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Friday, February 12, 2010

"Thoughts on Greece's Debt Problems"

Dave Backus at at NYU's Stern Business School emails thoughts on Greece's debt problem:

Thoughts on Greece's debt problems, by Dave Backus, February 10, 2010: An exchange of ideas from NYU Stern faculty compiled by Dave Backus. It was done "on the fly," but I think it covers the range of issues nicely.

Summary of the issues

This is my take, no one else implicated, although all the ideas come from others...

* Debt and deficits. Greece in serious budget trouble, with government debt at 125% of GDP and rising. Confidence is Greece has fallen with repeated upward revisions in deficit estimates, which raise suspicions that the situation is worse than reported.

* Contagion? Greece itself is small, but there's fear that if Greece defaults or leaves the Euro Zone (or perhaps some other dire event), there could be spillovers to other Euro Zone countries (Italy, Portugal, and Spain lead the list). One version of this is that it would undercut the credibility of the Euro Zone. Member countries have (generally) reduced their borrowing costs by eliminating currency risk, but if investors see membership as reversible, that could change quickly.

* Conditions for help. The policy challenge is to keep the problems in Greece from spreading without creating adverse incentives for other countries. A bailout, for example, might make other countries less likely to resolve their own budget problems (mumble "moral hazard" around now). The traditional solution is some kind of "conditionality," in which bridge loans are tied to concrete progress on the budget. IMF programs typically have this form, and the NYC bailout in the 1970s did, too. Such conditions solve the budget problem and make bailouts less attractive to other countries. When imposed by an outside agency (the IMF, for example), they may also provide political cover ("they made us do it").

* Who? The challenge in the EU is that the rules explicitly forbid bailouts, so there's no natural agency to execute a plan. That leaves us with ad hoc mechanisms (the finance ministers, for example). Or maybe the IMF.

* Euro Zone. It's an inherently weak structure, since there's no strong political entity at the top to enforce decisions on member countries.

* Who's next? There are several other EU countries with budget problems. And in the US, many (most?) states have serious budget problems, California being the biggest one.

Transcript of comments [from Paul Wachtel, Viral Acharya, Yakov Amihud, Dave Backus, Fabrizio Ferri, Tom Cooley, Marti Subrahmanyam, Sabri Oncu, Charlie Murphy, Anonymous 1, Gian Luca Clementi, Ingo Walter, and Larry White]

These are comments made on the fly. For that reason and probably others, no one should be held to them. I do think they lay out all the relevant issues.

Dave Backus

Anyone have a view of why the Germans are talking about bailing out Greece? Isn't Greece too small to have be systemic?

Paul Wachtel It is not Greece, it is the Euro. A troubled small country can be shrugged off but a currency area is either whole or not. The Germans will pay up to keep the Euro area in tact.

Viral Acharya I think letting Greece fail questions the very essence of what the Euro and Eurozone is, in my view, and can lead to lack of confidence in background Eurozone support for other weaker nations also. What I am saying is that though not as formally integrated, is Europe not supporting Greece too different from the US government not supporting California?

Yakov Amihud Perhaps because they are stupid? California may fail, it is much larger than Greece, and nobody comes to its rescue nor does it affect the dollar. NY (almost) failed in the mid-1970s. Maybe the labor unions in Germany are afraid of the example set in Greece that fiscal problems lead to wage cuts of government employees.

Dave Backus The US has a long tradition of letting state and local governments handle their own budgets. Bailouts more the exception than the rule.

What's the risk with Greece? If Greece's debt is in euros, why would they benefit from leaving the euro zone? And why would Germany care if they did? Wouldn't kicking out weak links make the Zone stronger?

Fabrizio Ferri There is an unresolved question of leadership in Europe. Perhaps Germany views this opportunity to "save the eurozone" (whether true or not) as a way to gain political leadership going forward. Or perhaps they are stupid indeed -- as an Italian, I can live with that interpretation ;-)

Tom Cooley I think letting Greece fail would be a disaster and would have ripple effects for the other PIIGS sovereign debt. I think bailing them out but making them suffer probably is the right strategy. If they suffer enough it won't seem so appealing to the other PIIGS to get to to that state.

Viral Acharya 1. If US allows California to fail in today's world, it may get brownie points for being smart from some investors; but some other investors will rationally question US's own balance-sheet and that may precipitate a rise in its sovereign CDS, raise US's cost of borrowing and could exacerbate matters. I am not saying US should bail out California but simply that in the current environment, eyebrows will be raised about the rationale behind not supporting California. That scenario and updating of priors would be a relevant factor. If US was keeping its reputation on bailouts clean by not bailing out ANYONE, this risk might have been lower. It may want to react in time and get California in shape to avoid the situation altogether, which may be an even smarter thing to do than watching California's failure.

