In-depth analysis of the Greek and Eurozone Crisis

June 13, 2011

If it’s up to Geert Wilders, the populist political leader of the Dutch Freedom Party (PVV), the Netherlands will no longer contribute to the European Union’s financial aid for Greece. To add insult to injury, Wilders suggests the Greeks to be thrown out of the European currency-consortium, the Euro. Wilders is an outspoken nationalist politician, known worldwide for his anti-Islamic and anti-Europe stance. The majority of his followers are disgruntled, politically alienated people with racist (even fascist) tendencies. I have written extensively about the latter subject elsewhere on this site (all articles are in Dutch). One of Wilder’s greatest talents is to translate complex subjects to his followers in plain language; the Dutch call it Jip-and-Janneke speak, named after the way of talking by a cartoon-duo of 5-year-olds). The Dutch newspaper, De Telegraaf, reported such an incident on May 18 (2011), where Wilders refers to Junk bonds: [1]

International credit rating agencies have already given Greece the BB status, the so-called junk bond status. “And you should never give money to a junkie because you’re never going to see that money again,” said Wilders.

Obviously, the term junk in this context is not the deceitful and fraudulent drug-addict. Junk simply means rubbish. A junk bond means that the particular investment entails high risks; it may ultimately be a bad investment. Wilders understands that much, but it is useful to twist the meaning of an unfamiliar word to his populist political agenda. Nevertheless, Wilders does not understand that there is a very large market for junk bonds. Why? Because many investors are willing to take risks and thus speculate on a big profit. After all, investors know: the greater the risk, the greater the profits when the speculation ends well. Of course, the investors try their best to reduce the risks by estimating the pros and cons; they call this “calculated risk”.

On May 19 (2011) Wilders, once again, made his presence felt in the Dutch parliament. I previously wrote about this event: [2]

The populist Geert Wilders knows how to convey his message to his followers. He uses Jip-and-Janneke language, and always refers to prominent people to put weight behind his claims. During the accountability debate in the parliament, Wilders defends his pitch to let Greece drown in its own problems by referencing a short list of several internationally renowned economists. The most prominent economist he named was Nobel laureate Paul Krugman. According to Wilders, Krugman does not see problems with a withdrawal of Greece from the Euro. Unfortunately, his translators and interpreters must go back to school. Krugman was referring to the effect that a potential fall of Greece (due to the financial crisis and exit from the Euro) would not be a major “Lehman-like” threat to the USA’s Economy. For Europe, however, he indeed foresees very serious trouble, which is contrary to what Wilders wants us to believe.

This is what Krugman writes:

What Remains seems unthinkable: Greece leaving the euro. But when You’ve overruled everything What remains seems unthinkable: Greece leaving the euro. But when you’ve ruled out everything else, that’s what’s left.

If it happens, it will play something like Argentina in 2001, which had a supposedly permanent, unbreakable peg to the dollar. Ending that peg was considered unthinkable for the same reasons leaving the euro seems impossible: even suggesting the possibility would risk crippling bank runs. But the bank runs happened anyway, and the Argentine government imposed emergency restrictions on withdrawals. This left the door open for devaluation, and Argentina eventually walked through that door.

If something like that happens in Greece, it will send shock waves through Europe, possibly triggering crises in other countries. But unless European leaders are able and willing to act far more boldly than anything we’ve seen so far, that’s where this is heading.

Ergo: everyone in Europe will bleed; not quite the message that Wilders wanted to convey. Krugman left unanswered how and what those “more boldly than anything we’ve seen so far”  measures should or could be.

Where Krugman stops with what the bold steps could be, this analysis begins. I will show that the majority of top economists have found consensus in the conclusion that aid should be given. The latter issue is of crucial importance in this analysis, because in the Netherlands (and elsewhere) the impression among people is that the differences between top economists are at opposite extremes and that there is no consensus possible.

