Guide to the Eurozone crisis

By Ajay Shah, on November 18th, 2011

How did it happen?

The worst financial crisis in the western world for nearly 80 years broke in September 2008.

It required banking/financial systems to be supported and recapitalised by governments across the EU and in the US.

In June 2009 it became apparent that the peripheral countries of the Eurozone (Greece, Portugal, Spain and Ireland) were grossly over-indebted.

Yet in some instances (Spain) their public debt to GDP ratios happened to be lower than those of the US, France, the UK and Germany.

The continued viability of their public finances depended entirely on markets being willing to refinance them with cheap money.

But, when markets scrutinised the sustainability of their fiscal positions, they baulked from refinancing except at punitive rates.

CDS spreads (against Germany as a benchmark) of peripheral Eurozone countries (PIGS or Club Med) debt began widening relentlessly.

Global financial markets began to price in an escalating risk of partial/full voluntary/involuntary default on PIGS bonds since December 2009.

Contrary to first impressions, except for Ireland, that was a result not just of the financial crisis and bank recapitalisation demands on the fiscus.

It became apparent instead that bank recapitalisation demands on public finance were only the last straws that broke the camel’s back.

Greece, Portugal, Spain and Italy, as a direct consequence of joining the Eurozone, had been running up unsustainable fiscal deficits since 2000.

Ireland had not. It suffered because the bailout of its disproportionately large banking system caused its public debt to rise astronomically.

PIGS became over-indebted despite the supposed self-imposed discipline adopted by the Eurozone of prohibiting fiscal deficits >3% of GDP.

That discipline was violated by almost all Eurozone members, beginning with France and Germany, but more egregiously by the PIGS.

To make matters worse, however, the PIGS were also running increasingly large current account deficits (with Germany, France, China).

Though countries like France (and to a lesser extent) Germany were fiscal sinners, they were at least running current account surpluses.

PIGS had access to excessively cheap public and private money available on terms totally inappropriate to their economic circumstances.

Given their inherent risks, which markets mispriced completely, their borrowing costs should have been 300-500 bp higher than Germany’s.

Instead, they were virtually the same for nearly a decade. That relieved market-induced pressure on PIGS’ governments to behave responsibly.

Consequently, their public expenditures after 2000 ballooned out of all proportion to their intrinsic capacity to fund them from tax revenues.

Such expenditures became almost wholly dependent on access to increasing amounts of cheap public borrowing from capital markets.

In response to access to excessively cheap money, wages in the PIGS rose across the board as did growth in public sector employment.

With the financial crisis triggering bank recapitalisation needs, on top of this unsustainable structure, the edifice began to crumble.

The first early warning signals became apparent in December 2009 but the dam broke in mid-2010 with the first Greek bailout.

How has the Eurozone crisis been handled?

Extremely ineptly; indeed very foolishly, by sophisticated Eurozone authorities (political, fiscal and monetary) that should have known better.

Eurozone leaders learned nothing from the preceding debt crises in Latin America (1982-87, 1994-95) and Asia (1997-2000).

They went through avoidable phases of serial denial that there was a structural debt (solvency) crisis that could spread via contagion.

They treated it as a liquidity crisis that could be dealt with by temporary patch-ups of additional money combined with fiscal restraint.

They reiterated their commitment to ensuring there would be no default – partial or full, voluntary or involuntary – by any Eurozone member.

They believed that their remedial measures would stop the crisis from ballooning beyond the first bailout package for Greece.

They were totally wrong. That package did nothing to convince markets that Eurozone leaders understood the nature/severity of the problem.

In fact, the inadequacy of that first bailout package — which did not provide enough money for sufficiently long – became quickly apparent.

Eurozone leaders were fixated on debt-affected PIGS being forced to live within their means through indefinite austerity without end.

Debt recovery/sustainability models did not provide sufficient new money, or permit debt restructuring, in ways that would restore stability.

Least of all were bailout packages designed to restore growth in a conscionable period of time that would be socially/politically acceptable.

