Friday, May 13, 2011

Cucumber season

The Silly Season, or Cucumber Season as it is called in several European languages – the diffusion of frivolous news to compensate for the mid-summer rarefaction of real events – has begun early this year. On 6 May Der Spiegel reported that Greece Considers Exit from Euro Zone” with a view to re-introduce the Drachma, negotiating to that effect with EC and Eurozone authorities at “a secret crisis meeting in Luxembourg” that evening. The fact that the meeting was at first officially denied by Luxembourg Premier Jean-Claude Juncker, then admitted ("When it becomes serious, you have to lie"), lent credibility to the story. The euro lost 2 cents overnight with respect to the dollar.

No Exit

This non-scoop is utter nonsense, and not just because there is no provision for exiting the Eurozone other than by leaving the European Union – a drastic and traumatic step in nobody’s interest. Nor just because this would annihilate the Greek banking system (and heavily damage German and other European banks, including the ECB), or because Euros in the hands of the Greek public would continue to circulate – possibly curtailed by the amounts that the Greek public might be unable to recover from their banks (though they have already salted away €30bn abroad as a result of the crisis). Nor just because Greece would lose the financial support already committed by European institutions (half of €110bn, which have not yet been disbursed), and support lined up in the near future (there is current talk of another €60bn).

Greek exit from the euro is nonsense primarily because the re-introduction of the drachma would not allow Greece to reduce its debt denominated in euro through drachma inflation. The euro debt would rise in terms of drachma through drachma devaluation to compensate for drachma differential inflation with respect to the euro, and remain exactly the same as before the exit.

True, the possibility of drachma devaluation – beginning with the re-introduction of the national currency – might make Greece more competitive and make it prosper to the point of re-gaining solvency. But if a devaluation was 1) politically acceptable (unlikely, after 10 general strikes since the first austerity measures were introduced by the Socialist government) and 2) economically effective (in terms of import and export elasticities with respect to devaluation), the Greek government could replicate its effects via a Latvian-style domestic deflation without the additional costs and turmoil of leaving the Euro.

Which is why Greek exit from the euro is a non-starter, pace Der Spiegel’s news and Hans Werner-Sinn’s advocacy. The only other two possibilities are: a bail-out, or a default: Quartum non datur, to coin an expression.

No Bail-Out

When a debtor is solvent but illiquid, a bail-out involves temporary assistance, perhaps by European institutions on terms friendlier than those that might be offered otherwise by financial markets, with full later re-payment. But there is an increasing consensus that certainly Greece – at any rate, leaving aside the similar cases of Ireland and Portugal – is not illiquid but insolvent. The provision of additional loans to allow Greece to repay outstanding loans as they mature, at an interest rate higher than the likely growth rate of the country's GDP (taking both either in nominal or real terms) is a recipe for bankruptcy – unless there is a commitment, on the part of European institutions, to continue to provide non-repayable loans until Kingdom Come.

Paradoxically, this kind of approach appears to have a Keynesian connotation. In “Economic Possibilities for our Grandchildren” (1930) Maynard Keynes quotes approvingly a passage from a book by Lewis Carroll, 1889, [Ch. 10, The other Professor]:

“Let me remind you of the Professor in Sylvie and Bruno:”
[“Come in!”]
“Only the tailor, sir, with your little bill,” said a meek voce outside the door.
“Ah, well, I can soon settle his business,” the Professor said to the children, “if you’ll just wait a minute. How much is it, this year, my man?”
The tailor had come in while he was speaking.
“Well, it’s been a-doubling so many years, you see,” the tailor replied, a little grufy, “and I think I’d like the money now. It’s two thousand pound, it is!”
“Oh, that’s nothing!” the Professor carelessly remarked, feeling in his pocket, as if he always carried at least that amount about with him.
“But wouldn’t you like to wait just another year and make it four thousand? Just think how rich you’d be! Why, you might be a king, if you liked!”
“I don’t know as I’d care about being a king,” the man said thoughtfully. “But it dew sound a powerful sight o’ money! Well, I think I’ll wait-“
“Of course you will!” said the Professor. “There’s good sense in you, I see. Good-day to you, my man!”
“Will you ever have to pay him that four thousand pounds?” Sylvie asked as the door closed on the departing creditor.
“Never, my child!” the Professor replied emphatically. “He’ll go on doubling it till he dies. You see, it’s always worth while waiting another year to get twice as much money!”

The trouble is that this approach can hold only in Lewis Carroll’s Wonderlands, for in the real economy there simply may not exist an interest rate such as to make a creditor, or the financial market as a whole, willing to renew a mature loan in its entirety for another period – let alone another and another. The creditor is more likely to want to cash in at least some of his credit and of the accrued interest, and re-lend only the rest. Clearly Maynard Keynes was not being serious, he was only amusing himself with literary references, as he might have done in conversation with fellows and guests at High Table dinner or over Wine Room drinks.

