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?

Unemployment Update in the EU

Source: Eurostat

Well, the figures give more or less the same story as last month. Unemployment is roughly the same in the EA17 or the EU27 (up just 0.1% in the EA17), Greece and Spain are champions both in youth as well as in overall unemployment, Italy, Ireland and Cyprus saw their unemployment rate rise while Austria's, Netherlands's, Luxemburg's and Germany's remained the countries with the lowest figures.

What I am eagerly waiting for some time now, is for the Eurostat announcement that EU27 and EA17 GDP has contracted over the last quarter thus officially throwing the Union into recession. I am not doing this out of hate towards the Union; just because I hope that this will be a wake-up call for politicians and policymakers all through Europe that what they have been doing up to now is erroneous. What the reader may ask is whether they have the common sense to admit their mistakes, which unfortunately I cannot answer now. Time will show and hopefully after that time we will still be part of a Union. Better late than never.

Change can only come from within as Protesilaos states in his latest article. Here's the part that I liked the most:

"The troika's "expertise", or in general the technocratic, "objective" knowledge of the various bureaucrats that make crucial decisions on the citizens' behalf (e.g. the preposterous proposal to have a Commissioner veto national budgets), is in effect nothing more than the facade which conceals an apocryphal desire or rather a specific strategy for the redesign of the Euro area along the lines of a corporatist-neoliberal economic system that will realize economies of scale for a selective corporate elite at the expense of suppressing the standard of living of most people across Europe; while also rendering any spontaneous entrepreneurial initiative practically unprofitable or near-impossible due to the complexity of legislation and entry criteria, which always operate as means of insulating big business from the powerful forces of real competition (neoliberalism should never be confused with genuine free markets)" 

I do not know whether there is a plan or strategy behind Troika's decisions. Nevertheless, it seems that the measures they are proposing are damaging the middle and lower class and leave the upper class unaffected. This basically means that people pay for the faults of their governments and/or banks without the latter assuming anything of the blame. Now I do not know how do you call such a regime but exploitism sounds like a good name.

Unspecified Policies

Over the history of mankind, whenever politician wanted to speak in presence of the public, their words spoke of broad generalizations on the subjects they were to address and accusations towards their political opponents. Over the centuries this kind of talking was (and is) the norm of political conversation. However, since the beginning of the 20th century, and due to the increased exposure to information mankind has obtained since then, people have started to catch up with them and demand specific answers to specific problems. Unfortunately, politicians (and policymakers as well) are yet to live up to these standards. 

There are only three possible explanations about this phenomenon: 

1. They think that by dizzying their audience with excessive verbiage will make the latter think that they know their stuff

2. They really don't have any idea about a subject and the only way not to look stupid would be to speak in broad generalizations (which would be fine as long as they only did it on a few subjects. Being excessively general means that they either No.1 or No.3 is true or hmm they have no idea about any subject at all!)

3. If they give a specific solution to a specific problem people will expect them to enforce what they propose.

Studies have shown that people respond better to politicians and policymakers who propose specific solutions to specific problems. From my point of view, being specific help people understand how the policy will affect them and even improve it by direct communication with the policymaker. This helps avoid the three I's as stated in Poor Economics: Ideology, Ignorance, Inertia. Specific policies lead to more votes for politicians and more credibility for policymakers.

It is thus not strange that Draghi-type statements ("the ECB will do everything to save the euro") are not very popular. "Do everything" does not mean anything at all. What is everything? Does it mean stand still and wait as it all breaks down? Does it mean financial aid to banks? Does it mean new plans for a Greek haircut? It could mean anything. Or it most probably means that they have no idea of what to do and just hope to boost financial markets by statements. Guess what guys: Markets (and everything else in REAL LIFE) don't go up in words, only in action.

Economists and the Real-Life Economy

Every time a crash, or a crisis or recession or any bad news in general comes up, people run to economists to "help" them "understand" what has happened. What most people fail to understand is that, about 99% of economists have no idea what is happening in the real world. The reason is simple: they are so caught up in their studying, publishing articles, using advanced mathematics and statistics to impress other economists with their knowledge that they do not actually know, let alone understand, about what goes on in the real world. 