Without financial system (and borrowing cost) stability, and absent growth, debt problems can never become better. They can only worsen.

Instead, as a result of poor design, all the bailouts did (except for Ireland) was to add new debt to bad debt and reduce growth prospects.

To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of GDP and the debt service ratio about 11% of GDP.

But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP and the debt service ratio nearly 20% of GDP.

It is projected with the third bailout to rise to 185% of GDP (although debt service will be lowered to 16%) before it comes down again.

In the meantime, over the last 32 months, the Greek economy has shrunk in size by almost 17% in nominal terms. It will be 1/5 th less in 2012.

Such inane ‘remedies’ do not solve debt problems. They only aggravate and exacerbate them.

While behaving in this absurd fashion Eurozone leaders repeatedly asserted for two years that they would do everything in their power to:

  • Maintain the credibility of the Euro while ensuring that every member stayed in the Eurozone
  • Not allow any default of publicly issued bonds to occur; and
  • Do everything possible to avoid contagion spreading beyond PIGS (even as it became clear that markets were worried about Italy.

Instead they achieved the exact opposite of all three objectives through their inability to understand the implications of what they were doing.

Though now contrite and claiming to have learnt a few lessons from their serial bungling over 30 months Eurozone leaders have no solution.

The EFSF facility they created is woefully underfunded. It can barely deal with financing the third Greek bailout.

The idea of leveraging it or using it as a partial guarantee facility is absurd since it would add to risk and uncertainty not resolve them.

Yet over-indebted governments (including France and Germany) would have to issue more public debt in order to fund the EFSF properly.

That would simply mean requiring their fragile, near-bankrupt, banking systems (or the ECB) or global markets to buy more Eurozone debt.

Except for Germany (and even that will be in doubt soon) the market has no appetite for taking on more Eurozone debt given its risks.

Contagion has spread from the periphery and now lodges at the core of the Eurozone economy in which Italy is the third largest member.

What could have been resolved with about 300 billion euro in additional financing in mid-2010 is now a problem that may require 2 trillion euro.

Where are we now?

Over 35 EU/Eurozone summits in 30 months have resolved nothing. They have made matters worse; despite Herculean exertions!

Right now Greece is in ‘effective’ default; though markets are overlooking that because of the implications of CDS contracts being triggered.

Its borrowing costs for refinancing its debt would exceed 30% if it had any access to private markets; which it does not.

Any refinancing of, or addition to, Greek debt can now only be financed by the ECB; which the Germans will not permit the ECB to do.

Meanwhile the Greek banking system is bankrupt. Indeed the entire Eurozone banking system’s credibility/stability/solvency is in doubt.

Today an outstanding portfolio of about 11-12 trillion euro in Eurozone debt – of which about 80% is held by EU firms – is souring relentlessly.

About 7 trillion euro of that portfolio is sufficiently affected by contagion to require provisioning (France and Belgium may soon be added).

About 5 trillion euro of Eurozone high-risk-debt is currently held by EU banks, insurance companies, pension funds and individuals.

That sovereign debt, which is supposed to constitute the ’safest’ component of any asset portfolio, now constitutes perhaps the riskiest element.

That reality inverts the whole basis of banking/financial system soundness and stability across Europe (including the UK).

It compounds the problem of calculating capital adequacy requirements for these banking systems and puts regulators in a quandary.

Ireland’s bailout programme is working but could be derailed by what is happening in the rest of Europe.

Portugal’s programme is not working as intended. But nobody is talking about it because it pales in comparison with Italy and Greece.

Italy’s outstanding public debt will soon cross 2 trillion euro (120% of GDP) and its debt service payments amount to around 300 billion euro per year.

That is made up of about 120 billion euro in interest payments and 180 billion euro in principal repayments. Average duration is 5 years.

Public debt service in Italy now amounts to around 17% of GDP and will rise to 20% unless Italy’s debt is dramatically restructured.

