I agree with Ambrose Evans-Pritchard and Jacques Cailloux. It's what I was trying to say yesterday. And on Thursday. It's probably gotten too big for Germany, France, the IMF, whoever, to fix. Only the European Central Bank has enough money to fix the Eurozone problem; because it can print it. What's ironic is that what they call "The Nuclear Option" is what first year economics textbooks describe as the normal way that central banks increase the money supply. We call it "Open Market Operations". Print money and use it to buy Eurozone government bonds.
But I don't think that will happen.
It's not so much the rules about what the ECB is and is not allowed to buy, or accept as colateral, (which, despite commenter JP's help, I still don't really understand); it's because it is ultimately a political decision. Who has the authority to say that the ECB may risk its seigniorage revenue on buying Greek or other countries' sovereign junk, when that revenue belongs to all Eurozone governments? Nobody. The Eurozone is not a real country. There is no central fiscal authority behind the ECB. That decision would have to be reached by a political consensus of all Eurozone countries, and I don't see that happening.
If Greece had a central bank of its own there is no doubt it would now be buying Greek bonds. But it doesn't; at least, not a real one that can print money.
Eurozone commercial banks hold Eurozone government bonds as assets. With the drop in those bonds' values, many commercial banks (inside and outside the Eurozone) will become insolvent. There will be (and already are) runs on those banks, as depositors seek to transfer their deposits to safer banks, if any can be found, or withdraw currency, if they can't.
The first year textbook says this fall in bank deposits will cause a fall in the money supply, and that this fall in the money supply will cause a recession. And the general fear of financial assets will also cause an increase in the demand for money which will exacerbate the problem of a declining supply. And the solution is for the central bank to do whatever it takes to increase the money supply by however much it takes to eliminate the excess demand for money.
I don't see how the ECB will do this, if it can't buy bonds, can't lend to insolvent banks, and can't lend against junk bond colateral.
Instead, the ECB will point to its nice low interest rate target and say "Look how loose monetary policy is!". And it will be low, because the only people who can borrow at that rate won't need to, and all those who desperately want to borrow at that rate won't be allowed to.
The fall in the Euro money supply will cause a worsening Eurozone recession. As I, Scott Sumner, Bill Woolsey, (and others) have been saying all along, central banks' nominal interest rate targets are not a good measure of the stance of monetary policy. But others will explain the same facts differently: they will say that a recession caused a fall in money demand. Which of course is true, in a way; when the money supply falls, the recession has to get bad enough so that money demand falls enough to match the reduced money supply.
We will know the truth when some Eurozone governments start paying their workers in new monies they have printed themselves, because they have run out of Euros, and can't borrow any more. If there were no shortage of Euros, who would ever accept those new monies as media of exchange? But if there's a shortage of Euros, accepting payment in New Drachmas will be better than nothing, and you will know that others will also be short of Euros and so will accept them from you in turn. When that happens, Greece (and it is unlikely to be alone) will have left the Euro.
If the ECB won't create enough money, some Eurozone governments will eventually start creating their own.
Worthwhile Canadian Initiative 
If the ECB won’t create enough money, some Eurozone governments will eventually start creating their own.
I was insistent that Greece would never voluntarily leave the Eurozone; I could never see the upside to departing. But your excellent post finally made it clear to me; it’s all about the money. Thank you.
Conjures visions of a banker, besieged by angry depositors demanding their money, standing in an empty vault saying “… but interest rates are low!”.
This might help clear things up. The ECB normally engages in open market operations, but these are in the form of repurchase agreements. It buys a security from a bank, holds it for anywhere from a day to several months, at which point the bank repurchases it from the ECB as per the prearranged agreement, and cash is withdrawn from the economy.
The “nuclear option” is a different kind of open market operation; outright purchases. The ECB buys bonds from banks outright ie. with no promise of repurchase. These bonds will be held on the ECB’s balance sheet till they mature (at which point they can be rolled over, perhaps perpetually). This sort of open market operation is much more permanent than repurchase open market operations, since the ECB doesn’t precommit to withdrawing currency as it did upon the expiration of repos.
I believe that shifting from repos to outright open market operations is a decision that can be taken by the governing council of the ECB. It doesn’t have to go through members’ respective parliaments. See: http://www.ecb.int/ecb/orga/decisions/govc/html/index.en.html. Of course, given the broad representation on this board the debate will be very political.
We will know the truth when some Eurozone governments start paying their workers in new monies they have printed themselves
.. just as California has already done with state income tax refunds and some payments to suppliers. Has California left the dollar zone, or is it just on its way?
Sam: Not the same at all. For one, Texas can’t refuse to send unemployment insurance or social security checks to California, and Californian can’t refuse to pay federal taxes. But Germans will never pay a dime in automatic stabilizers to Greeks, and Greeks will never pay taxes to Germany.
