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?

Easier to Preach than Implement

Don't know if you have seen it, but an article in Der Spiegel states that although Angela Merkel and Wolfgang Schäuble have forced almost every Southern nation in the EU to take harsh austerity measures, they do not plan to follow that recipe themselves. With less than a year until elections, Angela Merkel is planning on increasing government spending in the form of subsidies and pension raises. While this may be speculative as the German Chancellor has committed to presenting a balanced budget for 2013, it is in severe contrast with Schäuble's on austerity in the current G-20 summit in Mexico City.

You see, as in most philosophies and other principles and values, it is easier to preach and condemn people for not implementing them or even force people to apply them, than to use them yourself. The great socioeconomic experiment we are currently witnessing in Greece (and will soon witness in Cyprus as well) is indicative of people who are stuck in ideology and cannot understand simple economic reality. I am not talking about complex equations or ideas here: what I mean is the mere understanding that if you cut salaries and wages things will get worse than what they were. Any high school student could see and understand this. Sadly, we have no high school students in a position to apply policy.

If austerity measures were implemented to reduce structural problems the countries were facing, I would admit that, even though rapid implementation is never good, the measures were aimed at producing something good. Nevertheless, the measures are only aimed at reducing expenses and not addressing problems. As a result, they do nothing to improve a country's well-being. In contrast, what they do is deepen the gap between social classes, as the lower class assumes most of the burden.

The Greek domino effect. Source: socialistrevolution.org

It would look like policymakers and politicians in the EU are not really reading any blogger articles. The EU blogosphere has been expressing its objections about this for months now. What seems to be even more amazing is that even though blogger voices against austerity have increased over time, nothing is being done to correct the situation. What I fear is not that a nation will be destroyed. It is the domino effects of this destruction that I fear the most. A Greek bankruptcy, or even a fall of the government, would most likely force the nation out of the Union and the common currency. And if this occurs then maybe Cyprus, Spain and Italy will also flee, thus rendering the EU a non-Mediterranean union. Although the ties between nations are strong, which can be evidently seen in the youth, they are nevertheless weaker in the older population. As the older generation rules, it will be more difficult not to follow suit if Greece exits the Union.

What is suggested above is not just a far-fetched scenario. It is one of extreme likelihood if the austerity measures are not passed through the Greek parliament. And I am not sure what is worse for the Greeks: the painful austerity plans or the fall of a government? In the long run obviously the second would yield worse results, but in the short run austerity will bring those of the Greeks still standing, to their knees. 

Unfortunately, Greece, as well as Cyprus in a few days, is at the mercy of its creditors. They tell the country how much it shall be lent, when and what is should do with the money. It is essentially being an unelected and uninvited government. Can you really blame the citizens for not liking the Troika and what it represents?

A change in mentality?

Over the last week a serious change in attitude towards ailing countries within the EU has occurred. Leading with Chancellor Angela Merkel, the political scene in Europe has witnessed a 180 degrees turn. The change was so radical and impressive that Der Spiegel has published a full article on this. This could mean one of three things: 

1. The South has made real progress over the last month (hmm or week maybe?).

2. Merkel has understood that her policies and stance are making both her as well as Germans in general extremely unpopular in Europe (and elections are coming up in a year).

3. She has accepted that trying to push through many things very rapidly is not such a great policy after all.

Whatever the reason may be (Spiegel states that it's No2) the fact is that leaders now appear to be more united than ever before. Even statements of the "Greece should leave the euro/Union" kind are treated coldly by EU officials now. Still, as progress for unification in the political level appears to be improved the economy still fails to recover. Italy, just like Spain and Greece, has seen unemployment rates soar over the last months. While Mario Monti is doing his best to improve the overall economy, unemployment of youths under 25 has reached 40%. And with recession here to stay in Italy (forecasts expect GDP to contract by 2% this year) the situation does not seem to improve. 

European leaders fail to understand that people cannot live on GDP. After an EU-wide summit on unemployment nothing seems to have changed: the employed have not (cannot?) find anything to do about the jobless. I have proposed my set of ideas over reducing unemployment here, and while the list I have presented is not exhausting nothing has been done yet. Just as I have predicted, the EU will face a recession over the next few months. New evidence indicate that the recession will be far worse than we expected. The Purchasing Managers' Index (PMI) for the Eurozone predicts that the output will shrink by 0.5-0.6% over the current quarter instead of the initial 0.2% prediction. 

The worst part of these forecasts is that the EU's safest economy, the one where people actually paid to invest their money, Germany, is bound to move to the red. The OECD predicts that although Germany has grown by 0.5% and 0.3% in the first two quarters, in the following two an annualized contraction of 0.5% and 0.8% is expected. Only France may be able to remain more-or-less unscathed with output falling this quarter and rising on the next.