The first half of this analysis concerns a recently held debate between four prominent Dutch economists. A thorough analysis of that debate exposes the issues at stake (for the European Union and its people); the economists put the crisis in perspective and explain very well what the problems are, economicly as well as politically. The other half includes an analysis of potential solutions or options, especially those put forth by Nouriel Roubini, one of the most respected economists of our time.

Background: Greek economy

As an investor (NS Lachman & Co.., LLP) I gained experience (ranging from small to quite large investments) and learned the ropes in a microeconomic environment. However, the fundamental aspects of microeconomics are the same as a macroeconomics: if you spend more than you earn, you will have to pay the difference (negative cash flow in microeconomics and deficit in macroeconomic terms) one way or another. Much of the income of a country consists of taxes, and the more companies there are, the more income can be generated by the Government (through tax collection).

Foreign trade is called import and export. Greece has a very big problem: it exports almost one-third less (€ 69.6 billion) than it imports (€ 97.6 billion). The Netherlands, for example, has imports for € 358.9 billion while it exports for €397.6 billion, a surplus of about 10%. This means that Greece is -in many ways- economically lagging. To keep paying salaries (such as civil servants and politicians) and to finance the necessary maintenance of the country (infrastructure etc.) and investments (e.g. new buildings and economic-growth projects) the government must borrow money. That is what went wrong with Greece.

The Telegraph (April 28, 2010) summarized the Greek economic background and current situation concise yet accurately:

Greece has long lived beyond its means and spent much of the last two centuries defaulting on its debts. Joining the euro was meant to put an end to all that. However, it merely seems to have exacerbated its problems.

It was no surprise to any economist that the European Union, at first, refused to allow the country to join the euro when the new currency started in 1999.

Quite simply, its debts were too high and inflation was out of control. By 2000, the EU finally allowed it to join, though there were suspicions at the time that Greece was operating a “limbo dance” – squeezing its figures to hit the stringent euro criteria, only for them to flip back to dangerous levels once it had entered. Indeed many believe Greece simply lied about its figures to gain entry.

At the time its inflation was 4 per cent, much higher than the European average, and was suffering from one in ten people out of work – a higher figure than currently in recession-hit Britain.

Ben May, Greek economist at think tank Capital Economics, said: “Their mistake was to go out, borrow money and use it to fund huge wage growth, rather than pay down its already substantial debts.”

All this and much more, led to the financial/fiscal crisis in Greece. Politics and economy do not gel very well and it is something that most economists are critical of or try to avoid completely. The same goes for Dutch top economists.

Four Dutch top economists Debate the Greek and Eurozone Crisis

The Netherlands has already “loaned” the Greek government approximately €5 billion, and the politicians are sweating peanuts because of a potential backlash from their voters.

On June 6 (2011) economy students of the University of Amsterdam (UvA) organized (together with the PvdA, the Dutch Labour Party) a debate on the Eurozone and the situation in Greece. Participants included leading economists Nout Wellink (President Dutch National Bank), Willem Buiter (Chief Economist Citigroup), Arnoud Boot and Sweder van Wijnbergen (UvA professors). Ronald Plasterk (PvdA spokesman for Finance) was the moderator. Below is an analysis of the essential parts of this 80-minute debate. [4]

In this debate, the economists often lashed out at the hypocrisy of politicians. Boot opened the attack and points to a crucial issue: the ECB should be politically independent:

The ECB is not in business for solvency support or sovereigns support to countries. The ECB was forced by EU leaders into that role- to facilitate Europe. Because they could not explain to voters they have forced the ECB through a backdoor to do so … and that means now that the European leaders have to come clear, bare their buttocks. And “bare buttocks” means: the ECB should be removed [from the political issue]. That means that the risks should be removed from the ECB, and then the European leaders should decide, without a vote from the ECB, what to do with the debt. Right now, they need to understand that the ECB still has the leverage to say, “if you restructure without taking us out [of the controversy], we blow this up.” That is the only powerful weapon the ECB has.