“Greeks will never pay taxes to Germany”
Or, so it seems, to Greece.
http://www.wealth-bulletin.com/portfolio/tax-trust-and-legal/content/1056530676/
To be fair … If I were Greek, I’m not sure I’d want to pay taxes to the Greek gov’t either. It doesn’t exactly have a stellar record of providing public goods (or good to the public).
If California is sinking in debt, and the Fed is not going to print more dollars just to help bail it out of its debt, its people will just move away, and go to perhaps, Oregon or Texas, where the state finances are healthier, and they don’t have to suffer austerity measures. Same with Canadians, who can move provinces. If the ECB is not going to print more Euros just to help bail Greece out of its debt, can people just move away, and go to Germany or France?
Except that mobility within Europe is somewhat illusory … can Greeks speak French or German? Will the French/Germans hire workers that they can’t talk to? Not to mention different social customs etc. etc.
It isn’t the same as someone in Alberta moving to BC, or someone in California moving to Oregon.
helicopter drop
Kosta: Thanks! Yes, I can’t see any way that Greece (or any country) would voluntarily leave the Euro. But I can see it involuntarily leave the Euro.
Paul Krugman has just posted a very similar sort of view. Actually, I think his narrative is a bit better than mine.
http://krugman.blogs.nytimes.com/2010/04/28/how-reversible-is-the-euro/
JP: the way I see it is that a repo is essentially a loan to the commercial bank, with the government bond just acting as collateral in case of default by the commercial bank. While an OMO is an outright purchase. But I can see the other way of looking at it. Yet, as you say, the degree of permanence may be different between the two. How long is the loan/repo for? When will the bond/TBill mature?
Sam: I’m still not sure how far one can stretch the analogy between Greece and California. One big difference is that the US Federal government exists. There’s no federal government of the Eurozone.
A little off topic but about currency denominated debt and I assume the need for low interest rates.
From:
http://globaleconomicanalysis.blogspot.com/2010/04/shelby-seeks-to-end-casino-atmosphere.html
“Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job 😉 amazing how good I am in convincing myself !!!” Tourre said in an e-mail to Serres in January 2007.
“It’s bizarre I have the sensation of coming each day to work and re-living the same agony – a little like a bad dream that repeats itself,” Tourre writes. “In sum, I’m trading a product which a month ago was worth $100 and which today is only worth $93 and which on average is losing 25 cents a day …That doesn’t seem like a lot but when you take into account that we buy and sell these things that have nominal amounts that are worth billions, well it adds up to a lot of money.”
Is that really God’s work?
Yes, I think its the permanence that matters; however, even outright operations unwind. For instance, the dollar weighted maturity of the Fed’s portfolio is/was around 4yrs.
Clearly, something becomes outright as a consequence of the confidence that will be rolled-over, and over.
Its a bit fascinating that, the BoJ which all these years has never been able to induce inflation, is fixated on the overnight repo market.
Nick: Thanks for the Krugman link. His narrative is conscice, but I prefer yours. You’ve done an excellent job of illustrating some of the dilemmas with the present situation (like low central bank rates but no one being able to borrow and more importantly the fact the EU isn’t a country, but no Eurozone countries have central banks).
Also, when comparing repos versus outright purchases of bonds. Couldn’t the Eurozone countries start issuing very short term debt (bills and notes), then have their banks buy this debt and then use it as collaterol with the ECB in repo agreements? If the ECB then extends their repo durations to 6 months to 2 years, this has the effect of the ECB buying the bills or notes (with a small haircut).
It would lead to each participating nation having a much shorter maturity for its debt, but as long as the ECB was committed to entering into repo agreements, there would be no problem in rolling over new debt.
Admittedly with Greece’s 2 year yields hitting 16%, it would be expensive, at first. But with the ECB entering the market, the yields would drop.
Would this work?
Has the BoJ really been trying to induce inflation? They have a target of 1%, which might be too low (I don’t know). Seems to me they could print Yen to reach their desired level of inflation. They sure can’t cut rates much lower.
Isn’t Greece already paying taxes to Goldman Sach. Didn’t its government put up dedicated revenue streams as colateral on Goldman’s loans. And weren’t the loans structured as currency swaps in order to get around EU rules.
If Greece is to be punished for what it did, than what about its enablers. Shouldn’t the EU be looking for ways to punish Goldman Sach as a warning to banks that would undermine its authority. Have we found out if Goldman was shorting Greek bonds?
Please research the ECB money creation process thoroughly before writing on it.
The ECB creates money through tender operations. It’s main refinancing operations MRF are running 1 week, conducted weekly and cover about 75% of the total central bank money creation. Since 2008 and the Lehman crisis they run quantitative tenders with full allotment for the bidding banks at a key interest rate (the other 25% being 3month operations for financial institutions with longer term financing objectives).
