Monday, 28 May 2012

My Big Fat Greek Bailout

The sovereign debt crisis in Greece continues to play out in an ongoing pernicious cycle of immediate positive sentiment (after a European Central Bank announcement) followed by an equally or greater, and supposedly unforeseen, catastrophe. This unfolding disaster has rained havoc on global and domestic markets and will continue to do so unless a sustainable solution is agreed upon.

Despite this, no one within my circle of friends really gives a shit. I mean they have read about it, and maybe even know more than the average person, but it's not really conversation worthy. To be fair, the issue is massive and complex, so let’s dumb down the history and complexity of this issue just a touch. In doing so lets go behind the scenes of My Big Fat Greek Bailout - the most expensive production to come out of the European Debt Crisis, staring the Credit Fiend. So who is this Credit Fiend? 

Greece, and lets not forget many other peripheral German countries, are analogous to our movie star that has been using several unrestricted credit cards attained on the back of his membership within the actors guild (European Monetary Union: EMU). The card has an extremely cheap rate of credit and the actor buys plenty of useless shit and occasionally an ‘investment’ like a Hummer, because with really cheap credit you can carry groceries in whatever the hell you want. This Credit Fiend only works a few days a week, but when he is at work he can usually be found out the back kicking boxes and smoking cigarettes. On his day off, our movie star can be found mooching; pulling back a bong while simultaneously swallowing a Xanax. 

But the utopia soon falls apart when the bank (bond holders) realise they have issued too many of these credit cards (bonds) because arrear incidences increase. As there is a greater risk of default than was initially forecasted banks increase interest rates. The cost of servicing the debt becomes progressively more expensive until the Credit Fiend can no longer afford the repayments. As a solution the movie star applies for another credit card with a higher interest rate to pay for the outstanding debt repayments, but the result is a pernicious cycle that causes the quantum of debt to become too high – the risk of default becomes extremely likely.

The bank falters under the sheer quantum of the movie star's bad debt. To ensure the viability of the insolvent bank the central bank (European Central Bank) does two things. Firstly, it gives direct credit to the fiend, which allows him to cover credit card interest repayments in the short term. Secondly, it extends a line of credit to the bank. With the additional debt the bank issues more credit cards to the Credit Fiend, subject to him agreeing to repay the debt by working harder and cutting costs (austerity). Although it sounds counterintuitive to increase the number of credit cards, it is intended to reduce the cost of debt and put the Fiend on a sustainable re-payment trajectory: this is known as restructuring.

However this is not the case as the bank (bond holders) fears the Credit Fiend will not be able to service the debt, especially since it is anticipated that their gross income will fall because their wage is fixed and uncompetitive, akin to the Greek adoption of the Euro currency. Furthermore, they have undergone a significant reduction in spending on not only unnecessary items but necessities. This would be hard for anyone, but even more difficult for an individual that is used to such a high level of luxury.

As a result the bank increases interest rates as compensation for the inherent risk, also known as a risk premium – the Credit Fiend comes close to defaulting again. The bank finally resorts to cutting 50% of the debt owed, but it seems to late. A point is reached where the Fiend threatens to reneg on the caveats attached to the current credit card repayments and future credit card issues. And this is the ominous position that Greece finds itself in today.

Within this analogy there are two key discourses that need to be given a high degree of consideration; pre-crisis conditions that propagated debt levels and post-crisis measures. In regards to the former, there were no restriction surrounding the level of debt or number of bonds issued to Greece, and in all honesty it is hard to retrospectively critique rating agencies such as Moodys, which measure the level of risk and subsequent cost of debt for countries. This is because on paper important Greek macro-metrics were comparable with the all mighty Germany, but look at it now - it’s fucked. 21.7% unemployment with only resource driven inflation!

Unemployment                                                       Inflation
                                                             2007            2012                         2007         2012
Germany                      9.0               6.8                            1.9            2.1
Greece                         8.4              21.7                           2.6            1.9

(Sourced from the economist 2012)

But if these agencies dug a little deeper they would have found a whole tapestry of structural issues. Just like the bong smoking, pill popping, shit kicking credit fiend: Greece's economy is corrupt and inefficient. And as complicated as it is for economists to look past numbers, structural inefficiencies need to be given a greater degree of consideration in the future because they inevitably impact on a countries ability to repay debt. One of the biggest overlooked areas was the tax system. In some ways, the system was as informal as putting cash in a brown paper bag and giving it to some random dude who was the ‘tax man’.