Italy now needs to borrow about 40 billion a month euro (gross) and about 28 billion euro a month net in private markets to refinance its debt.

The world is holding its breath with every auction of Italian public debt (3-8 billion euro per week) any of which could trigger accidental default.

The cost of refinancing Italy’s public debt has risen from around 4% a year ago to around 7% now. That adds 20 billion euro a year to
its debt.

Meantime the Italian economy is flat-lining and its capacity to service additional debt is diminishing despite its running a primary balance.

Banks around the world are dumping their holdings of Italian public debt but there is no buyer other than the ECB because of the risk.

The ECB’s capacity to refinance Greek, Italian and Portuguese debt is limited and constrained by Germany’s unwillingness to consider
that.

Contagion from Italy is now beginning to affect Spain and France which is supposed to be a bulwark for the EFSF’s borrowing capacity.

The resulting gridlock is pushing the entire Eurozone system toward a catastrophic denouement with a binary outcome. Either:

  1. Crisis-induced progress toward fiscal union with national sovereign bonds being replaced by a single Eurozone bond with a joint/several guarantee, or
  2. Sudden disorderly collapse of the Eurozone with unimaginable fallout and consequences that would trigger a global double-dip
    recession.

Such a recession would last for a minimum of 2-3 years and would probably be quickly followed by a similar debt crisis in the US.

The resulting fallout of disorderly Eurozone break-up could trigger a break-up or restructuring of the larger EU as well.

So where do we go from here?

With the foregoing in mind it seems absurd that the world is waiting with bated breath to see what the new technocratic governments
in Greece (Papademos) and Italy (Monti) will actually achieve by way of structural reform and increased debt servicing capability in coming months.

These technocratic governments inject new credibility but lack political and social legitimacy. They have been appointed not elected.

It remains to be seen how long their technocratic legitimacy holds out without the backing of gradually earned political/social legitimacy.

The risk is that if the ministrations of these technocratic governments (which their societies believe have been imposed on them
from the EU above) do not work and bear fruit relatively soon (the probability is that they won’t), public patience with them will melt.

Will they be able to convince electorates to accept the inevitability of austerity without growth for the indefinite future?

The next Greek crisis is perhaps 10-12 weeks away.

The next Italian crisis could be triggered by any one of the upcoming weekly auctions of Italian government debt.

Despite these rather obvious realities, global markets deem to be reacting in dream-like hope and optimism that all will be well.

There is of course a solution at hand; and the only one that will work because all the other options seem to have been exhausted.

That option requires Germany to reconsider its refusal to bear its large share of the fiscal burden that will come with Eurozone fiscal
union.

It requires political/social willingness on the part of rich northern Eurozone members to finance fiscal transfers to poorer
southern members through an exponential expansion of structural funds, currently applied to help develop more rapidly the poorer regions of the EU.

Reciprocally, it requires other Eurozone countries to relinquish fiscal, and a great deal of political, sovereignty immediately; in
order to assure global markets of their commitment to structural reform, restoration of competitiveness, and relentless pursuit of fiscal/monetary discipline.

It requires all unwanted national sovereign bonds of Eurozone members to be replaced by a single Eurobond that is jointly and
severally guaranteed and underpinned by the weight and ability of the ECB behind it to print money if necessary to ensure that such bonds are honoured.

This solution would resolve both the over-indebtness problem of the Eurozone and the problem of banking system collapse at a single stroke.

If it were adopted the need to provide for risky Eurozone debt and recapitalise (yet again) the EU banking system would disappear.

Yet, this is the one solution that keeps being discarded because of legitimate German constitutional, judicial and political constraints.

They inhibit movement in such a direction regardless of the consequences for the Eurozone, the EU, and mostly Germany itself.

It is like witnessing a repeat of 1939; not of conquest but of mindless destruction. But, this time with money rather than tanks being involved.

If that only workable solution continues to be discarded, the other possibility that will manifest itself is the disorderly break-up of
the Eurozone; simply because its orderly break-up defies contemplation and imagination.