Actually receiving the allotment requires collateral in the form of elligible securities (mostly government bonds, but the ECB has leeway in choosing what it accepts as collateral). Repo actions are only done for fine tuning and are not a usual means of money creation in the ECB system.
Applying ‘quantitative easing’ as opposed to credit easing (which the ECB has already done) will put the bank squarely into the political battlefield between the German hawks and the doves regarding inflation targetting. Besides the ECB has a very indepenent mandate and more leeway than the BoE or the Fed, while political institutions which might apply pressure to it are deadlocking themselves.
Regards from Germany, an avid reader
Kosta: “Also, when comparing repos versus outright purchases of bonds. Couldn’t the Eurozone countries start issuing very short term debt (bills and notes), then have their banks buy this debt and then use it as collaterol with the ECB in repo agreements? If the ECB then extends their repo durations to 6 months to 2 years, this has the effect of the ECB buying the bills or notes (with a small haircut).”
Dunno. I don’t see how this is really different from what the ECB and Eurozone countries are currently doing. But if (say) Greek bonds are worth only 75 cents on the Euro (I nearly said “on the dollar”!), and German bonds are worth 100 cents on the Euro, I don’t see anything in this process that would bring Greek bonds’ prices back up. Who is on the hook if the Greek bond defaults? Is it the commercial bank, or the ECB? In an outright purchase, the ECB must take the loss.
Finster: “Please research the ECB money creation process thoroughly before writing on it.”
That’s what helpful, informed commenters like you are for! Blogging is a 2-way street.
Those tender operations you describe are just a way of the ECB making collateralised loans to commercial banks, right? With competitive bidding by the commercial banks, so that the bank that bids the highest interest rate gets the funds. And a repo is effectively just another form of collateralised lending to commercial banks? Because even if Greece defaults, the repo agreement requires the commercial bank to buy back the bond, even if it is now worthless.
So, simple story: The ECB creates money by collateralised lending to commercial banks. Right?
(When I looked at the ECB balance sheet, I did notice it had some percentage (around 30%?) of its assets listed as Eurozone government bonds. My guess is that this was the original allotment when the ECB was set up?).
“Applying ‘quantitative easing’ as opposed to credit easing (which the ECB has already done) will put the bank squarely into the political battlefield between the German hawks and the doves regarding inflation targetting.”
Does the ECB have the kugels to enter that minefield?
Correct to a degree. Until 2008 the ECB mostly used interest rate tenders, in which central bank money was auctioned off to the highest bidder. Since 2008 the ECB went back to fixed rate tenders at full allotment, meaning that banks will get as much central bank money as they bid for, provided they have sufficient elligible collateral:
http://www.ecb.int/stats/monetary/rates/html/index.en.html
The HP of the ECB is very helpful for researching this and the institution is by far the most transparent central bank of the world.
The important point being that the ECB creates money on a short term basis via tender operations and except for the credit easing operations and some fine tuning all central bank money creation is a short term and self retiring mechanism. Based on this central bank money the commercial financial institutions create money on their balance sheets (private money, roughly 90% of the grand total of Euro circulation).
Thinking more about it the problem is such:
Modern central bank money is highly synthetic stuff. Creating more of it is absolutely no problem. A hit on the return key will do. However if an excess ends up in the hands of the non-financial institutions aka M3 (this includes governments) it creates inflation. This genie is very hard to tame once it’s out of the bottle and at the same time it does not address the ‘pushing on a string’ problem of credit: if the private sector is maxed out in mortgages and cannot post any more collateral, all the central money creation in the world can’t get the banks to lend (as they should not under those circumstances).
Greece meanwhile is a totally different matter: locked to the Euro it operates under a ‘gold standard’ by other means. It’s caught in one currency with Germany or even more precisely it doesn’t have an own currency, because arguably the Euro is the currency of France and Germany and reflects their competativeness and productivity. So any adjustment in Greece will have to take place on a post WWI Great Britain/France/USA model, meaning deflation to restore productivity. Precisely that regime prompted Keynes to demand an end to the Gold Standard, precipitating in Churchill’s comment that restoring the Gold Standard post WWI in GB was his worst policy blunder (albeit at wrong parity to the US Dollar).
I might have strayed off topic here, but to my mind there is too much interpreting off effects going on as to understanding causes. And this maybe is the strongest case for Greece leaving the Euro for its own good, because otherwise it’s back to the history books and british unemployment of the 1920s, without taking into account the specifically british willingness to endure hardship to pay your creditors.
Finster: not really off-topic. But your main point, in the middle paragraph, the analogy to the Gold Standard, I take as read. It is part of my background assumption when writing this post. I spent more time on this sort of issue in my earlier posts on the Eurozone.
