Coyote Blog

I have been predicting for years that the only solution for the Greece problem is for it to exit the Euro, go through a horrible economic crisis and deal with substantial devaluation, and then hopefully move on with a cheaper currency that makes its tourist industry look better and plugs the hole between taxing and spending with inflation.  It appears we are closer than ever to this actually happening.  The Greeks would likely be moving forward now, like Iceland, if they had taken their medicine years ago rather than try to kick the can.  Now it is just going to be worse.

I have been enamored off and on with the idea of a gold standard but Megan McArdle made some powerful points today about how the Greek situation teaches us that a gold standard doesn't necessarily impose discipline on governments.

It's easy to moralize Greece's feckless borrowing, weak tax collection and long history of default, and hey, go ahead; I won't stop you. But whatever the nation's moral failures, what we're witnessing now shows the dangers of trying to cure the problems of weak fiscal discipline with some sort of externally imposed currency regime. Greek creditors and Brussels were not the only people to joyously embrace the belief that the euro would finally force Greece to keep its financial house in order; you hear the same arguments right here at home from American gold bugs. During the ardent height of Ron Paul's popularity, I tried to explain why this doesn't work: "You don't get anything out of a gold standard that you didn't bring with you. If your government is a credible steward of the money supply, you don't need it; and if it isn't, it won't be able to stay on it long anyway."

This goes double for fiscal discipline. Moving to a fixed exchange rate protects bond-holders from one specific sort of risk: the possibility that inflation will erode the real value of your bonds. But that doesn't remove the risk. It just transforms it. Now that the government can't inflate away its debt, you instead face the risk that they are going to run out of money to pay their bills and suddenly default. That's exactly what happened to Argentina, and many other nations on various other currency regimes, from the gold standard to a currency peg. The ability to inflate the currency had gone away, but the currency regime didn't fix any of the underlying institutional problems that previous governments had solved with inflation. So bondholders protected themselves from inflation, and instead took a catastrophic haircut.

Postscript #1:  I had one issue with McArdle's piece when she writes

The only people this will be good for is people who long to vacation on the Greek Islands. If Grexit actually happens, book those plane tickets now, but hold off on the hotel. It will be cheaper in six months. Then try to enjoy it as you remember that those fabulous savings are someone else's whole life evaporating.

Hey, if Grexit occurs, you have no reason to feel guilty about taking advantage of the weak currency and low prices for a Greek vacation.  There is nothing the Greeks need more than for you to do exactly that.   It is the single best thing you could do for the Greek people.

Postscript#2:  Here is why exiting the Euro, devalutation, and inflation are the only way out for Greece at this point. Creditors allow countries to run long-term deficits and keep lending despite rising debt (see: Japan) because of a combination of a) the country can always just print the money they need; b) the country can raise taxes and take the money it needs or c) the country can keep spending flat and grow their way out from the debt.

None of these are available to Greece. They can't print money, at least without running up new debts (excess printing of Euros is automatically added to Greece's debt to the ECB).  They can't raise taxes because their citizens don't pay the taxes that already exist.  And they can't grow their way out because there is zero support for austerity or market-based reforms that would be necessary, and besides a huge portion of Greek deficit spending is for inherently unproductive activities.  At this point Greece's only option is charity, that the other countries of the EU will forgive debt or write them new debt, either to be nice or to avoid bad precedents with other PIGS countries.  But  the EU seems at the end of its charity rope, and besides given zero prospects of any sort of Greek recovery, even after a major write-off of debt the EU would be in the position of still having to send Greece new money for its new debts.

I want to offer a perspective on the Greek financial mess.

I am not confused about the Greek desire to get out from under their debt load - past governments have built up intolerable levels of debt which is costs a huge portion of Greek GDP to pay off.

At one time in my life I would have been confused by folks, often on the Left, who argue that the answer to Greek debt problems is ... deficit spending.  This might have seen inexplicable to me earlier in life as a wondered how the same behavior of fiscal irresponsibility that led them into debt would get them out.  But I have learned that there is no limit to the optimism Keynesians hold for the effects of government spending.  The last trillion of debt may have not done anything measurable but the next trillion is always going to be the one that turns us around.  Sort of like Cubs fans.

No, what confuses me today is the fact that other institutions and countries are still willing to buy Greek debt and even entertain some sort of debt swap where they end up with even more Greek debt.  I have heard it said by many experts that it is unrealistic to expect that lenders will get even a fraction of their principle back from these loans.  So why loan more?

The key for me in understanding this is the book "Engineering the Financial Crisis".  In that book, the authors presented the theory that the Basel capital accords, which set capital requirements for banks, had a lot to do with the last financial crisis.  Specifically, the rules allowed bank investments in two types of securities to be counted at 100% towards their capital levels.  Any other type of investment was severely discounted, so there were enormous incentives in the regulations to focus bank investments on these two types of securities.  What were they?  Sovereign debt and mortgages (and mortgage-backed securities).