Thus, their knowledge is purely theoretical. Even what economists call empirical work (i.e. something which actually uses observed data instead of pure mathematical theories) is in fact a manipulation of past data, under statistical tools, to reach a certain point. Very few can leave the stagnant traditional economic thinking and start to think on their own. If one remembers, in a scene of Bryan Singer's Usual Suspects, Kevin Spacey states: "The greatest trick the Devil ever pulled was convincing the world he didn't exist.". In the same context, the greatest trick economists ever pulled was convincing the world that they understood economics.

The worst outcomes of this "misunderstanding" are that:

1. Economists with no idea on how the real world operates are appointed in critical positions in the economy

2. Good economists are mistakenly thought as bad ones, a consequence of bias and prejudices (obviously, if you ask an economist whether he belongs to the 99% or the 1% of economists s/he will  always say he belongs to the 1%)

This situation is described in Esther Dulfo's and Abhijit Banerjee's book, titled Poor Economics. They talk about a situation named the 3 I's: Ideology, Ignorance, Inertia. Although the authors (which I believe deserve to be at the 1% we have talked about earlier) mostly use it in describing politics and policies in third world countries, this situation is more than evident both in the EU as well as the world economy.

People with an ideology try to promote changes or policies (either for better or for worse) and the policies seem to fail, mainly due to their ignorance on the subject, as they are watching it from a distance. The situation, does is not made better due to inertia, i.e. people's "apathy" towards a policy which in essence does nothing.

The same rationale holds for the Greek bailout: economists and policymakers decided that a haircut of 70% of the bonds' value and severe austerity measures should be great to fix the problem. Well, I guess the situation looks better and decisions are easier when its not your job, city or country on the line. Or is it now?

Conspiracy Theories and the Eurozone

I do not like conspiracy theories. To be really honest I hate them. I believe that conspiracy theorists are those kinds of people who do not want to take responsibility for their actions (or their government’s actions) and think that this is all part of a massive hidden elaborate plan devised by -insert nation here- to control/take over their homeland’s economy/natural resources or whatever. Thus, anything they will do will be futile; all they can do is blame the one "responsible" for this as they sit around and do nothing. This kind of thinking I truly, honestly hate. 

However, lately I have been thinking about one. I am not proud to say it but I have. It all started when I began thinking about what they could do instead of the large haircut on Greek debt last year. If that haircut had not taken place the only country that would have been in direct danger from Greece would have been Cyprus, due to the explosive growth of its banks there. And even Cyprus wouldn't have been so worried then. Read more here.

What I have been thinking was this: Let's assume that policymakers in Eurozone are not stupid. Let's assume that what they have been doing has some rational reason hidden behind it. What were the consequences of their actions and who would benefit from that?

The first direct consequence would have been the fall of the value of the Euro. The following graph indicates this trend for the EUR/USD pair. (Graph was made by Yahoo!Finance)

As one may observe the value of the Euro versus that of the US dollar has declined dramatically of the past year and a half. Thus, it would mean that European products are now cheaper than they were 1.5years ago. Thus, more exports. This can be seen by the following graph (made by www.tradingeconomics.com)

As we can see exports began to rise after February 2010 and continue to rise to this day. (An examination of most EU countries individually would confirm this but to be honest I am bored to upload and comment on 20 graphs! I am sure you would be bored to read one article like that too.)

Thus the only conclusion we may draw was that the EU policymakers are deliberately keeping the EUR/any other currency rate down so as to export more. Any good news about the Euro economy would have as a result an increase in the rate and thus decrease exports. Thus the conspiracy theory would be that policymakers want to flood the world with EU goods (or maybe just German goods for obvious reasons. Wolfgang are you there?) and make us rich by large trading surplus; however not now but in a few years. It's a merchants world after all!

Or, they just make bad decisions. What do you think?