Nick: My suggestion about using repo agreements of bills and short-term notes to replicate outright purchases was meant to highlight that the ECB already has the capability to effective purchase debt. In other words, the ‘nuclear option’, which you referred to, is already within the ECB’s capability.
If the ECB made a credible commitment to “purchasing” (repo-ing with maturity while the ECB still holds the collaterol) all short-term Greek debt, there would undoubtedly be a large price effect. By taking this stance, the ECB would be guaranteering that Greece would meet all of its funding needs indefinitely. As long as the commitment is maintained, investors would be assured that Greece could roll over its debt, and they would be willing to hold short-term debt, which would raise prices and drop yields.
My comment is really technical, I was just trying to point out that in addition to the ‘nuclear option’, the ECB has the ability to accept all Greek debt, regardless of rating, as collaterol. If they do so with a credible long-term commitment, it’s the equivalent of the ‘nuclear option’, but with a maturity shift in the debt.
On to another topic, Simon Johnson and Peter Boone have another post on The Baseline Scenario where they outline a massive expansion in the size of the IMF. I’m ambivalent about their proposal (I think the ECB should do the heavy lifting), but it might work. One element of their suggestion was the need for a new IMF head, and they recommend drafting Mark Carney. And while I’m open to Canadian tax dollars supporting the IMF, I think they should keep their hands off our BoC governor 🙂
My understanding is that the ECB’s main refinance operations are conducted in the form of repos. ie it is auctioning of repos ie. the tender operations are repos. The crux of the “nuclear option” issue as I understand it is the potential switch from short term repo tender operations to long term outright operations.
“So, simple story: The ECB creates money by collateralised lending to commercial banks. Right?”
It’s not that easy. Repos look and act like loans, but from an accounting and legal sense they aren’t loans, but purchases/sales. When you lend money to someone, you don’t bring the corresponding collateral on to your balance sheet. It stays with the borrower. When you do a repo, you do bring the collateral onto your balance sheet.
From a legal sense, central bank law differentiates between lending operations and purchase/sale operations. Different sorts of collateral requirements may apply to either, so it is important that repos are properly classified. The BoC in 2007, for instance, illegally extended the wider collateral requirements governing its lending operations to its repos, and had to withdraw when confronted.
Anyways, this repo stuff is moving away from you main point, which seems to me to be the potential (or not) for new drachmas.
The ECB is run by strict mainstream economists and is not going to follow any innovative advice.Part of the problem is that it requires the collateral of national bonds to be of investment grade as rated by private rating companies. There is no democratic accountability with EU institutions greatly removed from EU voters and parliaments. The whole crisis in Greece started when the Greek central bank under instructions of the ECB pressured Greek banks to limit their participation in refinancing tender operations, especially the 12 month maturity kind in December 2009 and explained (!) that downgrades of Greek debt will limit the ability of Greek banks to borrow. Immediately spreads begun to rise. Furthermore, they raised the short float period to t10 days and allowed naked short sales with the right to withdraw without penalty!
Ok Kosta, I see what you’re saying. One difference between the nuclear option and your short term repo option is that the participating banks face different risks under the two scenarios.
In the first the private banks buy government debt and sell it outright to the ECB, end of story. Bank has cash, ECB hold Greek risk.
In the second the banks buy government debt and repo it to the ECB. But with a repo, when the value of the collateral falls, the banks must pay up the difference to the ECB. Banks would much rather sell bonds outright to the central bank, especially Greek ones, since they no longer have exposure to Greek risk.
I think it boils down to… why would the banks agree to participate in a trade that exposes them to Greece? Out of nationalism and pride? Are they forced too? Is there some sort of carrot involved?
Lovely comments above!
Kosta: like JP, I now see what you’re saying. And I have JP’s same response.
And that, Panayotis, is an interesting new (to me) fact.
JP: I can see why the leagl angle on repos might matter. But why does it matter how the accountants describe it? “Who’s on the hook if the bond defaults (the bank or the ECB)?” seems to me to be the key question. And if it’s the bank, as you say, then a repo is economically equivalent to a loan.
Kosta: Yes, I was just reading the Boone and Johnson piece, and trying to get my head around it. Why, for example, does it have to be the IMF that supplies the funds? If there’s a run out of Greek (and other) bonds, what’s it a run into? If it’s Euros, then why can’t the ECB supply the funds? And it would only be a run out of Euros into (say) dollars if the Eurozone had serious liquidity problems, which could be fixed by the ECB?
The accounting matters because if a repo is treated as a purchase/sale, you don’t have to keep the collateral on your balance sheet. Its a good way to get rid of a risky asset but still own it indirectly through the promise to buy it back ie. off-balance sheet financing.
If the repo is treated as a loan, than the collateral stays on your books and you have not succeeded in transferring the risky asset off-balance sheet.
But from an economic sense, you can’t go wrong treating it as a loan.