2. Commercial bank clearinghouses were arrangements by banks to support each other when some banks failed. The idea was that when bank x failed, other banks often had contagious runs, e.g., Knickerbocker Trust failed in 1907 causing information-based runs on other banks too. So to avoid this, clearinghouses would convert individual bank liabilities into joint liability certificates. Over time, clearinghouse members refused to support some players due to internal rivalries. This meant the co-insurance arrangements were not considered as robust as they were supposed to be. Ultimately, Central Banks came into play to act as lender of last resort rather than letting the system be privately managed through clearinghouses. What is the analogy? It could very well be that IMF (analogy with Central Bank) will come to the fore if Europe does not, but that might mean the demise or weakening of confidence in the Eurozone (analogy with private clearinghouses). Again, a better thing in my mind would be to support Greece but with conditionality to improve its state within say next two years, and this might in fact set precedent for better monitoring and requirement of individual nation solvency within the Zone going forward.

Yakov Amihud Tom, why do you believe that failure of Greece is different from failure of California?

Marti Subrahmanyam First of all, the EU and/or the ECB are prohibited from directly aiding any member state. Second, if Germany (plus France?) want to do this to bail out their own banks, which are heavily exposed to Greek sovereign debt, it would create serious political problems in those countries. I doubt whether the German treasury will simply write a check. In any case, how can they impose any sort of conditionality with any credibility? Ultimately, this would have to involve the creation of some sort of European Monetary Fund - perhaps with a loose link with the IMF - to save face for Europe. Whether this can be done quickly is doubtful. Failing this, this saga will continue for some time. The only practical way for a quick fix is to bring in the IMF and for Europe to eat humble pie.

Yakov Amihud It is cheaper for Germany and France to bail out their own banks than bailing out Greece. And the EU is weaker than the U.S. Federal government in enforcing anything -- indeed they cannot credibly impose anything on Greece.

Paul Wachtel California is not Greece.

I do not know what will happen if California defaults but I do remember what happened when NYC defaulted on its general obligation bonds in 1975 (I owned some). Investment banks, banks and the state government sat down and restructured the debts and imposed restrictions on the fiscal activities of the city. Essentially, there were institutions that could intervene and impose an acceptable restructuring.

Who is going to do that for Greece? The European capital market institutions would not be able (or even willing) to step up to the plate and negotiate a restructuring. The ECB is not allowed to. And the EC is not up to it.

There is an alternative -- the IMF has specific experience in this regard. But, allowing the IMF in would be an admission that the Euro area has not quite made it as currency union. The IMF, given its historical origin with exchange rate mechanisms, would convey a message that the big Euro players would not like to see. It would tar the reputation of the Euro even if there are no contagion effects on other PIIGS. Moreover, allowing Greece out of the Euro (or kicking) it out would be even worse.

That is why, I think, the Germans will pay up. They will pay to maintain the reputation of the Euro. Americans underestimate the commitment to the Euro.

Sabri Oncu But bailing out Greece and then making them (what do we mean by "they", by the way?) suffer, such as budget cuts, is calling for social explosions, first in Greece, then in PIIGS and then in broader Europe. Greece has a very strong labor movement historically, so does the rest of Europe. Greece must be bailed out, just as California must be bailed out, but somehow without making their populations suffer. Greece is already in a deep recession: asking Greece cut the budget deficit to 3% of its GDP by 2012 means pushing Greece into an even deeper recession, which would exacerbate the already high social discontent.

Charlie Murphy Agree with Tom but for one other very obvious reason. The Germans are not about to let a little member in a very bad neighborhood ruin a good thing. I'd call it political, social or family welfare!

Tom Cooley [Will the Greeks suffer some penalty for this, or get off easy?] Yeah -- good question given the militancy of the greek unions but I think they can if that is price for staying in the eurozone. Given that they have a socialist government in Greece it is a bit like Nixon in China -- they may be the only ones who could impose fiscal discipline.

Anonymous 1 First, as Tom points out, if there is a bailout effort for Greece, the prime motivation would be fear of contagion (and sudden stops) among the weaker sovereigns. The recent fluctuation of euro-area sovereign yield spreads has fueled these fears. If, in the United States, a sudden stop for a big state were to undermine market liquidity for several other large states, the pressures on the federal government to intervene would be much greater than, say, in the narrower cases of the past (e.g. Orange County, WHOOPs or even NYC).

Second, a round of sovereign defaults could (again) threaten euro-area bank capitalization -- even in the fiscally sound states -- with the kind of spillover effects that we witnessed in 2007-09.

Third, this sovereign crisis is occurring in the aftermath of the biggest post-1930s financial crisis when the euro area and its financial institutions have been weakened and confidence is fragile.

Put differently, the incentives facing policymakers would be quite different if Greece were an outlier in a euro area of healthy banks, sovereigns and economies.

The biggest issue (as Paul and others observed) is imposing conditionality. Clearly, the Stability and Growth Pact didn't do it. And it's not clear how the euro-area finance ministers will do better, but I agree with Paul that outsiders underestimate the commitment in continental Europe to make the monetary union work. For many European leaders, it is a step on the road to a "more perfect Union," so that crises invite greater efforts at political integration, rather than the reverse.