In addition to all these, Mario Draghi has announced a program allowing unlimited purchases of sovereign bonds in the secondary market, in order to keep interest rates at sustainable levels. The only opposition to this program is Bundesbank head Jens Weidmann who believes that the program is too close to state financing through the money press. He may be right up to a point, however, I do believe that the program is much ado over nothing, The problem with what Draghi has proposed is that the ECB will only assist countries that appeal for help to the euro bailout fund and submit to the required austerity conditions. What he also meant is that the ECB would only be able to do this for nations which are not considered as junk by the 3 rating agencies (Moody's, Fitch, S&P), i.e. Greece and Cyprus cannot be assisted.

Thus this leaves only two countries: Italy and Spain. However, the announcement failed to mention the amount which would be available to fund this action. Given the size of the Italian and the Spanish economy, it would have to be enormous. Yet, we are still unaware of the size and extent of the intervention and it would be nice to know some more details about it instead of the general idea.

In the meanwhile, what journalists have not yet proposed is that another reason of Merkel's newly appeared empathy towards the crisis-ridden countries maybe be that she is preparing to identify herself with the rest of the ailing nations if OECD forecasts are true. We will just have to wait until the official data is published to find out.

A re-build of Greek credibility

Over the weekend we all heard the news of the Greek Prime Minister, Antonis Samaras, meeting with Merkel and Hollande. The overall outcome of their meetings was positive and Samaras is now determined to re-build Greece's lost credibility.

I do not know if someone in Berlin or Athens has read what I wrote on compromise and press releases, but from what I can read in today's press the Greek Prime Minister has ordered his Finance minister to accelerate the procedures for the new 11.5 billion euro austerity measures package. Another request was that a draft of the 2013 fiscal budget should be prepared before the next Eurogroup meeting in Nicosia, Cyprus, in September 14th.

All of the above are targeted to convince Troika, which will visit Greece again in the next few weeks, and the EU of their good intentions, in order to gain a two-year debt extension. Although as I have argued before, a two-year extension might be too much to ask, a one-year one might not be too bad, especially since the Greeks will have announced the new austerity measures by then. If the new budget is also significantly improved than last year's, I would see no reason for the EU officials not to congratulate Greece with a one-year extension period. (Some political leaders in Berlin have stated in a Der Spiegel article that they might discuss a one-year extension of the Greek austerity program)

It would seem that Samaras is doing more to assist his nation than any of Greece's former leaders. Trying to re-build a long lost credibility, promote structural changes and reforms, balance a troubled budget, and restore the Greeks' belief in both their government as well as the EU. The task has been, and will be, difficult, however, I trust that will little assistance from Brussels they will be able to cope with it just fine.

A week to know about Greek Bankruptcy

Greek Prime Minister Antonis Samaras has a planned visit to Germany next week, during which he will meet with Angela Merkel to discuss a two-year extension to his country's austerity measures. 

On one hand Samaras's plea makes sense: The austerity measures taken so far have paralyzed the country and made it go through one of the worst recessions in history. Next year is expected to be better for the Greeks as a recent IMF forecast expects GDP to be stable for the whole of 2013. (more on Greece's Progress here). It is more than reasonable to assume that both his popularity and his country's GDP will face a sharp drop if any more austerity measures are rapidly implemented. Even now, due to lack of money, Greece has to resolve to creative emergency loans in order to avoid default.

On the other hand Merkel's hard opposition makes sense as well: If the leader of one of the strongest economies in the EU accepts Samaras's terms then what would stop the Greek Prime Minister from asking for longer and longer time frames at the end of the two-year period? Let us not forget that the Greeks are to blame for their mishaps, although they may be suffering more than enough for them. €4 billion in savings from austerity measures are still missing, a prerequisite for the additional €31.5 billion the IMF and EU will disburse under the second bail-out package.

It seems like the two have reached an impasse: None of them is willing to fully accept what the other has to propose. The situation might look like a Gordian knot, however, like Alexander the Great (or Solomon if you prefer) I would suggest something simple: Compromise at a one-year extension of austerity measures, in order for the Greeks to have a smoother adjustment to them. In essence this would ease the consequences of hard austerity measures as their effect would be smoothed out over a year. 

Nevertheless, for the Germans and other Greek creditors to be sure that the reforms will take place, and their hard-earned money are safe, Samaras will have to formally present the reforms to be undertaken on a given date. On that date, (maybe in late 2012 or early 2013) the reforms would be presented to the public in a press conference, and the exact date of their implementation will then be set. 