Nick: I had similar concerns with what they wrote (and Johnson undoubtedly favours his old organization). They did mention possibility of the ECB providing the necessary “liquidity”, but write “this is exactly the process that always and everywhere brings about high inflation. The Germans would fight hard against such a policy, although it would prevent default.”
I believe they’re subscribing to:
the ECB will point to its nice low interest rate target and say “Look how loose monetary policy is!”. And it will be low, because the only people who can borrow at that rate won’t need to, and all those who desperately want to borrow at that rate won’t be allowed to.
An expanded IMF could work, but having the ECB change policy seems to be the easier move.
With regard to the short-term repos, if the ECB makes a credible commitment to continuing its repo operations indefinitely, the risk of the collaterol falling in value will be small. As Panayiotis pointed out, one of the contributing factors to the most recent episode in the Greek crisis is concerns and manouevering about what Greek debt the ECB will accept. Similarly if (when) Moody’s finally downgrades Greece, Greek debt will not be accepted. The ECB could relieve a lot of pressure on Greek debt by simply suspending it collaterol requirements. If the commitment is credible, the trade will become nearly risk free, so why wouldn’t banks participate?
Of course, politically dropping the collaterol requirements is probably the equivalent of the ‘nuclear option’
I repeat, the ECB does not create the main part of EMU central bank money supply through repos, but via credit to bidding banks in the form of tender operations, which require collateral in the form of elligible bonds/securities.
Repo operations are used for fine tuning purposes if an additional need for liquidity arises between main refinancing operations. Yes, it is bizarre that the elligibility of the collateral depends on private rating agencies whim, because obviously as a central bank the ECB should be able to analyze securities itself. Let’s describe this as a legacy function of a disfunctional regime.
The real question at the ECB will be: Who do we credit central bank money to and what will happen with M3? Will the ECB in whatever way be engaged in government financing, which is not allowed according to the maastricht treaty. Monetary union central banks are forbidden from creating money and crediting the balance to their government. The ECB will not engage in anything similar.
Finster: you wrote:
the ECB does not create the main part of EMU central bank money supply through repos, but via credit to bidding banks in the form of tender operations, which require collateral in the form of elligible bonds/securities.
I am definitely not an expert in these matters, so I appreciate your input. I was wondering if you could comment on how Greek banks (and I assume other Eurozone-member banks) have over the past year or so purchased debt from their own gov’t’s and then used this debt as collateral at the ECB to obtain additional funds at a lower interest rate. I’ve read about these transactions numerous times and always assumed that it was completed through some sort of a repo operation. I also assumed that Greece (and other nations) used these transactions as a major mechanism to fund their fiscal deficits. Were these repo operations? And did they not create a substantial portion of the “money” in Europe?
I’m pretty sure the main refinancing operations are conducted with repos. See for instance:
Click to access ecbwp1052.pdf
Click to access ecbwp157.pdf
Click to access ecbwp359.pdf
I quote from the last: “The ECB conducts repo auctions as weekly main refinancing operations (MRO) with a (bi)weekly maturity and as monthly longer term refinancing operations (LTRO) maturing after three months”
Again, I must point out the absence of democratic accountability and control in EU institutions, the absence of EU fiscal authority in coordination with the ECB and the absence of full employment and growth mandate for the ECB monetary policy. These are at the core of the European problem, regardless of the operational mechanics of refinancing measures. The EMU is a regime of a nonconvertible fiat currency with flexible exchange rates externally and a gold standard with fixed exchange rates internally and national fiscal authorities that are revenue constrained. Is it realistic to base policy on internal deflation/fiscal austerity and debt restructuring? If national debt of member states cannot be purchased by the central bank and/or is under threat from private rating downgrades, restructuring with a haircut is the only choice rather than austerity measures with a bail out that bring a debt deflation feedback loop. At the end the bail out is forced to become a debt restructure at worst terms for all.Notice that restructuring is already validated by mark to market revaluations in portfolios so it is really neutral in its effect.
Panayiotis: “restructuring with a haircut is the only choice rather than austerity measures with a bail out that bring a debt deflation feedback loop”
I’m not sure about the legitimacy of any type of debt restructuring without Greece first doing its utmost to put its fiscal house in order. And that means austerity. It may very well be too late for Greece to cut its budget sufficiently to stabilize its finances, it may very well push Greece into an inescapable debt deflation feedback loop, but ultimately it’s Greece’s responsibility to do what it can to stabilize its own finances. The austerity has to happen first, and especially before any debt restructuring, with or without haircuts. Otherwise, it would appear that Greece is getting a free lunch, courtesy of those creditors foolish enough to buy Greek debt. What creditor would voluntarily agree to a haircut while knowing that Greece could still cut its own budget? If they’re forced, while knowing that Greece could still implement austerity, what party would ever extend Greece credit again?