There are two reasons why politicians do not want to do that, according to Boot.

They do not want openness to the voters with regards to what they are actually are doing, what Europe is doing, and two: they are busy with the question of who to blame. European leaders want, if possible, put the blame on the ECB, and they do not care about the reputation of the ECB. Who to blame is a concern for politicians; economists want to resolve the matter, but politicians are busy with the blamegame.

Boot gets support from his colleague Wijnbergen, who notes:

The politicians are just fooling everyone… there is nothing unique to crises: the last thirty years there have been some six crises. Research has been done, and what is the expensive way of problemsolving? Doing nothing and procrastinate. So, we know: “I do not want to tell the taxpayers that they have to pay now, but by doing so, I am ensuring that they will; have to pay even more in the near future.” Aren’t you scamming the voters then?

Wijnbergen also provides a comparable example:

It’s not going to be great from the one day to the other. You cannot say, “I’ll reform” and one week later you go and expect to see the whole country has become like Singapore. That is not the case, and probably: the more you will look, the more skeletons in the closet may appear. But… to give an example: Mexico was a kind of Greece in the eighties, except they had oil. And that was a process that went from 1986 through 1990, with exactly the same factors that play now: financial sector reform, public sector reforms, deregulation, fiscal restructuring, that should all happen. Saying, “Guys, we’ve been working three months and I’m still seeing someone somewhere benefiting from a sloppy pension administration,” I am sure you will.

With the sloppy pension administration, Wijnbergen was referring to a recent news item that exposed some pension fraud by Greeks. Boot in turn agrees with Wijnbergen. He adds:

Greece actually lacks an institutional structure. All kinds of basic things, such as tax collection, are automatically arranged in a country like the Netherlands, but for Greece it is a new thing. But it literally means that for a country like Greece… and that must be part of restructuring, part of providing perspective to Greece [its politicians and people], means you need a long-term program. But providing a perspective to Greece is an element of it because of the political unrest in Greece. You have to give the politicians an opportunity to operate in Greece, but at the same time you obviously have to make sure they have the willingness to operate.

On this remark, another panel member, Buiter, remarks:

Be careful when we say that “Greece must reform itself”… it does not mean -if she reforms adequately- that she can can pay everything as they are supposed to.

My guess is that Buiter makes this remark because he seems to be quite confident that debtors will have to take a hit by writing off some debts in any scenario whatsoever. Wellink, the president of the Dutch National Bank and board member of the ECB, takes the opportunity to explain the current status:

… At the moment, a massive effort is underway, under pressure from the international community but also with the knowledge and willingness of the Greek Government to fundamentally reform this society in a number of areas. That is of essential meaning, also for the rest of Europe. This society has been behind in her reform drive … there was not much passion for reform, but there is progress now in a number of areas: in the labor field, the pension field, the field of public companies, and I would say: “Let’s give them a chance and not jump into a process of definition.

According to moderator Plasterks the dilemma exists of a potential crisis-trigger or infection of other countries, but Boot remarks:

That is not the dilemma; it is a dilemma that politicians make out to be. Right at the beginning of the economic crisis, the euro crisis, politicians said, “If we don’t do this for Greece, there will be domino effects to other countries.” What the politicians actually did correctly last year at one time… they likely intervened too weakly in Greece, and too late, but when they intervened in Greece, they put a huge safety net under the other countries. That safety net itself, I was a proponent of it because with a safety net you create security in those countries where you do not want to risk infection. Thus, instead of just talking about risk of infection you have in that case already put a safety net. The politicians actually do much worse … if you create clarity, there will be no risk of infection. Politicians create the greatest possible confusion when they say that all those countries are in the same situation, by which they are already saying that there is contamination danger.

