistics on Q4 2012 in the Eurozone. Nothing that we did not expect actually: Portugal -1.8%, Cyprus -1.0%, Italy -0.9%, Spain -0.7%. No statistics were published regarding the state of the Greek economy.

These results indicate that during the last three quarters the Eurozone had a contraction in each and every one of them. (I would remind you that the definition of a recession is two consecutive quarters with negative GDP growth. And we are experiencing three...)

What many did not expect though was the following:
Germany: -0.6%
Finland: -0.5%
France: -0.3%
UK: -0.3%

We all thought that the German economy was impervious to such things as recessions right? Well, let me remind you that this was a not-so-unexpected phenomenon. I have explained that the recession would have a very important effect on the German exports (which are about 60-65% to countries within the EU, and specifically within the Eurozone) in this article published in mid-November. Wolfgang Schäuble was said to secretly prepare for this downfall in the last days of 2012 by "cutbacks to prepare for a weakening economy and possible fallout from the euro crisis" (for details read this).

It looks like this time is now here for Germany. I have no other explanation for persistence in plans which do not work than obstinance and illusory beliefs and views of the world. If Schäuble is allowed to do the same with Germany as he proposed (and unfortunately pulled through) with Greece, Spain, Portugal and Cyprus the Germans are in for a much worse fate than they expected. 

And this will only be the beginning...

Austerity and Wages: The Real Data

From what we can see very few have actually bothered to see the effects of austerity measures in the lives of people. Thus, after some (very light) data mining I present you the effects that these austerity measures had on the Greek and Irish economies. Unfortunately, we do not have the opportunity to study other nations for the time being, as data only go as back as June 2012. Yet I will contrast the results for Greece with those of Germany during the 2006-2012 period.

Note: All results are inflation-adjusted (i.e. real) and account for gross wages (y-axis represents aggregate wages in the economy)

Real Wages in Greece

In the graph above, the two vertical lines represent the first two austerity packages the country passed, one in May 2010 and the other in February 2012. According to the data, the real value of the country's wages began to fall just before the 1st memorandum and is continuing its downwards slop up to day. In contrast, have a look at real wages in Germany:

Real Wages in Germany

Here, real wages only took a slight fall during the late 2008 crisis, but have resumed their upward trend in 2010, rising substantially over the past couple of years. If the Greek data are not enough let's have a look at the next graph:

Real Wages in Ireland

As anyone can see, wages in Ireland have also taken a tumble over the past 3 years. The straight line represents the 2009 budget which was aimed at salvaging the Irish banks and reduced government spending so that the debt burden assumed would be sustainable. The point of contrasting the aforementioned two countries with Germany is not to blame the latter. It is merely to point that Germany is here a case where policies have worked well while Greece and Ireland the cases where terrible policies did not have the results expected by policymakers. Worse of all, the result expected had no relationship with reality whatsoever. 

As economists, we expect that once the public's purchasing power is lowered then prices will fall as a result of less demand. This is actually what is being taught in Economics 101 in every university in the world. (see graph below)

Simplistic economics: Lower demand (Demand 2) means lower price (P2).

What economists in the IMF and the EU have failed to see is that prices do not change so fast. In fact, they may not change at all during the short-term (depending on how you measure short-term of course. Here, I assume is it as less than 2 years). In fact, an article in a Greek newspaper stated that prices in the economy just showed a declined. The date: February 6th, 2013. One could post data on inflation in Greece but these would be redundant. Real wages represent the current state of the economy much better and with greater insight on the public's purchasing power.

Since people do not behave as economists believe they do (and no economist has ever thought about changing the models or defining "rationality" in a different way) it is obvious that real-life effects will differ significantly from what is expected in theory. Greece and Ireland appear to have been nothing more than economic experiments; so that economists can learn that the world does not function the way they had thought. Unfortunately, it takes more than just one nation for economists to understand and admit mea culpa. The same situation is about to happen in Cyprus and has already happened in Portugal, Italy and Spain.

Did the authorities have an alternative? Yes: induce less rapid austerity measures, so that the reduction in government expenses would not cause such extreme responses, making a more gradual move from over-spending to under-spending. Now, let's assume that they did not know about this and they had to make a mistake to learn about it; now that they have learned, will they do anything fix this situation?

Mea Culpa but let's repeat it: IMF and the Bail-outs

Olivier Blanchard, IMF's Chief Economist

It appears that the IMF's spokesperson, Mr Jerry Rice, has said the following over an interview yesterday, concerning Washington Post's article on what appears to be Olivier Blanchard's (the IMF chief economist) mea culpa:

"(...) going way back to 2010, if we can cast our minds back, I think it's fair to say everyone was a bit too optimistic on forecasting Greece's recovery. (...) These included, the depth and the protracted nature of the European crisis itself, and the political crisis in Greece, which severely affected economic confidence, and delayed the implementation of reforms. (...)