Kosta,
Thank you for your comment. Restructuring is a fact of business life. It is an admission that the original conditions of any agreement no longer apply and terms need to be changed. The creditors agree in order to avoid total loss if default occurs especially when there is no collateral to compensate them. Austerity measures will worsen the situation as they will lead in a deflation spiral and at the end will make things worse even for the creditors. Furthermore, thete is collateral damage upon the population and a moral hazard because the poor, the workers and the unemployed, who are not at fault, will have to pay so the creditors can collect their money in full. When you lend you take risk and you must pay for the outcome of your credit decision. As about lending again, my point is that Greece has the means to turn to domestic savings, which are substantial, for its borrowing needs as Greek private sector has less debt as ashare of GDP than in most other developed economies.. It is not healthy to have 82% of debt owned by foreign creditors as the income drain during the severe recession that follows will make things worse! Furthermore, notice that most creditors have validated loses in their portfolio of Greek debt because of mark to market accounting and also have transferred some of the expected loss on the ECB that holds a substantial amount of Greek debt as collateral of refinancing facilities.
Panayiotis,
We both agree that there needs to be a large adjustment in Greece for that country to escape this crisis. It seems that you are suggesting that the pain resulting from that adjustment should be bourne by the foreign creditors instead of by Greece. I don’t think that can happen, first off because Latvia and Ireland have both chosen austerity, but perhaps more importantly because the credit was originally offered to Greece based on misrepresented financial statements. Are you suggesting that Greece should be given an exception because it cheated?
Greece is not in a strong bargaining position here. The foreign creditors are the ones with alternatives. In particular if Greece defaults the ECB and other Eurozone countries will likely bail the private creditors out to prevent the financial system from collapse. Instead you are suggesting that these creditors should take a haircut when it was Greece that has presented misleading fiscal information for the past decade. Recent precedents in Europe (Latvia and Ireland) are clear, austerity is plausible. It will be painful for Greece, but ultimately it’s Greece’s responsibility.
In any case, haircuts will not solve the problem. I posted a link earlier to a study exploring haircuts, and even with a sizeable cut in the foreign debt, Greece would still have to cut it’s own fiscal expenditures by 7.5% of GDP to stabilize its debt. Even if Greece tries to turn to domestic savings in this scenario, at what rate will these loans be made available? Can Greece survive without cheap loans from abroad?
Paul Krugman: The Euro Trap
IMO, the morality play presentation is not entirely accurate or helpful.
Paul Krugman’s two posts on this are very good. The one (important) thing he has missed is the “Lender of Last Resort” problem. And I mean LLR not just to prevent a run on the commercial banks, but to prevent a run on government bonds.
Sure, in principle, the ECB could act as LLR to banks and governments, but there’s the political question. Who pays whom? Will Germans pay for Greek banks and government? That question was bad enough within the US, for example. But at least there is a US Federal government that can decide one way or the other.
German Tea Party, anyone?
About Greek bank runs, I saw this on Bloomberg’s “Deposits in Greek banks fell for a third month in March, leading to a 4.5 percent drop in the first quarter. That coincided with a fourth monthly increase in deposits held in Cyprus by local branches of Greek banks on the island.” http://www.bloomberg.com/apps/news?pid=20601087&sid=a1oOwudcKN2g&pos=2
It’s not a full blown run, but the trend is continuing.
Also Nick: in principle, the ECB could act as LLR to banks and governments, but there’s the political question. Who pays whom? Will Germans pay for Greek banks and government?
It’s a good point, but if the LLR is effective, then it should make a profit, having bought at the lows which its intervention created. Just consider the record profits the US Fed has been making these past few quarters. I think the political question devolves down to which country takes ultimate responsibility if the LLR’s intervention fails? In the case of failure, Germany will be paying for Greece?
Kostas,
I do not agree with your mainstream views or your assessment of the situation in Latvia and other countries where austerity measures were implemented! You are also wrong on your assessment of restructuring. Even conservative economists like Feldstein,Johnson,Roubini and many others propose similar opinions to mine! You are a victim of a lot of propaganda regarding Greek budget reporting which was audited repeatedly by the EU anf fount acceptable! A viable program for Greece will be based on tax collection and waste control in addition to a haircut of about 30% and a maturity extension. I have proposed an elaborate program to high government officials and politicians who prefer to represent foreign banks rather than their own voters. As far as domestic debt is concerned earning 3-4% in Greece is much higher than what banks are offering in deposits.You seem to be more interested to have banks that access their risk to be paid in full rather than innoccent citizens who according to your prescription will end up paying dearly with the austerity package. On the dilemma who will pay, I say the banks first, the tax evaders second and waste control third, the last two follow because thet are long term policies!
Kosta,
The deposit figures in March show a much smaller decline, mainly reflecting seasonal and recession factors. There is no run on greek banks as I know first hand!
Latvia is suffering a terrible depression. I wouldn’t wish that on anyone.