Talk of Greece being ejected from the Eurozone, or of Germany departing from it voluntarily, is fanciful simply because neither can
afford to bear the costs of the consequences that will follow, regardless of what their populations and political leaders may believe
or think (though ‘thought’ seems to be conspicuously absent from the process just now). Neither can their neighbours, regardless of what they may think.

Yet it is not unimaginable that a break-up will be forced on Eurozone members by global markets if the only workable solution
continues to be ruled out as it seems to be repeatedly by the German Chancellor. But she has changed her mind so often the hope is she will yet again.

A disorderly break-up may result in a reversion to national currencies; which would be better than members trying to retain some
semblance of the Euro through separate residual monetary unions of more compatible economies.

That would probably require four different Euros (for the super-efficient Northern economies a Baltic Euro, for the relatively efficient middling economies a Franco-Euro; for the newly acceding countries an Eastern-Euro and for the inefficient, uncompetitive Club-Med economies, a PIGS-Euro). Other than the first, none of the others would be credible for holding as reserves, or for trading significantly in global currency markets.

Finally, bear in mind that we have spoken of only the public debt problem in the Eurozone.

Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt problem will be accompanied by an unresolved private debt problem throughout the Eurozone of equally monumental proportions! That really will break the system and the banks!



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Crunchtime in the Eurozone

By Claus Vistesen, on August 12th, 2011

I am handing the mike to my good friend and colleague Edward Hugh who has penned what I consider to be the most accurate analyses to date of the issues facing the European continent.

With fiscal union off the table, there are basically three possibilities. The first is to stay more or less where we are, expanding the ECB’s bond-purchasing program and simply trying to hang in there. The stability fund could be increased, but the more numbers start being accounted for in detail, the further away the various parties get from being able to agree. If this continues, the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, because the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totaling about 660 billion euros, and given the financing needs of the banks on top of this figure, reaching agreement to expand the bailout mechanism looks pretty improbable, especially when one considers that there’s no turning back once it starts. So, at some point, the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed toward the brink of breakdown.

The second possibility would be to disband the union entirely, leaving each member to go back to its national currency. This would be a disastrous outcome for all concerned and for the global financial system. Coordinating the unwinding of cross-country counterliabilities would be a nightmare given the level of interlocking corporate and sovereign bond markets. The sudden disappearance of one of the major global currencies of reference would also cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is happening to gold, the Swiss franc, and the Japanese yen to catch a glimpse of what would be in store. Of course, this kind of violent unwinding would never be undertaken voluntarily, but that doesn’t mean that it is impossible — particularly if solutions are not found and the force of market pressure continues.

Fortunately there is a third alternative: The eurozone could be split in two, creating two separate (and unequal) euro currencies. Naturally, the composition of the groups would be a matter of negotiation because some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, the Netherlands, and Austria. It might even take Estonia, which has been making it pretty clear that it would also be up for the ride. Spain, Italy, and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

Go read!



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Random Shots - All Back to Square One?

By Claus Vistesen, on August 4th, 2011

Starting a new job and settling in a new city/flat has proved a little more unsettling for my blogging efforts than I had expected. Anyway, what better time to return to the fray when the SP500 completes its worst run in a long time returning to levels not last seen since March where we thought we had to write off the entire Japanese economy as a nuclear wasteland. So, is it all back to square one for the already weak recovery?

Arguably though the catalyst this time is more sinister in that it cannot really be pinned on any single event. Surely, the debt ceiling charade and the prospects of Spain and Italy spiralling further into the arms of what ever bailout that might be on offer are catalysts in themselves, but the underlying economic data is getting increasingly sour.

All the leading data we are looking at, both in terms of the global breadth of economic momentum and specifically on the US economy have rolled over in a dangerous fashion and a recession in the US cannot be entirely ruled out. Indeed, on some measures we would even be calling one. Elsewhere, the slump in the July Australian PMI also suggests that one of the hitherto strongest economies in the global recovery may be about to embark on its own homegrown downturn.