On the issue whether or not the risk of contamination or infection already exists, Wijnbergen puts it in context:

… It’s actually hard to determine if contamination occurs because there is nothing happening in this country and it just spills over to that country, or whether it is something that occurs simultaneously… it is almost impossible to distinguish. The main point here is, I think, due to the policies currently conducted, procrastinating the problem and ensure that the Greeks will have to unnecessarily bear high costs for a long time… that increases the risk of infection because it increases the chance that an even bigger blow will happen, and then it might be more difficult. So, … it’s not a dilemma. The earlier you intervene the less likely you will get uncontrollable problems.

Barack Obama, President of the United States, has a similar opinion. In a CNBC article he is quoted, saying: [5]

“America’s economic growth depends on a sensible resolution of this issue,” he said.

“It would be disastrous for us to see an uncontrolled spiral and default in Europe because that could trigger a whole range of other events.”

With regard to Wellink’s statement/question Wellink whether the solution lies in more institutional reforms with more power concentrated at a central place, Wijnbergen gives two points of consideration.

… When things are difficult, and politicians can’t tell their story, and their supporters say, “We want a benevolent dictator, he us going to fix it all” … two things against it. One: I have never, and I’m really talking about thirty or forty adjustment programs that I’ve been involved in my life… I have never seen a program that is imposed from the outside. That just does not work. Second point: there is an opinion – and I honestly believe that Nout [Wellink] and I -when all is said and done are more in agreement than we think-… a certain part of politics if of the opinion that if you flee from institutional reforms it is a substitute for a lack of political leadership, and it’s not. There were far less institutional instruments to intervene in the eighties, and yet it happened. Why? Because in the Latin American case the old Bush took the lead. In Eastern Europe, Helmut Kohl took the lead. And when in 1998 the Japanese acted as if nothing was wrong, America picked up the ball … you need someone who says, ‘I do not care what the rules are, this is what we are going to do “…

As for current displays of such leadership, Wijnbergen blames German Chancellor Angela Merkel:

Merkel is dropping the ball just awfully at the moment.

Others are of the same opinion. John Sfakianakis, group chief economist at Banque Saudi Fransi, is quoted in an interview (Nov. 2010) with CNBC [6]

“At the core of this problem there is a crisis of leadership in the EU. The French are good, they’re capable, but they’re not the biggest. The Germans want to lead, but they’re not willing to lead,” Sfakianakis said.

The Germans have to be “very careful” with their rhetoric over the crisis, he said referring to comments make by Chancellor Angela Merkel earlier this week. Merkel said that some of the cost of bailing out countries at risk of default should fall to the bond holders of that government debt. The move sparked arise in bond yields for periphery euro zone countries as investors balked at the prospect of taking a haircut.

“The Greek crisis could have been avoided had the Germans stepped in faster and had the Germans censored themselves a little bit better,” he said.

The debate-moderator is now about to close the debate with the final remarks. When asked by Plasterk what his final advice to politicians is, Buiter says:

Either restructure tomorrow if you do not have high expectations of both Greece and Ireland and Portugal. Greece, 60% depreciation, Ireland and Portugal: 40% and 50%. Do it immediately, unless you think that if you can introduce institutional innovations in two years, implemented by the ESM and by a special resolution team of banks that allow things to be done a bit more elegantly. The advantage of doing it now is that more debts remain with the creditors, where it belongs.

Plasterk asks whether this would mean that Greece continues with the Euro. Buiter replied firmly:

“Of course… being in the Euro has nothing to do with whether the government goes bankrupt.”

The consensus appears to be there and is well articulated by Wijnbergen (by then Buiter has already left for another appointment):

The target is obvious. I think that the Greeks should indeed go through the mill, and I also think there should be positive intervention, but you should not do that by saying that you hold on to all debts and all those bankers with solid profits if they exited at market-lows with solid profits on face-value… That strikes me as not being a positive message to the Greeks, and does not appear to me as a positive message to the people who take risks at the bank, because they hear: the positive side is yours, and the negative side is for the taxpayer. Then they will do more rather than less. This way you’ll get, no matter what kind of institutional reforms, no stability ever. So, what happens next: yes, the Greeks have to reform, make it politically easier for them by also letting some feathers fly at the banks. If there is a capital problem, solve the issue immediately. You do not solve undercapitalization of banks by letting accounting tricks exist. Then you put the problems under the rug, and everyone will think that the problem is three times bigger than it actually is, and there will be less confidence. Last point: keep the ECB off the hook, otherwise we will no longer have the ECB. It will arrive at the taxpayer, whether through the ECB or outside them. Then rather go outside because then at least we will still have a functioning ECB side.