When it became apparent that the underlying conditions were different to what had been assumed, we certainly moved as fast as we could to update our multiplier assumption. (...) there's been a lot of discussion of this fiscal multiplier, which is probably something very few people had heard of until some months ago. (...) I think it's a very healthy thing that the IMF and Olivier Blanchard have been completely transparent in how this was done, what the whole context was. I think that's the basis we want to move forward on."

From what it appears, nobody at the IMF had any idea what a fiscal multiplier was about a year ago. To say that there have been academic papers published the subject for the last 20 years would be an understatement. A simple search of "Olivier Blanchard Fiscal Multipliers" in Google Scholar yields results which date from 1987! Even if that is not enough then results from 2002 (including Blanchard's own paper) and 2009 could have assisted them. The point is that their estimations were wrong. That is why I have been calling the whole situation "the Greek experiment" (see here, here, here or here just to give out some of them). It appears just like if some people have been trying their theory to see if it works in the real world as well. Well it doesn't.

We can all agree that it is a healthy thing that they have been completely transparent about this. Yet, it would be an even greater thing if they were not trying to do it again in Cyprus, Spain and Portugal. Greece is not so different than any other ailing nation. It's as simple as that: government spending going down means that GDP is going down; just faster. Obviously I am not against fiscal consolidation. Yet as I have stated before, it needs to be made gradually. We cannot just slash €3-4 billion from government spending and expect the economy not to react. Of course it will. That is why change needs to be more subtle. 

Think of it this way: if there is only a buyer and a seller, then if we cut the buyer's wage by 30% don't we expect that he will buy less? Obvious isn't it? Now you may imagine the whole link: the seller will order less goods, then less goods would mean less raw material and so on. But I guess economists cannot think that simply can they?

The Consequences of Exits

The case of Cyprus undoubtedly resembles the case of Greece. The amount the country needs is not large per se, as was the case with Greece, yet it is the equivalent of about 100% of its GDP, casting doubts on whether its lenders would ever be able to get their money back. In both cases, two options exist (and existed): either give the country all the money it requires to completely avoid default or let it fall and consequently exit the EU or more likely the Eurozone.

Advocates of the latter base their arguments mainly on whether it is rational or good practice to send good money after bad, or whether the EU will forever be the lender of last resort for troubled nations. As the number of Member-States which face trouble as a consequence of either irrational expenditure or housing bubbles continues to rise, proponents of the Pontius Pilate method (i.e. "I wash my hands of the subject") believe that a line should be drawn somewhere. Yet, where should that line be drawn and what are the consequences, if any, of that action?

During the most severe case of the Greek crisis over the last 6 months, notably over the summer months, it was stated that there was a great danger of Greece exiting the Union. What we have witnessed, however, is that Brussels made the decision to support the nation, both monetary as well as politically, given that the Greeks would play their part as well (which they did). Economic consequences would have been severe had Greece exited, but what of the consequences of a Cyprus exit or another small country's?

Here, the problem is mainly political and not an economic one. Having barely 0.2% of the EU's GDP does not qualify the island on being an economic force whatsoever. Nevertheless, think of the consequences of setting a precedent by letting Cyprus fail. The probability exists that all other countries will fear that their turn will come if they do not pay attention to their fiscal policies and they will do their best to follow suit on the instruction of the IMF and Brussels (or is it Berlin?). Yet, there is another possibility: that the Member-States will think that such a behaviour is not an acceptable one, and one could liken it with bullying: kick the little guy out so the medium ones can see what will happen to them if they disobey. And what of the probability that other Member-States may think "if Cyprus is out of the Eurozone and can work it out why don't we exit as well?"

It has to be considered though that it is highly unlikely that another country will be in direct need of assistance in the near future (one cannot foresee the outcome of the Italian elections however). This would mean that essentially what the EU would be doing is that they should be supporting one of their own; or even better something they created. Was it not Victor Frankenstein's fault for the monster he had created? Now it is their fault for not looking two steps ahead when they were making the decision on the Greek haircut about a year ago. 

Exits should not be an option for either Eurozone or EU countries. If even a small country the size of Cyprus exits then you may mark the day as the one which set off the destruction of the EU. All that has been built over the past 70 years, all that nations have been through over the past couple of years, with uncertainty and economic misery would be in vain. What is the message by the EU officials if when a nation is in trouble we fail to assist it?