Bail-outs as Ponzi Schemes

The nature of European bail-outs has been well understood and demonstrated in an article in the Financial Times of 5 May by Mario Blejer – former Governor of Argentina’s Central Bank and director of the Centre for Central Banking Studies at the Bank of England. Blejer likens financial support for Greece, Ireland and Portugal to a giant pyramid or a Ponzi Scheme. Ponzi paid insustainably high interest rates out of new deposits, before running away with the residual loot. European bail-outs involve the accumulation of non-sustainable interest rates without the possibility of their ever being paid together with the original loans. The principle is the same.

The bail-outs raise total debt and its share of GDP. “A case in point is the €78bn ($116bn) loan to Portugal. It is equivalent to more than 47 per cent of its gross domestic product in 2010, possibly increasing Portugal’s public debt to about 120 per cent of GDP.”

“It could be claimed that this mechanism is helping the countries involved since the official loans, although onerous, carry better conditions than the ones that need to be serviced. But the countries’ debts will increase (as a percentage of GDP the debts of Greece, Ireland, Portugal and Spain are expected to be higher by the end of 2012 than at the start of the crisis). The share of debt owed to the official sector will also increase (in addition to the bond purchases by the European Central Bank, which reportedly owns 17 per cent of these countries’ bonds with a much higher percentage held as collateral).”

“Some of the original bondholders are being paid with the official loans that also finance the remaining primary deficits. When it turns out that countries cannot meet the austerity and structural conditions imposed on them, and therefore cannot return to the voluntary market, these loans will eventually be rolled over and enhanced by eurozone members and international organisations. … “… this “public sector Ponzi scheme” is more flexible than a private one. In a private scheme, the pyramid collapses when you cannot find enough new investors willing to hand over their money so old investors can be paid. But in a public scheme such as this, the Ponzi scheme could, in theory, go on for ever. As long as it is financed with public money, the peripheral countries’ debt could continue to grow without a hypothetical limit.”

Except that there is a political limit to solvent countries’ willingness to take on the debt of those insolvent: “We are starting to observe public opposition to financing this Ponzi scheme in its current form, but it could still have quite a way to go. It is apparent that, if not forced sooner by politics, the inevitable default will only be allowed to take place when the vast part of the European distressed debt is transferred from the private to the official sector. As in a pyramid scheme, it will be the last holder of the “asset” that takes the full loss. In this case, it will be the taxpayer that foots the bill, rather than the original bondholders that made the wrong investment decisions.”

Blejer points out that the desirability of this approach depends entirely “on how one assesses the value of the time gained. Would a bank crisis now be more damaging to the European economy than a future debt write-off? Or, alternatively, is recognising reality and accepting a debt restructuring now preferable to increasing the burden on future taxpayers? At the end, it is a political decision, but it would be refreshing if things are called by their name. Euphemisms may be useful in the short run, but one finally recognises a Ponzi scheme when it persists.”

No Default?

The undesirability and ineffectiveness of exit from the Eurozone, and the Ponzi-like nature of continued assistance to insolvent sovereign debtors, leaves only one option: default – preferably consensual, negotiated with creditors rather than unilaterally declared and abrupt; in the form of lengthening debt maturity, interest rate haircuts, as well as debt reduction, but default nevertheless. There is no way “No Exit, no Bail-Outs, no Default”, or immovable objects and irresistible forces, can co-exist other than in a Wonderland.

Richard Portes (who was involved in Poland’s 1981 default) makes a powerful case for the restructuring of Ireland’s debt: “A reasonable target would be a debt reduction of €40-50 billion, in present value. That is on the order of 30% of GDP and would bring the debt ratio down to a sustainable 80% or so. The required haircuts would be in line with current market valuations of Irish sovereign debt.”… “Of course, there is a way for Ireland to escape responsibility. Just wait for Greece to restructure its debt, at which point there will be general confusion and the markets will shun Ireland anyway. Then restructure, when it will be widely accepted as unavoidable. Maybe that is the unspoken strategy. If so, there may not be long to wait.”

Martin Wolf (in his FT Column of 11 May) works out that with a debt/GDP ratio of 160%, and with very optimistic assumptions of a 6% interest rate (less than half of the current 15%, or the 25% on two-year bonds), and a 4% nominal growth rate, even to stabilize debt Greece would need to run a primary surplus (before interest payments) of 3.2%; and a 6% primary surplus would be necessary to reduce the debt/GDP ratio down to the Maastricht Treaty ceiling of 60% by 2040. “Every year, then, the Greek people would need to be cajoled and coerced into paying far more in taxes than they receive in government spending.” “What might persuade investors that this is sufficiently likely to justify funding Greece? Nothing I can imagine. But remember that 6 per cent would be a spread of less than 3 percentage points over German bunds. The default risk does not need to be very high to make this extremely unappealing.”