The morality play formulation cuts both ways. One could argue that Greece’s creditors should be punished for making a dumb decision to lend money to Greece. And no doubt many of Greece’s creditors would be classified as sophisticated investors. They should have known that Greece was not a sure thing. If they wanted a sure thing, they should have bought US T bills.
Seems to me that the responsible thing to do at this point is to do ‘all of the above’: restructure Greece’s existing debt, implement tough but reasonable ‘austerity’ measures, and the EU should provide reasonably priced financing. They might as well work out a formula everyone can live with, because they’re probably going to need to apply it to Spain, Portugal, and Ireland – and note that Spain and Ireland were running surpluses prior to the financial crisis.
Panayiotis,
The bank numbers show a trend where deposits are leaving the country. You may be right that the trend is entirely seasonal; it would be best to compare these numbers to previous years. On the other hand, banks in Cyprus are showing an increase in deposits. Is the Cyprutian seasonal trend up in Jan-Mar while the Greek trend is down? Are recessional factors different in Cyprus from Greece? Or is there a trend towards deposits moving out of Greece into Cyprus?
With regards to Greek budget reporting, it is well established that Greece falsified its reporting to gain entry into the Euro. It is also well established that more recently Greece has entered into currency swaps to conceal the size of its own debt (note, other EU countries also participated in these swaps). Most importantly, as late as last Summer, the Greek gov’t was reporting a fiscal deficit on the order of 4% of GDP. After Papandreaou won the elections, the deficit climbed to 12%. While changes in estimates of deficits are common around elections, an 8% increase is much larger than can be attributed to forecast errors. All of these facts are well established, none of this is propaganda. Greece has routinely provided misleading fiscal information, the magnitude of the problem only came to light last Fall. The fact that the EU accepted previous Greek fiscal statements extends the culpability to the EU, but does not excuse Greece from being misleading in their reporting.
With regards to the restructuring of debt, I assume we are both discussing the scenario where Greece does not default. If Greece defaults, the debt restructuring question takes on a different tone. My main issue is the impracticality of a debt restructuring. Is it supposed to be voluntary? Or is the EU going to force a debt restructuring on the banks? If it is forced, is that not tantamount to a default? If it is voluntary, why would any creditor acquiesce to a haircut? You’ve presented this issue as the creditor choosing between 70% and 0%. That’s a false dichotomy. The choice really is the creditor can insist on 100% repayment with a chance that Greece will default, or 70% repayment with a smaller chance that Greece will default. In either case, if Greece defaults, the creditors will be bailed out. Maybe not 100 cents on the Euro, but they’ll get something back. So why would a creditor choose a haircut?
I don’t mean to say that debt restructuring can’t be part of the solution, I’m more pointing out that a voluntary debt restructuring seems impractical, and a forced restructuring will involve a default. The other issue with debt restructuring is that by itself, it won’t solve Greece’s problem. Even with debt restructuring Greece will still have a very large fiscal deficit which much be closed (7%-10% from the studies I’ve seen). The way your proposals have sounded, very little effort will be made on the part of Greece to close this deficit, but without this deficit being closed, Greece’s fiscal problem will not be solved, but just postponed until the debt climbs again.
If Greece put forth a credible plan to close its deficit, then debt restructuring could be part of the solution. But unless this plan reliably closes the deficit, I fail to see the incentive for creditors to voluntarily take haircuts? And note, difficulties with previous Greek fiscal reporting detracts from Greece’s credibility; that’s part of the reason the IMF was called in.
There are some very good reasons why haircuts to the creditors should be avoided. Most importantly, we all need the banks to funtion normally. A forced haircut and/or default could potentially lead to a repeat of Lehman’s failure with loans being recalled system wide and forced selling all around. No one wants to repeat that. Second, we want the banks to as assured as possible that they will always get their money back because that leads to the banks lending at lower interest rates. A lower cost of capital spurs economic growth, which is something Europe needs righ now. I suppose an argument can be made that the cost of capital was priced too low the the past decade, and that forced haircuts would teach banks to not lend at such advantageous rates, but do we really want banks to revalue risk and to raise rates by 1% across the board across Europe and North America? Is that your suggestion? Forcing banks to take a haircut, who will penalize the rest of the world, so that Greece suffers less pain? Is that your solution?
Arguably it is better for Greece to suffer the pain, so the rest of Europe can recover quicker to pull Greece along.
Ultimately, the responsibility for what is happening lies with Greece. I think you need to accept this. Instead of blaming the EU for approving Greek fiscal statements, and instead of blaming foreign banks for extending credit to Greece, why not look at your own society and ask why the heck did your country get into this much trouble? That’s my problem with the haircuts, and that’s my problem with the bailouts. It’s Greece that has to change, not the rest of the world. Greece is the one that needs to sort out its finances, whether by spending cuts or clamping down on tax evasion, or making the wealthy pay their fair share. Once that happens, I’m all for debt restructuring or bailouts, but until Greece takes ownership of its problems, why should the rest of the world help?