It was also interesting to see the SNB finally cave in (yet again) to the relentless rise of the CHF despite the bank’s efforts both communicative and with hard money to starve off the beast. As I have remarked before, safe haven flows hurts and can be akin to holding Old Maid. Indeed, it may turn interest rate decisions on their head as rates will be lowered going into a melt up of economic activity to attempt to deter speculative inflows.

Generally, one of the most obvious consequences of the recent bout of weakness will be that more stimulus is in the pipeline, at least in the US economy whereas the ECB will probably need a little time before the reality dawns on them. However, the underlying inflection point between an economic recovery that is clearly turning out much weaker than expected and the reality of too much debt is starting to hurt. In that vein, it is difficult to see a viable way out of the obvious need to cut spending and reign in excessive public spending with the simple fact that what has largely driven GDP in the recovery has been government consumption and investment.

We can consequently expect that the Krugmans of the world to get another big chunk of the discourse as the call for further and bolder stimulus packages increases. In this respect, the Squid had nice note out on Monday on the possible avenues a new round of QE would take where the main message seems to be that the Fed will try to further cement its position of low rates for an extended period. But more interestingly is the widespread expectation that if the Fed engages in further asset purchases it will be on the long end of treasury curve and thus to flatten the curve on the long end. Surely, this makes sense in so far as goes the idea that the housing market remains in an extremely poor condition. Mortgage rates are thus likely to be driven more by long term rates than rates on the short end or at the middle. Coupled with outright targeted asset purchases of MBS using the proceeds from its securities portfolio the Fed would be signalling that the size of its balance sheet will remain inact.

Sufficient on to the day and all that but with the current sinister backdrop of market currents and poor economic data we can expect Bernanke to step up any time now.

It has occured to me here that what we might be facing in the developed world is a mirror image of the situation in the emerging world and that the combination is not the best of mixtures for the global economy.

Consider then the situation e.g. in India where the RBI is trying frantically to weigh against excessive government spending not to mention China where you get the distinct feeling that at least some part of the inflation problem comes from the central authorities’ credit policies (or lack of tight standards). Conversely, in the developed world austerity is the name of the game quite simply out of necessity and faced with extremely fragile economies it is largely up to the central banks to attempt giving the economy some tailwind. On a personal note, this is also why I consider the ECB’s recent hiking campaign as the biggest policy failure since, well, they raised just before a recession the last time. The very best we can hope for in Europe is then not a recovery but simply that we might end up back at square one.



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The Welfare State and the Future of the Eurozone

By Rok Spruk, on May 13th, 2010

The $140 billion rescue package to Greece is a milestone in the European Monetary Union. A lively debate on recent macroeconomic imbalances in the weakest economies of the Euroarea – Greece, Italy, Spain and Portugal – in the Eurozone has reopened the old debate on whether the Eurozone is an optimum currency areas (here, here, here and here). The idea of optimum currency areas was first proposed by Nobel-winning economist Robert Mundell. In general, if several countries form a currency union, they should have at least four common macroeconomic features as essential framework of the currency union. In this article, I’ll review the labor market criteria and fiscal adjustment criteria in the light of a recent imbalances in the Euroarea, and leave production diversification and export criteria for future discussion.

First, there should be a high degree of labor mobility between countries in the currency union. The basic idea behind the labor mobility criteria is that the lack of labor mobility triggers divergence of productivity growth rates and asymmetric adjustment of wages. If inter-country productivity divergence persists, there is an upward pressure on wages adjustment given the lack of exchange rate adjustment since the countries share a common monetary policy. The formation of the currency union in the United States was relatively straightforward given the fact that labor mobility between the states is very high. In Europe, the level of labor mobility is relatively low. The lack of labor mobility has a lot to do with labor market institutions in European countries. Workers from the European periphery can hardly move to Germany, Netherlands or Denmark as they do not speak the same language. The lack of inter-country mobility resulted in significant wage premiums and rise in rents since European labor markets share a pretty high degree of monopoly power since European workers can’t switch easily between labor market structure. The resulting outcome of the lack of labor market competition was a significant “union capture” of the labor market, leading to rigid wage determination and high market switching costs.