Wellink thanked Wijnbergen for his argument, because that’s exactly what he thinks. Boot also agreed with Wijnbergen. Connecting with his earlier argument about political states Boat:

The ECB is an institution you have to protect that cannot be otherwise. This means that politicians must bare it all. It is up to the politicians to outline what they want with the eurozone; it is also up to them to sketch the perspective. Just restructuring, without a program, is useless. The restructuring is part of an overall solution that must provide Greece with a solution. It is part of that package. Greece is allowed to have this expectation as part of the package … It is an integral package with which Greece can agree. Nevertheless, let us not underestimate how very complicated it is. Very complicated. Sweder [van Wijnbergen] mentions it briefly . “If problems occur in banks elsewhere, we must of course find a solution,”I completely agree. Rather than just leave that at the banks, solve the banking [problems]. But what is the blueprint for Europe? The blueprint for Europe is that we should not let European banks lean on national governments as they do now. Which means, that part of the blueprint is a restructuring of the banking system when it is clear where the risks of the banking system are, and they cannot be only with the national governments. Restructuring the banking sector is a crucial part of the whole package of Greece shows, and shows how complicated it is.

Restructuring options according to economists

On the issue of possible restructuring options, and very much in line with Boot’s opinion about politicians and their tricks, The Economist wrote recently: [7]

No European policymaker seems willing to countenance a serious haircut on Greek debt yet, for fear that it undermines confidence elsewhere. And no European politician wants to be seen giving more taxpayers’ money to the Greeks without getting something back.

Another option is a “reprofiling”, whereby creditors agree to a voluntary extension of the maturity of their bonds. That would not sort out Greece’s finances—it might reduce the net present value of Greek debt by up to 20-25%—but it would keep the country away from the markets for a while. But the ratings agencies have said that such a “soft restructuring”, or even the buyback and cancellation of outstanding bonds (which Moody’s calls a “restructuring by stealth”), would count as a default and lead to further cuts in Greece’s rating. That makes it unacceptable to the European Central Bank (ECB), whose opposition to any form of debt restructuring borders on the pathological.

The table below provides a clear overview of the restructuring options that the Economist lists.

But the array of options can be even more extensive. The Turkish Nouriel Roubini, one of the most prominent economists in the world, professor of economics at New York University’s Stern School of Business, and founder of Roubini Global Economics, is known for his vision and correct “calls”. He warned in 2005 that the speculation in housing prices would sink the economy. Even Krugman, Nobel Prize winner whom I quoted earlier in the analysis, Roubini has complimented for his vision and prophecies.

The Financial Times of May 10 (2011), published an article with a helicopter view of the restructuring options that Roubini has in mind. [8]

The path of Greek public debt is manifestly unsustainable.Fiscal austerity and structural reforms are necessary but will not suffice. In the best-case scenario—incorporating a 10% of GDP fiscal adjustment and structural reforms—Greek public debt to GDP peaks around 160% before “stabilizing.” It is more likely that the debt ratio will exceed 160% and, left untended, will render market access both before and even after 2013 severely limited (or effectively non-existent).

There are multiple approaches to an orderly debt restructuring, with varying degrees of debt relief for the sovereign, additional official financing and systemic risk for the eurozone (EZ). We assume only domestic public debt—95% of the public debt stock—would be restructured.