Wolf recommends “a pre-emptive restructuring of the debt, perhaps next year. Since market prices tell us that this is what investors expect, it should not come as a shock to them. A restructuring ought to raise the country’s creditworthiness and increase the incentives to sustain a programme of stabilisation and reform. Moreover, with a planned, pre-emptive restructuring the authorities could also prepare the needed support for banks, both inside Greece and outside it.” “Overindebted countries with their own currencies inflate. But countries that borrow in foreign currencies default. By joining the eurozone, members have moved from the former state to the latter. If restructuring is ruled out, members must both finance and police one another. More precisely, the bigger and the stronger will finance and police the smaller and the weaker.”

What used to be isolated voices contemplating default are turning into an increasing chorus. “A Reuters poll finds that investors and economists believe Greece will have to restructure its sovereign debt, with 14 out of 15 fund managers and 26 out of 28 economists polled. Opinions are more divided when it comes to the timing. Half of these economists and a third of the fund managers believe it will happen after April 2012. From those 11 economists and 8 fund managers believe restructuring will happen through haircuts, while a majority believes it will happen through extending maturity and lowering interest rates.” (, 13 May). “FT Alphaville picked up on a paper by Barclays Capital, which looked at the haircut needed by Greece to achieve a primary balance - which is 67% in 2012 – based on a primary balance of minus 2.5% this year. It goes into a great detail about recovery values to conclude that the situation is really messy.” (Ibidem).

The most vocal opposition to any talk of default comes from Lorenzo Bini Smaghi, at present a member of the ECB Executive Board. Bini Smaghi’s solution of the sovereign debt crisis is the issue of European sovereign bonds, that would compete with US Treasury Bonds, lowering interest rates and financing the bail-outs. It is immensely naïve to believe that a EU institution, backed by a tiny budget of just over 1% of EU GDP and a built-in zero primary surplus might successfully compete with the US Treasury, with a tax revenue of over 35% of GDP out of which it is conceivable that a primary surplus sooner or later might be sufficiently high to service its debt.

With Mario Draghi’s coming appointment as ECB President, after Angela Merkel’s endorsement, Bini Smaghi is expected to have to leave his ECB post to make room for a Frenchman, and was considered to be in a strong position for a bid to succeed Draghi as Governor of the Bank of Italy. But other frontrunners for the post, Vittorio Grilli (Director General of the Italian Treasury and the president of the EU’s economic and financial committee), Fabrizio Saccomanni (the Director General of the Bank of Italy) and Ignazio Visco (his deputy), are less committed to Bini Smaghi’s agenda. Certainly Draghi has already stated firmly that there can be no European sovereign bond ahead of Fiscal Union. Maybe he will also be more open to orderly but unmitigated defaults, before the sovereign debt crisis becomes unmanageable.


Lapo said...

"In an opinion piece in today’s [13 April] Financial Times, Mr Bini Smaghi said Ireland’s taxpayers should foot the bill as they are the ones that benefited during the pre-crisis boom years and elected the governments that regulated the banks as the problems built."

See: "They call him Lorenzo Bin Smughi".

D. Mario Nuti said...

Bini Smaghi actually wrote:

"The principle of 'no taxation without representation' should work both ways. If taxpayers have the right to share in decision-making, they must also accept the consequences".

"As long as the accountability of supervisors to taxpayers is primarily a national affair ... then there is a high risk that taxpayers will foot most of the bill. They should not complain when it actually happens."

Tough on the Irish, who naturally did not like him for this.

However, he also recognised that, while in theory shareholders, managers and bondholders should bear the costs of a bank being restructured, in an open system like the euro zone such problems could pose systemic risks. Pure national regulation was flawed and in future needed to be steered at a euro zone level or wider. Which was a fairer statement though it somewhat contradicted the first two propositions.

Bird said...

So, what are the precise conditions for sovereign debt to be sustainable?

D. Mario Nuti said...

“The arithmetic of public debt dynamics is simple but inexorable.” (Willem Buiter on debt sustainability:

Buiter defines public debt as the net non-monetary debt of the augmented general government (the consolidated general government and central bank). If s is the augmented general government primary (non-interest) surplus as a share of GDP, r the effective real interest rate on the public debt, g the growth rate of real GDP, and d the public debt to GDP ratio at the beginning of a period then, letting Dd denote the ‘change in’ the public debt to GDP ratio the end and the beginning of a period, it follows that the change in the ratio of public debt to GDP is given by:

Dd= -s+ d(r-g)/(1+g)

So to keep the ratio of net public debt to GDP constant, the augmented general government’s primary surplus as a share of GDP has to satisfy:

s >= d(r-g)/(1+g).