In the authors' view, which I find persuasive, a lot of the last financial crisis was caused by these rules creating a huge artificial demand by banks for mortgage securities.  This created a sort of monoculture that was susceptible to small contagions spreading rapidly.  As this demand for mortgage backed securities inevitably drove down their returns, it also created a demand for higher-yielding, riskier mortgage investments that might still "count" as mortgage securities under the capital requirements.

Anyway, for the Greek crisis, we need to look at the other piece of these capital requirements that give 100% capital credit:  sovereign debt.  Now, I may have this wrong, but for Euro denominated credit, it all counts as 100% whether its German or Greek, which is a bit like saying a mortgage to Bill Gates and a mortgage to Clark Griswold's country cousins count the same, but those are the rules.

So here is the problem as I understand it:  Greek debt, because of its risk, paid higher returns than other sovereign debt but still counted the same against capital requirements.   So European banks loaded up on it.  Now that the debt is clearly bad, I am sure they would love to get paid for it.  But what they want even more is to continue to get credit for it on their balance sheets against capital requirements.  So what the banks need more than getting paid is for the debt to still exist and to (nominally) be current so that they can still count it on their balance sheets.  Otherwise, if the debt gets written off, that means banks need to run out and raise hundreds of billions in new capital to replace it.

Yes, I know this seems insane.  If everyone knows that the debt is virtually worthless, isn't it a sham to keep taking expensive steps (like issuing even more new debt) just to make sure the debt still appears on the books at 100%?  Yes, of course it is.  This is a problem with just about every system ever tried on bank capital requirements.  Such requirements make sense (even to this libertarian) in a world of deposit insurance and too big to fail, but they can and do create expensive unintended consequences.

The Business Secretary of the UK is desperately worried that when travelling to other countries, Brits will encounter a different selection of Netflix programming from what they are used to at home.  This trivial issue seems to demand a whole new regulatory and copyright regime:

Vince Cable will risk a clash with the film and music industries on Tuesday by calling for the creation of a single EU market for digital services such as Netflix.

The Business Secretary will say in a speech in Brussels that such services should offer the same content in all EU member states, for services paid for in one country to be available in the same form in all countries and for pricing offers to be replicated across the continent.

At present Netflix and Spotify, which operates a subscription streaming service for music, offers different catalogues at different prices depending on where the customer is located.

Harmonising such services across the EU would require copyright holders to change the way they license their material, which is currently carefully segmented for different geographic markets to maximise sales

Greece is looking like it's falling apart again.  Or perhaps more accurately: Greece continues to fall apart and the lipstick Europe put on the pig a few years ago is wearing off and people are noticing again.

I warned about this less than a year ago:

Kevin Drum quotes Hugo Dixon on the Greek recovery:

Greece is undergoing an astonishing financial rebound. Two years ago, the country looked like it was set for a messy default and exit from the euro. Now it is on the verge of returning to the bond market with the issue of 2 billion euros of five-year paper.

There are still political risks, and the real economy is only now starting to turn. But the financial recovery is impressive. The 10-year bond yield, which hit 30 percent after the debt restructuring of two years ago, is now 6.2 percent....The changed mood in the markets is mainly down to external factors: the European Central Bank’s promise to “do whatever it takes” to save the euro two years ago; and the more recent end of investors’ love affair with emerging markets, meaning the liquidity sloshing around the global economy has been hunting for bargains in other places such as Greece.

That said, the centre-right government of Antonis Samaras has surprised observers at home and abroad by its ability to continue with the fiscal and structural reforms started by his predecessors. The most important successes have been reform of the labour market, which has restored Greece’s competiveness, and the achievement last year of a “primary” budgetary surplus before interest payments.

Color me suspicious.  Both the media and investors fall for this kind of thing all the time -- the dead cat bounce masquerading as a structural improvement.  I hope like hell Greece has gotten its act together, but I would not bet my own money on it.

In that same article, I expressed myself skeptical that the Greeks had done anything long-term meaningful in their labor markets.  They "reformed" their labor markets in the same way the Obama administration "reformed" the VA -- a lot of impressive statements about the need for change, a few press releases and a few promised but forgotten reforms.  At the time, the Left wanted desperately to believe that countries could continue to take on near-infinite amounts of debt with no consequences, and so desperately wanted to believe Greece was OK.

I have said it for four years:  There are only two choices here:  1.  The rest of Europe essentially pays off Greek debt for it or 2.  Greece leaves the Euro.  And since it is likely Greece will get itself into the same hole again some time in the future if #1 is pursued, there is really only leaving the Euro.  The latter will be a mess, with rampant inflation in Greece and destruction savings, but essentially the savings have already been destroyed by irresponsible government borrowing and bank bail-ins.  At least the falling value of Greek currency would make it an attractive place at for tourism if not investment and Greece could start rebuilding its economy on some sort of foundation.  Instead of bailing out banks and Greek officials, Germany should let it all fall apart and spend its money on helping Greece to pick up the pieces.