Cyprus is merely an example. Greece was the example in the last few months, and hopefully Italy will not become the next example in the following ones. We cannot have a perfect Member-State, we cannot have a perfect Union. Yet, we can support each other, regardless of petty issues. Spiegel mentions that the island is considered a safe haven for tax fugitives. One can remember posts about Russians moving funds to Cyprus for the last couple of years. Why now? Why didn't the EU try to impose stricter regulations on Cypriot banks earlier than that? 

The same issues arose in Greece, Italy and Spain. Why did Brussels fail to do nothing, not even suggest something when they had known about tax evaders in Greece since 2009 (the now notorious Lagarde list featuring more than 100 names of fraudsters with millions of deposits abroad)? Or why did they not try to change the Italian election law, which essentially does not let the people elect whom they want to lead them? Even better, why haven't they tried to do it when Mario Monti was in charge (he tried to pull it through but I believe that the legislation has not yet been passed) or even try to push Italian politicians now to do it? How about Spain and the horrible situation with evictions and homeless people? 

I can agree that the EU does not have the power to meddle in Member-States legislation and politics; nor should it. Yet, it should be noted that EU law is superior to country law, and thus many a legislation could be passed on in Brussels; legislation on important issues like election law, money laundering or evictions. What is more is that they should be able to impose severe sanctions to the members who disobey on serious issues. Being an optimist I hope that the memorandums have given the EU an opportunity to make the living environment better in the ailing countries than it was before; not used merely for punishment.

Cypriot presidential candidate Nikos Anastasiades with Angela Merkel.

As for a prediction: the EU will grant Cyprus its memorandum and support. How much money the island will receive and what sacrifices they will have to do I cannot know. Yet, it is highly unlikely that they will receive it before the February election results as a change of government will bring a change in credibility; the same issue with Greece over the summer. Just wait and see...

Ireland and False Promises

Anyone who has been watching the news over the last 4 years will definitely remember the case of Ireland. A very strong economy, booming at the time, faced significant constraints in 2008 due to the large exposure of banking institutions to sub-prime loans abroad, in addition to a housing bubble burst in the country. Thus, in order for the Irish to be able to save their banks, a joint IMF and EU loan of about €85 billion was granted to the nation. The terms were the usual: austerity and even more austerity.

The result: as of 2012, only 1% growth in GNP instead of the promised 4% in a 2009 forecast. Government debt is 120% instead of the forecasted 79%, investment fell about 4% instead of rising by 9% and the only reason unemployment has fallen is because 350,000 people have fled the country. (I am really beginning to wonder what the people behind the forecast were thinking when they calculated the numbers).

Protests against austerity measures. Source: William Murphy/Flickr under CC 2.0

The case of Ireland resembles the cases of both Spain and Cyprus: a housing bubble bursting and bank bailouts which forced the nation to assume extreme levels of debt. The result will also be the same: austerity measures, destroying any potential for growth over the next years, people facing extreme difficulties in their everyday lives as even though wages and pensions are falling prices do not follow the same route, and the "upper" class not having to worry about any of these.

Bank officials are still earning six-digit incomes every year, and politicians have seldom seen their wages diminishing over this period. According to the Irish Times, politicians most people have never heard of, are entitled of a €2.2 million pension. Had this occurred at any other period of time, we would have just thought it was because the economy is booming; at the present time it appears as a ridicule to the efforts of the innocent people bearing the cost of the banks' errors.

We are moving towards a pure capitalist society where money comes first and everything else second. At least that is how our leaders behave. We have to pay for the mistakes others have done. I heard a saying once that an insane person throwing a rock in a well will need 40 sane people to get it out. This is what is essentially happening in Europe now. We are paying for wrong decisions, poor judgement and false ideologies. Politicians cannot see the way we do because their incentives are different. In a discussion with Constantin Gurdgiev he stated that politicians face the same incentives as bankers; he was right. It does not mean anything to them whether 99% of the people are paying for the sins of the other 1%. Simply because they will get their money and benefits anyway. And if they manage to do something good for the country as well then even better; if they do not who cares?

The distinction between politicians and those who elect them is growing larger and larger. This inevitably leads to the former believing that they are masters of the game and the latter hoping that the game will someday change. The only way for this to change is to have the politicians more liable for their actions than they are now. I have already proposed a scheme for this, with the goal of aligning the politicians' and policymakers' incentives to those of the people who elect them. The issue is who would be brave enough to apply it?

We all know that having to suffer for the banks' mishaps is unfair. Yet, the banks should not have allowed us to spend so much in the first place. It all goes back to a vicious cycle of banking policies, supervision and the notion that the state will always be there as the lender of last resort. New banking supervision rules should be made so that no systemic collapse can occur when a banking institution fails. Given the size of the banks in the modern day a simple solution would be to split them into separate institutions. Yet, what politician or policymaker would be so determined to do so given that their incentives tell them a different story?