In a compromise like the one described above, Greece's creditors would have an easy way of checking whether the Greeks have kept their word, while at the same time allowing the country to ease the pressure of rapid austerity measures. This would allow markets to believe that the odds of a Grexit scenario are declining. 

However, even if they disagree on everything, the Greeks should still receive the €31.5 billion package. Failure to do that would bring the EU down until the end of the year.

Greek Bankruptcy can help the EU?

In an article in Der Spiegel yesterday, Stefan Kaisser states that a Greek bankruptcy, although costly, is the best way to resolve the current situation in the EU. Current plans for Greece, as stated in the article, are the following: The Greek government is supposed to borrow the money it needs from the ailing Greek banks. In return, the banks receive sovereign bonds that they can, in turn, provide as securities for new loans from Greece's central bank. In this way, Greece's central bank is financing the Greek state in what is really just a kind of shell game that gets riskier the longer it is played. This arrangement reminds me of leveraging (the idea that instead of banks lending a proportion of what they have as deposits, they end up lending maybe 50 times more, a policy most large banking institutions adhere to) and is not one which leads to stability.

However, I do not believe that bankrupting Greece would solve anything.

On one hand, the consequences are unknown. Even Germany, with its strong economy, has to to prepare itself for a major economic catastrophe. And whilst the Germans may have the funds to bail-out their banks, most EU countries do not. So what would happen is that more countries will ask for help from the EFSF/ESM. What happens if these countries also face fiscal difficulties which would be a direct outcome of the Greek bankruptcy (and in essence German EU politics)? Let them go broke too?

The other big question is what happens after the bankruptcy. Does Greece go back to drachma or does it stay in the common currency? If Greece exits the euro then what is the message sent to other countries: bad fiscal planning and you are out of the euro? Will Greece be allowed to return after some years have passed? For conversation's sake let's assume that Greece does not do the stupid thing and remains in the Euro (although I highly doubt it, since anti-european movements will increase in popularity after a bankruptcy). What happens next? Who is going to lend a country which received enormous amounts of help from the ECB and the IMF and still managed to default? Guess: the ECB and the IMF again.

Although the Greeks should - and do - receive the blame for the situation in their country, Merkel's austerity remedies seem to have lost their charm since they have not been able to reverse the current situation. The Greeks themselves cannot do anything more than austerity measures and stimulus from the ECB anymore. What should be done is a change in German and EU politics: The ECB should be allowed to move directly and INDEPENDENTLY in order to buy Greek bonds or any other sovereign bonds deems proper, to restore order in the markets, just as a normal central bank would do.

Let us not forget that it is the Greek haircut we have to condemn for the current situation in the EU; and this is a direct consequence of political decisions (mostly German) which were based on flawed arguments. I do not think that it is too late for an ECB intervention which would end problems in the South in the next years and restore confidence in the markets.

As for the "spiral of threats and rescue actions" Berlin and Brussels got themselves into they only have to accuse themselves. It is never too late for admitting a mistake and moving on to correct it.

The Big Bang Policies

It has been noted that the Troikans are in favor of rapid changes in bailed-out economies, a policy that has been very cleverly been dubbed "big bang solutions". The same policy is to followed (or at least Troika intends in following it) in Cyprus. As if the consequences in Greece are (unfortunately the past tense cannot be used here) not a great example of what these rapid changes can cause. It looks like some people never learn from their mistakes.

The Wall Street Journal hosts an interview by Mario Monti, with the latter stating that he is certain the ECB will do what it takes to save the euro, the night before it disintegrates. He wonders: Do we have to reach that night before the ECB does something? For me the answer is obvious: Yes Mario we do. The crisis has began to spread amongst the EU countries which were so far resilient, like France which is expected to witness a 0.1% contraction of GDP in the third quarter of 2012, while expectations were that a 0.1% contraction would have occurred as well in the second quarter. Two consecutive contractions and then welcome recession!

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The same holds for Germany which has witnessed both imports and exports declining and is hoping that demand from emerging markets will offset the fall in demand in the EU. German GDP is expected to rise by 1% in 2012. I wouldn't be surprised if that proves to be an optimistic estimation. Even politicians in Germany have started to doubt whether the policy Angela Merkel is pursuing in the EU is a rational one. The next Federal Parliamentary elections in Germany are to be held in September-October 2013. If Merkel is defeated then a new Chancellor may have different views on the subject. Can the euro last until then without any assistance? Most likely not.