Paul Krugman recently argued (link) that the major problem behind the European Monetary Union is the lack of common fiscal policy. To a very large extent, the absence of common fiscal policy seriously affects the future prospects of the European Monetary Union. Common fiscal policy could easily absorb asymmetric shocks withing the Euroarea. However, instituting the policy could not alter the trade-off between fiscal autonomy and asymmetric shock intensity. In other words, the main problem of the Euroarea right now is the free-riding of Eurozone’s most problematic countries on a common monetary policy using disrectionary fiscal policy. Before the economic crisis, Spain had a budget deficit while, at the moment, the 2010 budget deficit forecast is more than 8 percent of the GDP. The estimate Greece’s balooning public debt in 2009 ranges from 110 to 115 percent, depending on the consensus forecast. If the EMU countries unified a fiscal policy, the countries would not have an incentive to free-ride on discretionary fiscal policy and further increase the stock of public debt. The major impediment on the recovery and long-term economic outlook of Eurozone countries is largely dependent on how these countries will reform the pension systems in the light of a growing old-age dependence and a near fiscal insolvency of the pay-as-you-go (PAYG) pension schemes. It will be impossible to reverse the aging population and its persistent pressure on an increasing public debt. The integration of fiscal policy would require a sizeable harmonization of taxes given high costs of coordination and sufficient incentives for moral hazard. Without the reversion of long-term public debt pressure from aging, discretionary spending and entitlements, countries such as Greece, Spain and Portugal would leave the Eurozone.



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The European Bay of “PIIGS”

By Rok Spruk, on April 7th, 2010

The Economist published a fascinating overview (link) of the macroeconomic indicators in Europe’s most vulnerable economies in the current debt crisis (Portugal, Italy, Ireland, Greece, Spain).



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Drawing the Right Lessons From an Obscure Tale of Obscure Interest rate Swaps

By Claus Vistesen, on February 19th, 2010

The Eurozone’s current problems are not mainly a result a of prolifigate and reckless spending of government resources in the Eurozone periphery [1]. Even nobel laureate Paul Krugman has begun to forcefully push this argument arguing that the real source of the malaise is the steady build up internal Eurozone imbalances. I only conditionally agree. As I have argued on several occasions, the key to understand the current situation in the Eurozone is to see the connection between the obvious inflection point reached in the context of the public debt/deficit and the need to correct through an internal devaluation (relative price deflation). The main point is then to recognize that the while the former is definitely a prerequisite for the latter, the process itself (deflation) will only serve to intensify the short term and long term pressure on public finances.

Moreover, the recent flurry in the context of interest rate swaps used by the Eurozone (and other) governments to generate current assets for future liabilites in an effort to massage public deficits only serves to add a further layer of confusion and uncertainty to the fiscal aspect of the situation. More generally, and ever since the inception of EMU the growth and stability pact  (SGP) has been critisized for being an ineffective tool to police the need for fiscal soundness in the Eurozone member countries. The re-emerging discussion on on the use of interest rates swaps and other financial instruments by Eurozone member countries only further serves to emphasize this critique. Interestingly and despite the rather massive coverage, many financial market pundits have emphasized this as a non-event because the use of such techniques are not new [2]. I respectfully disagree that this is the main point here even if I agree that the there is no reason, in particular, to point the guns at Goldman Sachs [3] either.

In this way, I think this is in fact quite significant, and I am a bit surprised to see that no-one (bar my regular complice) seems to be getting the main drift here. This is consequently not a question of creative accounting by part of Eurozone debt management offices, but simply a question of drastically poor balance sheet management. Thus, one wonders where we would have been today if these people had actually studied the nature of assets and liabilities of the institutions (i.e. (macro)economies) they were employed to safeguard and how it is affected by things such as a population ageing and the demographic transition rather than studying more or less exotic financial instruments (click on picture for better viewing).