“… why not look at your own society and ask why the heck did your country get into this much trouble”
This makes no sense. You need to read Krugman’s posts. The morality play angle is NOT accurate OR helpful.
Why would anyone want to duplicate these performances is beyond me:
http://www.indexmundi.com/spain/unemployment_rate.html
http://www.indexmundi.com/ireland/unemployment_rate.html
http://www.indexmundi.com/latvia/unemployment_rate.html
Panayiotis: “A viable program for Greece will be based on tax collection and waste control in addition to a haircut of about 30% and a maturity extension.”
Well, setting aside the question of a haicut for lenders, what’s the viable program for tax collection and waste control? If the Greeks could pull that off, it’s creditors wouldn’t be freaking out. The problem is tax evasion is rampant in Greece as is public sector waste. While it’s fun to blame foreign lenders, at the end of the day Greece’s problem is that it’s been living a lifestyle over the past decade that it can’t afford and that it’s citizens (however much they enjoy it) don’t want to pay for. Giving Greece’s lenders a 30% haircut and maturity extension won’t change that (although it might cripple large chunks of the EU banking system).
Panayiotis: “As far as domestic debt is concerned earning 3-4% in Greece is much higher than what banks are offering in deposits.”
That may be true, but on the other hand, if you invest in German bonds, you can earn the same 3% and not risk taking a 30% haircut when the government defaults. Unless you’re proposing to restrict capital outflows from Greece, why would Greek savers invest their money in Greek Bonds (or Greek banks, for that matter), when they can get the same return with far greater certainty in Germany/France/US/Canada/etc? And don’t tell me it’s out of patriotism since those same Greeks who you think will be lending money to the Greek government are also the ones hiding their money abroad and evading their taxes.
Panayitois: “You seem to be more interested to have banks that access their risk to be paid in full rather than innoccent citizens who according to your prescription will end up paying dearly with the austerity package.”
Personally, I’m of the school of thought that says investors take their chances. Greece is a borderline third-world country and the fact that it’s part of the EU doesn’t meant that investors should have lent money to it at goofy low interest rates. But the reality is that that Greece’s “innocent citizens” (who lived high on the hog on other people’s money during the boom years) are going to be taking a hit no matter what, because the lifestyle they’ve been used to over the past decade simply isn’t within their means. Frankly, rather than calling the proposed reforms an austerity package the government should be calling it a reality package.
“This makes no sense. You need to read Krugman’s posts. The morality play angle is NOT accurate OR helpful.”
Patrick, I am of Greek descent and have lived in both Greece and Canada, and am in fact a citizen of both nations. I have friends and family in both countries. I have also read lots of Krugman, who loves to moralize when it suits him. I am not moralizing as a Canadian telling the Greeks they are in the wrong. I am pointing out, one Greek to another (as my compatriot knows from my name), that there’s something systemically wrong in Greek society, and that Greeks need to figure it out and fix it.
Am I out of place to say such a thing seeing as I live in Canada? Perhaps, but I have had the fortune to live in both countries, do business in both countries, and pay tax in both countries, which gives me a perspective that most do not have.
And yes, there are problems in Greek society that led to the present situation, and hopefully Greeks will correct these issues as they fight their way through this crisis.
Patrick wrote:
Why would anyone want to duplicate these performances is beyond me:
http://www.indexmundi.com/spain/unemployment_rate.html
http://www.indexmundi.com/ireland/unemployment_rate.html
http://www.indexmundi.com/latvia/unemployment_rate.html
Those numbers are gruesome, but what’s the alternative? How about default? Have you looked at Argentina’s numbers post their default in 2001?
http://www.indexmundi.com/argentina/unemployment_rate.html
or
http://www.latin-focus.com/latinfocus/countries/argentina/argunemp.htm
Kosta, your personal views are what they are. But can any of us say that we’re free of moral defects? I’m Irish, so I know all about moral defects 😉 How much of Canada’s relative good fortune of late is attributable to moral rectitude, and how much of it is due to dumb luck? I’m in the ‘dumb luck’ club.
The general point I’m making is that it’s easy and makes us feel superior to get on our high horse, hand out hair-shirts, and moralize; telling Greeks, Irish, Spanish, etc that it’s for their own good that they have to suffer mass unemployment and deflation, but the fact is that it’s real people who had nothing to do with the Greek gov’t mismanaging public finance (aided and abetted by Goldman), who end-up suffering. And the damage could potentially last decades. Would paragons of virtue like me and you condemn an entire nation to such a fate when alternatives exist? For my part, I say no.
Krugman wonders: Why Isn’t Britain In More Trouble?