Mario Monti said yesterday that high lending costs reflect not only the economic situation in a country, but the fears that the euro will collapse. In addition I believe the markets also fear that the country might leave the euro. Unfortunately, Super Mario is right, although he may not be able to save his country from bankruptcy. (Thank 8 years with Mr. Bunga Bunga for that) If the ECB does not intervene to lower borrowing costs in the South, we may be talking about a euro collapse in the next year. And to think I am mostly an optimist!

What I would love to see is Draghi take some action, and Merkel leaving him alone to act. Holland has been strangely quiet over the last month or so, which makes me wonder whether the "anti-austerity" policies he claimed before the elections were just the usual political promises.

Impressions from a Southern European Country

After watching that Cyprus has also applied for a bailout from the EFSF/ESM fund (following Greece, Ireland, Spain and Italy) I decided to to watch a bit more carefully on how the situation will be handled this time. From what I can see in the news, the group of experts (or technocrats if you prefer) of the International Monetary Fund, the European Commission and the European Central Bank (the so-called troika) have reached the same conclusions as they had done before for the case of Greece, Ireland, Spain and Italy: Austerity Measures. Surprise, Surprise! As if any European citizen was expecting anything else.

News stories of what they intend to propose specify things like large cuts on government expenses, decreases in civil servant wages and benefits and increases in direct and indirect taxes. Although I am positive that the Cypriot state needs to perform some sort of rationalization over its expenses (the Southern European states have a much deserved reputation of not being very logical when it comes to government spending. An excellent example of such irrationalities is Greek government's allowance to the civil workers who arrived at work on time) this sort of thinking and acting will not ease the burden of a sovereign debt crisis. Judging however of the ease at which the troikans believe that austerity measures are a panacea I would propose that the next country that will need a bailout ship its accounting books to them and spare the EU some money on traveling!

As one may observe, austerity measures have not so far helped in easing the effects of the near-bankruptcy of Greece. In Spain, unemployment has reached 25% amongst the population and about one out of two youths under 25 is jobless. And yet, Mariano Rajoy's government announced huge cuts in the nation's budget which will only worsen the situation. Mario Monti's government of technocrats in Italy (in my opinion the best leader in the EU at the moment) has only taken 30bn euros worth of measures, and those in December 2011. In comparing the two states it would now seem that prospects seem slightly brighter for the Italians as per the spring 2012 European Commission forecasts. (for more details read the European Commission Economic Forecast. Be warned it is 190 pages long!)

As one may observe the Commission states that after 2012, a bright future awaits the Union.However I do not believe that such a comeback will be feasible so easily. In an already depressed economy the cost of slashing government spending is going to be more than the amount of money not spend.

As one may see from Google's public data Spain had negative growth only twice in the last 50 years while the more politically unstable Greece and Italy have had more ups and downs. On the other hand Cyprus's only year of negative growth since 1961 was 2009 (wouldn't it be nice if they could just keep it up? Damned bank exposure to Greece!). However, if you exclude the 1974 change in Greek authorities after the 1967 coup d'état, a year which was marked by a 6,44% Greece had not faced major economic downturns. The same holds for the Italians whose worst year was 1975 with a 2,09% drop.

According to the Debt-Deflation Theory of the Great Depression by Irving Fisher and the academics who have studied and written about it over the years (one of which in the Governor of the Bank of England Mervyn King) a large government sector has stabilizing consequences to an economy. In Hyman Minsky's Stabilizing an Unstable Economy (you can find it here) this idea is revisited and it is once again shown that a large government (up to a point obviously) is beneficial for the financial stability of a nation. (I am under the impression that the troika will not especially enjoy this paragraph) Thus the danger that may arise from an excess of austerity measures is to make the already fragile system more prone to future crises.

Following this ideas it is more essential to provide incentives for growth and then impose austerity measures. The logic behind the EFSF so far has been: we give you money if you promise to be frugal with them. Well gee EFSF thanks a lot! What would actually make sense would a be a policy of ''we give you money, spend them to boost the economy, and then impose some austerity measures". (If you are one of those who like to derive examples from economic history you may use the one of Theodore Roosevelt and the Great Depression) I once again state that I am not against the rationalization of government expenses. However, this should be done after the economy stabilizes and not before! If the economy does not grow how is the nation going to pay back it's lenders?

I guess that following the traditional German logic of keeping inflation low and finances tight at all costs led us to where we are now (a note on the solution of the Greek debt haircut on posts to come) and will keep us there until the Germans realize that the hyperinflation of the 1920's will not occur if the let the ECB act as regular central bank and print money. It would even make the value of the dollar fall which would help German exports! 

(Mrs Merkel please listen to reason! Most Europeans are bored of the same meetings with the same conclusions!)