Oh well and before I turn completely Neanderthal on you I am obviously being unfair here. There is nothing wrong with an interest rate swap itself and anyone with even a basic economic intuition can see the clever and sound proposition offered by an interest rate swap in the context of debt issued in foreign currency while your liabilities, obviously, remain in domestic denomination. This would be good balance sheet management then.

What transforms it into poor debt management and essentially poor governance is when those same currency swaps are entered at an exchange rate which is unfavorable to the private market counterparty. The immediate effect is to create a lump sum transfer of funds to the issuer of the underlying debt (e.g. Greece). This is then used to bring down the running deficit or the public debt for the purpose of reducing interest rates. However, it also creates a future liability not recorded in the balance sheet. Felix Salmon provides the best no-nonsense explanation I have seen so far;

How might a deal like this work? Let’s say that Greece issues a bond for $10 billion, which it would then normally swap into euros at the prevailing interest rate, getting $10 billion worth of euros up front. In this case, it seems, the swap was tweaked so that Greece got $11 billion worth of euros up front — and, of course, has to pay just as many euros back when the bond matures. Essentially, it has borrowed $11 billion rather than $10 billion. But for the purposes of Greece’s official debt statistics, it has borrowed only $10 billion: the extra $1 billion is hidden in the swap.

So, why might this be a problem then? Well for a whole host of reasons, but I can think of one in particular.

Essentially, the future liabilities (and assets) of the state finances of Greece, Italy and all other sovereign states ultimately hinges on the demographic transition. At least, this is the case in developed economies where societal structure is largely built upon intergenerational contracts and various forms of pay-go pension and health systems. In this way, trading liabilities into the future for a short term cash flow concretely helps to undermine already eroded public finances. But it gets worse. It creates a mismatch on the balance sheet of the government which is effectively hidden from the market and other stakeholders. More worryingly is then the fact that while these swaps imply long term lump sum liabilities such liabilities can easily be discounted to the present and in the current context with bond vigilanted at large fixing their gaze on the Eurozone sovereigns, long term liabilites may soon turn into current ones if push comes to shove (i.e. this is then what the Titlos affair is all about). This naturally directly undermines whatever credibility the SGP had left, but it also effectively adds uncertainty to a situation which is already beyond difficult for the EU and the Eurozone to handle.

Now, at this point all this is obviously water under the bridge and what is really left now is to slowly but surely try to figure out the extent of the liabilities Eurozone governments have swept under the carpet. As noted, the maturity structure on such instruments mean that while they are not set to payment in the immediate future the implied future liability and its effect on the current stalwart attempts to breathe life back into these economies is likely to make all those neat recovery plans drafted so far worth next to nothing. I would hold this to be particularly true in light of the obvious fact that this is not only something done on the sovereign level, but also on lower levels of governance. It will be interesting indeed to see whether the bond vigilantes will draw the final gasp on this one.

The Right Lesson

At the end of the day the issue of interest rate swaps and other derivatives used by public entities to hide and mask debt is likely going to pass over quickly exactly because it is, as the current choir sings, not news. I understand this dynamic of the market discourse. However, this should not deter a simple macroeconomist from drawing out a longer line of thought.

In this way, I believe that if the Eurozone is going to have a credible future on the back of this mess, it must be equipped with institutions that adamantly establishes a much tighter fiscal coordination mechanism among its member economies. The flurry described above only serves to accentuate this furhter. The SGP should thus be relegated to the eternal dust bin of poor institutional setup where it deserves to be

The idea of a common monetary union was always flawed in a number of ways, but there is also a way forward. Yet, it requires I believe a much more transparent fiscal supranational body to complement the single monetary policy wielded in Frankfurt. Naturally, this will not solve any of the looming problems in the context of how to get and sustain growth faced with a demographic transition locked in towards very rapid ageing. However, it may provide a sound institutional setup on which to start building a future more solid economic edifice.