If we replace current rates s, r and g with their long run effective equivalents we can interpret the same relationship as a solvency condition for sovereign debt.

In turn, the primary surplus of the augmented general government (as a share of GDP) is made up of taxes , minus public spending, plus seignorage (the real value of new monetary issues) all taken as a share of GDP.

But Buiter reminds us that: “Higher taxes are distortionary, costly to extract and politically unpopular. Lower public spending is politically unpopular and can hurt growth when public spending cuts fall on productive infrastructure spending and essential ‘intermediate’ public administration goods and services. In addition to these adverse supply side and distributional effects of fiscal tightening, fiscal tightening will weaken effective demand through the usual Keynesian channels. Attempts to raise seigniorage revenue will, sooner or later result in higher inflation which is distortionary and politically unpopular. Empirically, the demand for real base money balances takes a form that is consistent with the existence of a long-run seigniorage Laffer curve: real seigniorage revenues first increase but ultimately peak and decline as the rate of inflation rises."

"All this supports the view that there is, in any polity, an upper limit on the size of the permanent primary surplus that can be supported.” If fiscal consolidation requires a primary surplus higher than this upper limit, determined by political, cultural and social conditions, sovereign bankruptcy is unavoidable.

For a broader and deeper analysis we refer to Buiter’s paper, and to James K Galbraight’s “Is the federal debt unsustainable?”

Carmen said...

default is definitively the option now. But they -we- should consider euro exit soon...

D. Mario Nuti said...

Exit from the euro would raise the value of euro debt in domestic currency, in absolute terms and as a debt/GDP share, and interest rates in domestic currency, to such an inordinate extent that it would be followed by instant default. Therefore euro exit cannot possibly be an alternative to default.

Default is the alternative to never-ending cumulative bail-outs of insolvent sovereign debtors.

Carmen said...

Sure. This is why I said default NOW, euro exit SOON - i.e. at some point in a not too distant future.

D. Mario Nuti said...

But, Carmen, once you have defaulted, and reduced debt to a level now sustainable, why would you want to exit from the eurozone?

so as not to be tied by the so-called Growth and Stability Pact (such a terrible euphemism)? or in order to be able to devalue the domestic currency? or to re-instate monetary policy (though, remember, national central banks are supposed to be independent in the EU)? or to be able to default again at will?

Carmen said...

All the reasons you give, and a few more. You said it: "The ultimate source of euro vulnerability is its premature birth".

A monetary union without real convergence is too costly for the poorer member states (Mundell). The only adjustment mechanism is through labour markets. Speculation cannot attack individual countries other than through their sovereign debt.

Greece may or may not be able to meet its debt obligations, but will be ruined either way. It is much better to be out of the euro.

Frank said...

There has been talk of "re-profiling" sovereign debt of peripheral EMU members. Is this a feasible alternative?

D. Mario Nuti said...

“Re-profiling” and “soft re-structuring” – as opposed to “major restructuring” – are fairly new euphemisms for the offer to replace short-dated maturities with longer-term maturities.

“The rating agencies will without a doubt treat [such] a voluntary exchange offer as a default – and this will essentially wipe Greece off the map of the financial markets. Even though a voluntary exchange offer does not trigger CDS payments, this is still an extreme credit event” (today’s, attributing the neo-logism to Jean-Claude Junker).

Reuters quotes “an investor who said he had never heard of this word before, except in the context of a nose job” (ibidem).

D. Mario Nuti said...

More on "re-profiling" and "soft re-structuring" of (Greek) sovereign debt, from today's

"The FT reports that Jean-Claude Trichet walked out of a recent meeting chaired by Jean-Claude Juncker in protest at Juncker’s proposals to reprofile Greek debt.

FT Deutschland reports this morning that Trichet told finance ministers on Monday night that the ECB would respond to a reprofiling by refusing to buy any new Greek debt instruments (meaning it will not be part of any voluntary arrangement in respect of its own Greek debt portfolio).

Furthermore, the ECB would refuse to supply the Greek banking system with any further liquidity. (This is something we suspected would happen. A reprofiling would be considered by the rating agencies as a default, which would lead to an instant downgrading of all Greek securities, government and banks, to C, which would make them no longer acceptable to the ECB.) This means that the ECB will effectively boycott Juncker’s silly plan. That, in turn, would force Greece to quit the eurozone within days.

Other ECB executive board members also went nuclear on this issue..."

D. Mario Nuti said...

This post turned out to be more prophetic than anybody might have anticipated. See Der Spiegel Online. 06/03/2011:

Cucumber Warning 'Remains as Valid as Before'
The Spanish government is demanding compensation for its vegetable farmers after a German warning that cucumbers were the cause of the E.
coli outbreak proved to be false. German newspapers are divided over
whether the early warning against Spanish cucumbers was an appropriate