The free flow of sovereign debt to Greece also outlines some of the issues inherent within the EMU system. The EMU basically controls the monetary policy of members because they have all adopted the Euro and subsequently surrendered their constituent monetary power. As a result they can not manipulate the relative exchange rate. This is now a major issue because Greece cannot devalue and make their goods and services more competitive relative to other countries.

But the odd thing is although the EMU supposedly controls monetary policy they do not control member debt markets or bonds - odd because bonds are a major part of monetary policy as the supply and demand for them influences interest rates and the relative exchange rate of a currency. Hence, why would they not issue one single Euro bond that could be more tightly regulated? Analogously, why was the movie star issued a platinum MasterCard rather than a monitored company card.

In regards to the latter discourse, the timing and severity of the austerity was too soon and too much.  The ECB and other governments around the world need to stop interpreting World Bank and IMF recommendations about the benefits of debt reduction as gospel and be more pragmatic about the situation. An insolvent country like an insolvent individual can not pay back debt if they are stifled by restrictions in the short term – they will be dead from starvation before they pay back the debt. 

In saying this governments and central banks do not want to prescribe too much debt and it needs to be prescribed in the correct manner - there is a fine line. Unlike other nations, the ECB typically prefers to indirectly influence debt markets by extending cheap credit to banks at around 1%, which then purchase sovereign debt, similar to the bank extending more credit cards to the credit fiend within the analogy. The issue with this strategy is that it crowds out lending to other areas, data from the ECB shows lending to businesses and homeowners stagnating or receding, hence stifling recovery efforts.

I am not suggesting the ECB drops everything and adopts a direct method such as: Quantitative Easing as seen in the US or UK where bad debt is bought directly from insolvent zombie banks with toxic assets(assets with no value), as this has its issues as well. But what ever approach is adopted needs to be backed 100% by the ECB with unlimited debt support.

Furthermore, the ECB needs to play a bigger role in encouraging growth, as it is in their interest because more growth means more interest repayments and less chance of default. From a macro viewpoint this is known as Keynesian Policy: policy that increases aggregate demand through public spending. However, the situation in Greece is complex, firstly because it has no money; secondly it is part of a larger organisation, the European Monetary Union (EMU), which refuses to handout more money. I believe Germany, the powerhouse of the EMU, should be playing a bigger role in stimulating the Greek economy through Keynesian measures rather than solely synthetically adjusting debt yields, which has done nothing to fix the problem as of yet. On balance, if it is to follow a debt restructuring strategy it needs to instill confidence within the debt markets by giving its full unlimited support to Greece.

Coming back to the analogy, it is inventible that the insolvent credit card holder, which has not been supported and who is presumably starving and tired from sleeping upright in his Hummer, will eventually switch to anarchic survival; put simply, don’t-give-a-shit mode. In Greece this has already involved erratic and costly behavior such as rioting, mass withdrawal of deposits and now the possible adoption of an extreme political leader such as Alexis Tsipras, leader of the radical left Syriza party, that want to repudiate Greece’s rescue deal with its European and IMF creditors. The scary thing about this negative public sentiment is that it may fuel the sequel, My Big Fat Greek Break Up.

The costs of a break up are high for both sides. In Greece’s case a break up would result in something similar to the Argentinean crisis and that is probably best case scenario. According to Japanese financial company Nomura, an exit would lead to a 60% devaluation of the new drachma. For Germany and the EMU, the loss is in bad debt, the credit already invested into Greece and the likely negative sentiment that would contaminate other peripheral bond markets. The best outcome would be a re-evaluation of Greek austerity, with achievable goals over a longer time horizon and unlimited sovereign debt support coupled with Keynesian assistance from Germany.

But like this analysis, even the most intelligent high calibre figures within these countries can be simple, even just plain dumb. Logic and pragmatism is one road, while IMF/World Bank austerity dogma is the other. A lack of the former has led to My Big Fat Greek Bailout; let’s hope neither a lack of the former or extreme adoption of the latter lead to the sequel.

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