By letting Greece join the Euro, the Germans essentially let their irresponsible country cousins use their American Express Platinum card, and the Greeks went on a bender with the card.   The Germans can't keep paying the bill -- at some point you have to take the card away.

The Left continues to push the myth that government "austerity"  (defined as still running a massive deficit but running a slightly smaller massive deficit) is somehow pushing Europe into a depression.  Well, this myth-making worked with Hoover, who is generally thought to have worsened the Depression through austerity despite the reality that he substantially increased government spending.

It is almost impossible to spot this mythical austerity beast in action in these European countries.  Sure, they talk about austerity, and deficit reduction, and spending increases, but if such talk were reality we would have a balanced budget in this country.  If one looks at actual government spending in European nations, its impossible to find a substantial decline.  Perhaps they are talking about tax increases, which I would oppose and have been occurring, but I doubt the Left is complaining about tax increases.

Seriously, I would post the chart showing the spending declines but I can't because I keep following links and have yet to find one.  I keep seeing quotes about "commitment" to austerity, but no actual evidence of such.

Let's take Britain.  Paul Krugman specifically lashed out at "austerity" programs there are undermining the British and European economy.  So, from this source, here is actual and budgeted British government spending by year, in billions of pounds:

2007: 544.0

2008: 575.7

2009: 621.5

2010:  660.6

2011:  683.4

2012:  703.4

2013: 722.2

Seriously, I will believe the so-called austerity when someone shows it to me.  And this is not even to mention the irresponsibility of demanding more deficit spending without even acknowledging the fact that whole countries already have so much debt they are teetering on the edge of bankruptcy.

Here is the European problem -- they are pouring hundreds of billions of Euro into bailing out failed banks and governments.  They are effectively taking massive amounts of available resources out of productive hands and pouring it into failed institutions.   Had they (or we) let these institutions crash four years ago, Europe would be seeing a recovery today.  The hundreds of billions of Euros used to keep banks on life support could have instead been used to mitigate the short term effects of bigger financial crash.

It is an open question how long this bailout will plug the dam.  I continue to maintain the position that Greece is going to have to be let out of the Euro. Pulling this Band-Aid off a millimeter at a time is delaying any possible recovery of the Greek economy, and really the European economy, indefinitely.  All to protect the solvency of a number of private banks (or perhaps more accurately, to protect the solvency of the counter-parties who wrote the CDO's on all that debt).

Anyway, the interesting part for me is that with this bailout, the total cumulative charity sent the Greek's way by other European countries now exceeds Greek GDP, by a lot.

As I predicted, the various highly touted European debt and currency interventions last month did squat.  This is no surprise.  The basic plan currently is to have the ECB give essentially 0% loans to banks with the implied provision that they use the money to buy sovereign debt.  Eventually there are provisions for austerity, but I wrote that I don't think it's possible these will be effective.   It's a bit unclear where this magic money of the ECB is coming from - either they are printing money (which they refuse to own up to because the Germans fear money printing even more than Soviet tanks in the Fulda Gap) or there is some kind of leverage circle-jerk game going where the ECB is effectively leveraging deposits and a few scraps of funding to the moon.

At this point, short of some fiscal austerity which simply is not going to happen, I can't see how the answer is anything but printing and devaluation.  Either the ECB prints, spreading the cost of inflation to all counties on the Euro, or Greece/Spain/Italy exit the Euro and then print for themselves.

The exercise last month, as well as the months before that, are essentially mass hypnosis spectacles, engineered to try to get the markets to forget the underlying fundamentals.  And the amazing part is it sort of works, from two days to two weeks.  It reminds me of nothing so much as the final chapters of Atlas Shrugged where officials do crazy stuff to put off the reckoning even one more day.

Disclosure:  I have never, ever been successful at market timing investments or playing individual stocks, so I generally don't.  But the last few months I have had fun shorting European banks and financial assets on the happy-hypnosis news days and covering once everyone wakes up.  About the only time in my life I have made actual trading profits.

Thought problem:  I wish I understood the incentives facing European banks.  It seems like right now to be almost a reverse cartel, where the cartel holds tightly because there is a large punishment for cheating.  Specifically, any large bank that jumps off the merry-go-round described above likely starts the whole thing collapsing and does in its own balance sheet (along with everyone else's).  The problem is that every day they hang on, the stakes get higher and their balance sheets get stuffed with more of this crap.  Ironically, everyone would have been better getting off a year ago and taking the reckoning then, and certainly everyone would be better taking the hit now rather than later, but no one is willing to jump off.  One added element that makes the game interesting is that the first bank to jump off likely earns the ire of the central bankers, perhaps making that bank the one bank that is not bailed out when everything crashes.  It's a little like the bidding game where the highest bidder wins but the two highest bidders have to pay.  Anyone want to equate this with a defined economics game please do so in the comments.