Editor’s Note: This is Part 2 of a two-part series. Click here to read Part 1.
It Always Ends in the Same Way
No one, including the IMF, seriously believes that the austerity program announced by Greece will work. Argentina had debt to GDP of around 60% and a budget deficit of 6%. Adjustments necessary to halve both failed. After a long-drawn-out struggle between 1999 and 2001, Argentina was forced to reschedule its debt and have still not quite made its way back to normality. Many of the vulnerable countries in Europe are in a much worse position than Argentina in 1999.
Rapid economic growth or high inflation would improve Greece’s prospects for survival. Neither is a realistic option. The eurozone could continue to finance Greece, which would require extension of the current package, which is initially for three years.
Greece may not be able to avoid a debt restructuring. For the countries like, Ireland, Spain, Portugal as well the others, the savage austerity measures required are unlikely to be palatable and probably won’t work in any case. All roads may lead eventually to debt restructuring.
The best course of action for Greece would be to "temporarily" (that is, for the next several hundred years) opt out of the euro and unilaterally re-denominate its debt into the "new" drachma. Through the currency devaluation, this would effectively reduce debt and restore competitiveness. In any debt rescheduling, lenders would take significant write-downs, reducing Greece’s debt burden, giving it a chance to emerge as a sustainable economy.
The real agenda of the bailout is to avoid foreign lenders taking large losses. The investors were imprudent in their willingness to lend excessively to countries like Greece assuming EU "implicit" support and are now seeking others to bail them out of their folly. As Herbert Spencer, the English philosopher, observed: "the ultimate result of shielding men from the effects of folly is to fill the world with fools."
As at June 2009, Greece owed US$276 billion to international banks, of which around US$254 billion was owed to European banks with French, Swiss, and German banks having significant exposures. Bank for International Settlement data indicates that German and French banks’ exposure to Greece is about $50 billion and $75 billion respectively.
In aggregate, the exposure of Germany and France to troubled European countries is around $1 trillion. According to the Bank for International Settlements, as at the end of 2009, French banks and German banks have lent $493 billion and $465 billion respectively to Spain, Greece, Portugal, and Ireland.
The real purpose of the bailout is to prepare for a possible series of sovereign debt restructurings in Europe. In an ideal world, banks and investors raise capital and write down their exposure to the troubled debtors over time allowing the restructuring to be relatively smooth, avoiding disruption to financial markets.
Contagion is already a reality. Highly indebted sovereign borrowers with immediate financing needs are facing higher costs and lower availability of funds. Scrutiny of their public finances is forcing them to adopt austerity programs to remain credible borrowers with access to markets. The risk of losses from a Greek or other sovereign defaults has affected financial institutions. Mirroring events at the start of the GFC, the close linkages between eurozone banks through cross-border loans and investment to each other remain a serious potential problem. The stress is most evident in inter-bank funding rates that have risen sharply to their highest levels in a year.
Since 2008, money markets have operated on the basis that large banks are "too big to fail,” due to support from the relevant sovereign. The problems of sovereigns themselves have heightened concern about the credit risk of banks. Banks fearful of the quality of borrowing banks may limit lending.
Banks, especially those in Europe, are paying higher interest costs and may face difficulties in raising funds. The ECB recently warned of the problems faced by European banks in financing their operations and refinancing maturing debt. Markets are stockpiling liquidity, as evident by surplus balances at the ECB and other central banks, fearing a sequel to the deep freeze in financial markets in 2008.
Activity in bond markets and new equity raisings have slowed sharply.
In the real economy, forced or voluntary retrenchment of government spending is restricting demand restraining economic growth. Lack of demand in Europe affects the exporting economies of Japan, China, and East and South Asia.
Currency volatility, dominated by the appreciation of the dollar, is creating problem. It’s driven by a flight to quality, away from euros and yen to dollars. It’s also driven by a forced de-risking as traders unwind the carry trade (long risk/short dollars). The Australian dollar, which has been masquerading as a respectable currency, reverted to the peso of the South Pacific, falling an astonishing 12+% in a few days. Concerns about commodity prices and Chinese growth accelerated the fall.
Dollar strength belies the economic fundamentals and will slow the ability of the US to use exports as a growth engine. The weakness of the euro and resultant appreciation of the renminbi by 14+% also reduces Chinese exporters’ earnings and competitiveness. China is now even more reluctant to take steps to allow the renminbi to appreciate.
The sovereign debt problems are creating serious dislocations and perverse outcomes. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars has pushed down interest rates on US government debt. Paradoxically, lower interest rates reduce pressure for deficit reduction by lowering the cost of servicing public debt.