In our view, the best approach for all stakeholders is akin to a Brady par bond option, an exchange offer in 2011 with potentially significant maturity extension, no face-value reduction and moderately reduced coupons. The public debt would remain very high but would be more sustainable as refinancing risk and the interest bill would be cut. We also suggest variations on this theme that would affect the balance of interests of Greece and private and official creditors.

Credit enhancements—as in the Brady bonds—may or may not be added to act as sweeteners for rating- or capital-constrained creditors like banks, subject to a key caveat: Principal collateral would be expensive, given the large nominal stock of debt and prevailing low interest rates on “risk-free” public debt. It is not yet clear what the source of funding for any substantial principal collateral would be, short of a transfer from other EZ member-states, or more official lending.

Greece’s debt problem is a globally systemic pivot: All stakeholders—Greece, the EZ and indeed all global financial markets—are better served by a pre-emptive and orderly, market-oriented debt exchange rather than sticking with a misbegotten and clearly failing Plan A … The current approach, Plan A, in effect bails out private creditors who exit early or have short maturities, but exposes continuing creditors, by extension the reputation of the debtor and EZ and global financial stability to three rising risks: Subordination as the debt is transferred to increasingly senior creditors like the IMF, EFSM/EFSF/ESM and ECB; the rising threat of a disorderly outcome as an unsustainable fiscal adjustment, far from enhancing debt payment or carrying capacity, actually undermines it; and the risk of a vicious circle among the PIIGS, the EZ and indeed the whole world, which remains under the gun of renewed contagion when market consensus flips from bailout to get-out mode. Indeed, repeated market experience bears this view out in other cases and in Greece/EZ PIIGS to date.

Roubini’s preferred option — a Brady-esque exchange, or ‘Option 3? in the above table — would involve exchanging old debt for new bonds with the same face value as the old ones, but with a longer maturity and lower interest rates (no haircuts here, folks). …

So Option 3 subdivided into Option 3(a) 3(b) and 3(c).

Intriguingly, there’s also the prospect of a combination of those options 3(a) plus 2, or whatever:

Also, note that Options 3a and 3b—a par bond—are not incompatible with Option 2—a discount bond. As in the Brady plan, there are some investors who mark-to-market (hold the debt in their “trading book”)—usually hedge funds and other alternative asset managers—and there are some investors—banks, pension funds, insurance companies—who don’t mark-to-market as they—at least in principle—hold the debt to maturity and/or in the “banking book”. Thus, as in the Brady plan, offering a menu of options—a discount bond for “mark-to-market” investors and a par bond for “hold-to-maturity” investors—makes sense. One group would prefer a discount bond and the other a par bond. And as is well known, on a [net present value] basis, a properly designed par bond is equivalent to a discount bond.

There you have it. As shown in my analysis, there is indeed a consensus among top economists. Paul Krugman was incorrectly quoted and understood by Wilders. The Dutch top economists (if push comes to shove) also agree. So do President Obama and his advisers, and Roubini also. Greece should not only be bailed out because of moral obligations and/or because we are afraid of losing our tax dollars, the country must be saved from the downward spiral because bailing them out is a limited risk to the international community and the lesser of two evils. Calculated, after all, so the loans to Greece are definitely not wasted money.

[1] ” No more money to the Greeks “, Ruud Mikkers, De Telegraaf, May 18, 2011

[2] Wilders bend words and opinion of economist Paul Krugman , Neal Lachman, Republic Libertas, May 19, 2011

[3] Greece: why did ITS economy fall so hard? , Harry Wallop, The Telegraph, April 28, 2010

[4] The debate Greece , RTLZ, June 6, 2011

[5] Obama presses Europe: pledges support for Greek crisis , CNBC, June 8, 2011

[6] Greece deflation needs to be saved , Robin Knight, CNBC, November 19, 2010

[7] Europe’s debt crisis: World’s worst menu , The Economist, May 26, 2011

[8] Roubini’s Guide to a Greek Debt Restructuring , Tracy Alloway, Financial Times, May 10, 2011

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