Many will recoil in horror from this blatant political and Eurofederalist argument. Let them recoil I say, but as an economist I see no other alternative. And that, contrary to blaming Goldman Sachs or emphasizing the fact that it is not news, is exactly the right lesson to draw from an obscure tale of obscure interest rate swaps.

—

[1] – Someone please look at the future liabilities of Germany!

[2] – See an original source here, this from FT Alphaville, as well as this which is the original academic piece detailing the issue in an Italian context.

[3] – Who has been under much scrutiny by part of the Eurozone finance ministers in the context of a particular swap arranged with Greece back in February 2009 under the notional name of Titlos PLC (all this is very wonkish!).

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The Euro Crisis

By Rok Spruk, on February 17th, 2010

Paul Krugman has blogged an interesting analysis of the anatomy of the recent economic crisis in Europe (link).

Europe’s difficult macroeconomic situation in the aftermath of the financial and economic crisis has exacerbated rising fiscal deficits and public debt alongside strong deflationary pressures. These pressures were triggered by the highly negative output gap – the difference between the economy’s potential output and the real output. In fact, a brief observation of the output gap estimates (link) shows that the sick men of Europe (Portugal, Greece, Spain, Italy, Slovenia) are likely to face negative output gaps. In 2010, Spain is likely to reach -2.12 percent output gap. Slovenia, Italy and Greece will also face a negative output gap. The negative output gap triggered strong deflationary pressures since the nominal aggregate demand is insufficient, causing a decreasing price level.

Before the financial and economic crisis of 2008/2009 evolved, Europe’s peripheral economies faced strong asset price bubble. As real estate prices were soaring, these economies attracted significant capital inflows which lead to inflationary pressures. Before the crisis, the inflationary dynamics in the peripheral countries of the Eurozone were strong. In Greece, Spain and Slovenia, consumer prices increased by more than 3 percent on the annual basis. The asset bubble was further spread by low interest rates. The asset price inflation in these countries was very high. In Slovenia, five-year asset prices increased by 500 percent (see: IMF, International Financial Statistics). As the increase in asset prices widened, Europe’s sick men were faced with rising current account deficit.

In 2007, Spain’s current account deficit amounted to more than 10 percent of the GDP. In such circumstances, a clever monetary policymaker would push up interest rates. As interest rates were at historic lows during the pre-crisis period, the real cure was on behalf of the fiscal policy. Before the crisis, Spain’s fiscal picture was very well indeed. From 2004 to 2007, Spain was running a fiscal surplus which reached the level of 2 percent of the GDP in 2006 and 2007. However, massive capital inflows were not sterilized by raising interest rates which further inflated the real estate bubble and overheating of Spain’s economy.

Independent fiscal policies and a common monetary policy – which is an economic model of the EMU – cause asymmetric shocks. During the years of high growth, these shocks are mostly neglected. However, during the crisis these shocks might cause a serious trouble in the macroeconomic adjustment. Greece, which recently declared a worrisome possibility of debt default, is a typical case of what happens when asymmetric shocks persist.

As Greece, Spain, Italy, Portugal and Slovenia now face high fiscal deficits and poor economic growth, these countries will likely face years of deflationary pressures and high unemployment. The fiscal policymakers already exhausted the ability of governments to boost spending. Further growth of government spending is impossible unless European countries want the Greek debt episode to evolve in a domino effect throughout the Eurozone. The ECB will sooner or later this year raise the baseline interest rates to avoid the inflationary swings in Germany, Austria, Netherlands and other countries with current account surplus.

The macroeconomic outlook for the Eurozone is backlashed by the debt crisis in Mediterranean countries. An economic recovery may include indepedent monetary policies to adjust interest rates and prevent another asset bubble episode as well as to target current account balance. However, European countries will have to rethink the role of indepedent and discretionary fiscal policies pursued by the sick men of the Eurozone.

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