A combination of self-reinforcing events is driving a pernicious reversal of the dynamics of 2008-2009. Then, coordinated government action on a grand scale stopped the global financial crisis from turning into a depression. Government and central bank strategy was a bet on growth and inflation, as the most painless means of adjusting the overly leveraged and deeply indebted global economy. In the words of François Duc de La Rochefoucauld: "Hope, deceitful as it is, serves at least to lead us to the end of our lives by an agreeable route." Now, governments have become the problem, perhaps calling time on the wishful thinking of markets. The most important consequence of Greece and European sovereign debt problems will be to force governments everywhere to stabilize and reverse the deterioration in public finances by a combination of new taxes and cutting expenditures. Many indebted economies, including Britain and Italy, have implement austerity measures. The sharp reduction of government spending coincides with the end of the effects of stimulus packages and is likely to slow economic growth.
Country-specific factors -- attempts by China to rein in excessive lending growth and property price rises; higher interest rates in Australian and India, driven by perceived inflation in local economies -- may also undermine growth. Government demand for funds and deteriorating conditions in the financial system will reduce the availability of funds and increase cost, further restricting growth.
The GSC has profoundly shifted economic dynamics. Refusing to acknowledge the real problems, major economies have, over the last decades, transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of assets and risk are now held by central banks and governments, which aren’t designed for such long-term ownership. There are now no more balance sheets that can be leveraged to support the current levels of debt.
Borrowing can only be repaid by the sale of assets, including those funded by the debt, or by redirecting income, perhaps generated by the asset purchased, toward repayments. Unfortunately, in many cases, the current value of the asset won’t cover the outstanding debt. The level of income and cash flow generated is insufficient to cover interest costs or amortize the amount borrowed. The GSC focused attention on the excessive level of debt and how it was used.
Based on per capital income of $30,000 (roughly 75% of Germany), Greece gives the appearance of a developed economy. In fact, Greece’s economy and its institutional infrastructure are weak. In the World Bank’s Index for Doing Business that measures the commercial environment, Greece ranks 109th behind Lebanon, Egypt, and Ethiopia and, among developed countries, in the same index, second-last. Around 30% of the Greek economy is unreported and informal. Tax-revenue losses may be around $30 billion per annum. Productivity and quality are low. Despite the size of the public sector, public services are inadequate. Corruption is endemic.
While entry into the euro may have assisted Greece’s ascension into major-league status, the euro decreased international competitiveness as the country effectively priced itself out of the market for goods and services. Entry into the euro compounded existing weaknesses by providing access to low-cost funds. Greek bonds became eligible as collateral for ECB funding. Assumptions of "implicit" ECB and EU support (since proven correct) facilitated easy access to bank funding. A period of credit-driven expansion financed a construction boom and social policies, such as early retirement with large pension entitlement, often in excess of those available in more affluent countries.
The reality is that much of the debt in Greece wasn’t used to finance productive enterprises but fueled consumption or was channeled into unproductive uses. There are no substantial assets or income from those investments that will help repay the debts. Many countries and businesses face identical problems and now must face and adjust to that painful reality.
As Tyler Cowen, Professor of Economics at George Mason University, observed in a May 21, 2010 opinion piece entitled "How Will Greece Get Off the Dole?" in the New York Times:
…it’s a moot point whether Greece is a poor country masquerading as a wealthy country or vice versa. … If the old illusion was that Greece was a wealthy country, the new illusion is that Greece will, in short order, become wealthy enough to pay back ever-growing sums of debt.
The lack of viable policy options is increasingly evident in the panicked reactions of governments. In literature, they all quote Shakespeare in the end. When things go wrong in financial markets, it seems that everybody looking for a scapegoat blames speculators and short-sellers.
Nowhere to Run to, Nowhere to Hide
The onset of the GSC marks a new dangerous phase of the credit crisis. At best a withdrawal of government support (through lower spending and higher taxes) will reduce global demand and usher in a potentially prolonged period of stagnation. At worst, increasing difficulty in sovereigns raising money and a clutch of sovereign debt rescheduling may result in a sharp deterioration in financial and economic conditions. Recent difficulties by Germany to issue debt highlight the risks.
Financial institutions will continue to build up capital and reduce balances sheets, anticipating further losses and write-offs over time, including potential losses on exposures to sovereign loans. Lending growth will continue to be low, reducing growth. Consumption and investment will be below potential.
There’s no political will to tackle deep-seated problems. The electorate is unwilling to accept the adjustments and lower living standards that will be necessary. As the credit crisis enters its third year, the scale of sovereign debts means that governments now have limited room to counter any new economic downturn, any new problems or crisis.
The liquidity and government spending-driven rally also caused "bubbles" in emerging markets. There’s a risk that the GFC and GSC may morph into an EMC (Emerging Market Crisis).
Until early 2010, markets were “dancing in the streets.” Increasingly, another Holland-Dozier-Holland standard also made famous by Martha and the Vandellas is relevant: "Nowhere to run to, baby/Nowhere to hide."
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