Gian Luca Clementi I am confident that [Greece will be bailed out with punitive conditions attached].

They will convene an eco-fin (meeting of finance ministers), write down a set of conditions for the Greek government to abide by, and then come up with the money -- which is not much money by the way -- the Greek government's deficit is about 40 billion Euros.

Letting Greece go would open up speculation on sovereign debt of large economies such as Spain (4 times Greece) and Italy (6 times Greece). That would be dramatic. If I remember correctly, Italy is #1 among importers from Germany and #2 among exporters to Germany....

Sabri Oncu One thing the EU can do is to sell the sovereign credit default insurance themselves and underbid the present high-priced sellers. Buying Greek bonds and stocks massively may be combined with that. Hong Kong Monetary did something like that during the South East Asian crisis, as I recall, and it worked for Hong Kong.

Tom Cooley [On why Greece is different from California] Because California is part of a Union with a strong Federal Fiscal and legal structure that could probably survive a California restructuring of its debt. There is no comparable structure for the EU. It would make it harder for California to borrow in the future...

Anonymous 1 [On whether bank regulation encouraged German banks to hold Greek debt despite its increasing risk.] The attached WSJ piece from December highlights the role of the ECB and its collateral rules:

http://online.wsj.com/article/BT-CO-20091208-707569.html

Ingo Walter I agree with Gian Luca. Here's my 2 cents worth on Greece --

The good news is that this is exactly what we teach in emerging markets, open-economy macro, etc. If you have fixed exchange rates or a currency board or a single currency you lose one policy tool and have to live by the relevant rules of the game. Violations of those rules get reflected initially in market spreads and maturities and then in policy strictures, as in NYS and NYC 1974 and Argentina 2001 and UK 1992 etc. Whoever can't perform, possibly with the help of some tightly controlled bridge financing, has to get out of the kitchen. In the latter, moral hazard is a huge problem. Hence the long experience with conditionality, which often helps give local policymakers some backbone.

In the euro context the design flaw is that the whole experiment upside down. Usually political unification gives rise to currency unification (US in 1865, Germany in 1870s and 1989, etc). Here currency unification comes first (1999) subject to Maastricht fiscal constraints and a no-bailout clause - but in the absence of political unification and fiscal centralization. Italy's entry was quite a bit of smoke and mirrors, but it was too important to omit, especially as an intellectual founder of the whole European integration movement. Greece was pretty much of a shell-game and should never have been admitted in the first place, and the water in the pot has been boiling for a very long time waiting for the lid to blow off -- even taking account of Maastricht violations from time to time among the other euro countries. I doubt that anyone who teaches this stuff has been very surprised by the outcome of Greece's fiscal incontinence. Everybody knew that at some point the euro would be stress-tested, and several smaller ones in the last ten years, now it's showtime.

If Greece's departure from the euro carries unacceptable contagion risk and the euro is deemed worth saving, which most people believe, then substantial bridge financing with strong conditionality is the only option. I was in Finland the other day and they were really livid about the possibility of having to take part in a bridge for Greece. The Germans are likely to be equally agitated, with considerable risks for Merkel and the CDU especially at a time when the real-sector performance outlook is pretty miserable. In my view an IMF ESP and conditional financing facility provides the most elegant and politically acceptable solution. Barring that, the EU will have to construct one of it's own which does pretty much the same thing. Politicians may figure out that it's better to have the IMF draw fire and be responsible for applying the fiscal corset.

In the case of California that's not an option. In retrospect the [President] Ford "go to hell" message [to NYC] 35 years ago probably was the best thing that could have happened to us.

Larry White I believe that the NY Daily News headline was, "Ford to City: Drop Dead" (but Ford never explicitly said those words).

Sabri Oncu Here is a very interesting Globe and Mail article entitled: "Greece: from superpower to impotence":

http://www.theglobeandmail.com/news/world/greece-from-superpower-to-impotence/article1463767/

To say a word about what Ingo said, it is my view that euro is not worth saving in the long run (I have always been against my country's joining the European Monetary Union, more or less for I thought that what is happening to PIIGS now would happen), but if euro is not saved at the moment, we all will be in deep trouble: this "Great Recession" can get even "Greater." There are no "party walls" in place!

Sabri Oncu Something has to be done about [rating agencies] also, if the EU wants to get out of this mess:

http://www.reuters.com/article/idUSLDE6191TD20100210

And I am with Larry wholeheartedly:

"In his congressional testimony, Professor White argues that the best way approach to reining in credit rating agencies is not more regulation, but rather ending regulatory reliance on their ratings."

As you may remember, Thomas Friedman said this in 1996:

"There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful."

If we do what Larry says, Moody's can no longer be a superpower. The same goes for S&P and Fitch, of course.

    Posted by on Friday, February 12, 2010 at 12:50 PM in Economics, International Finance | Permalink  Comments (21)

          


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