The Euro crisis: a primer
(For this topic, I must tip my hat to Tyler Cowen, Scott Sumner, Nick Rowe, Karl Smith, Megan McArdle, Ezra Klein and Matt Yglesias, without whom my economic autodidactism would have been considerably less successful, and certainly less enjoyable. I would also like to thank my father, who has made some very helpful comments on an earlier draft of this piece)
With a growing number of my friends asking me what I think of the Eurozone debacle, I thought it was time to put together a general guide to the crisis. Below I try to explain what has happened, why it has happened and the things you should know in order to understand whatever happens next. If there is anything here that I have missed out or you think is wrong, please do leave a comment and if I am convinced by your point I will update accordingly and note your contribution. If anything is not clear, leave a comment and I will update the post if I think a better explanation would be generally helpful.
I have not referenced every claim I have made here, as I would if this were a proper piece of scholarship. If you think any particular piece needs referencing, leave a comment and I will put in a link or two.
And if you doubt my credentials to write this guide, I’ll have you know I scored 10/10 on the CFA Institute’s “So You Think You Understood the Financial Crisis?” quiz.
So, without further ado…
Why is there a sovereign debt crisis?
Essentially, there is a sovereign debt problem because there was a private-sector financial crisis and a recession. Most of the governments in question were doing just fine until 2008, when suddenly they found themselves with less tax revenue and more expenditures on things like unemployment benefits. Governments were also implicitly writing a massive insurance policy for the creditors of big financial firms, which manifested itself in the bail-outs we saw and continue to see.
Why are things in Greece so bad in particular?
Greek political institutions are extremely dysfunctional. For example the government, with the alleged help of accounting gimmickry from Goldman Sachs, has understated its budget deficit in the past. I highly recommend checking out this excellent and entertaining article in Vanity Fair by Michael Lewis, who is by far the best ‘popular’ financial journalist that this world has ever seen.
Is Greece going to default on its debt?
In the words of Churchill the dog from the eponymous insurance adverts, ‘Ohhhhhhhhh Yes’! There is simply no way it can be avoided, as recognised by the 50% writedown on Greek debt held by the private sector that features in the latest bailout plan (although this was structured in a way so as not to technically be a default). The kind of bailout that would be necessary to stop the rot would require large permanent transfers of money (rather than more loans, which is what all bailouts so far have consisted of) from the Germans, French, Slovakians etc. which is simply never going to happen. Since the crisis began, Greece has perpetually been missing its targets for bringing down its debt/GDP ratio, with the forecast ‘peak’ in the ratio constantly being revised upwards.
Will Greece leave the Eurozone?
This is where things start to get tricky. It is first of all necessary to understand what the point of leaving the Euro would be – which is that the new Greek currency would massively depreciate (‘lose value’) against the Euro and other currencies. This is good for Greek economic activity and employment as it means exports are cheaper, and we’ll all be able to pick up a hotel room in Zante, a bottle of ouzo and a Greek salad for roughly the price of a Jaffa cake*. It’s bad for Greek standards of living as it makes imports more expensive, but whatever happens I can assure you Greek standards of living are going to fall.
Second, it is also very important to understand that the Greek government budget is not in ‘primary balance’ – this means that even without interest payments on debt, the budget is still in deficit and the government would need to borrow more. And it turns out that if you default on your debts, people don’t like lending more money to you. If Greece remains in the Eurozone it will probably be easier to persuade people to hold any new debt it issues, or to get a preferential deal from the other European countries. If it leaves the Eurozone, the only option for financing a deficit is domestically. This will be very difficult as the greatest problem that the Greeks will have to manage if they leave the Eurozone is how to prevent what economists call ‘capital flight’, but is more commonly known as ‘everyone trying to get all their money out of the country ASAP’. In order to leave the Euro, ‘Greek’ Euros will have to become New Drachma. This means that before the conversion, ‘Greek’ Euros will be worth substantially less than ‘German’ Euros. That means no one wants to have ‘Greek’ Euros, and everyone wants to have ‘German’ Euros with the aversion to Greek money continuing until the new currency stabilises. This is, in my view, the single greatest policy obstacle to Greece leaving the Eurozone as it implies an enormous run on all Greek financial institutions (also, good luck figuring out which Euros are ‘German’ Euros and which ones are ‘Greek’). Given the general incompetence of the Greek government, I am pretty pessimistic about its ability to prevent capital flight. It would also require that the government announce it is leaving the Eurozone and imposing capital controls before everyone works out that it is going to do so, which doesn’t seem very likely to happen. At the end of the day, if Greece leaves the Eurozone it is still either going to have to go through with government austerity, raise taxes or (in my opinion the most likely scenario) finance the deficit through the printing press.
Furthermore, Greek companies and financial institutions have liabilities in all kinds of foreign currencies, and others with Greek banks. The introduction of the New Drachma has the potential for sending the value of those liabilities all over the place, with serious consequences for both fairness and economic efficiency. There is either going to be an almighty row within Greece over some businesses who have had the value of their debts vastly increased and will go bankrupt, or there is going to be an almighty row with foreign creditors of private Greek businesses who won’t get anything back.
All of the above notwithstanding, I do believe that if Greece doesn’t leave the Eurozone I see literally no prospect of the country making an eventual economic recovery. Greece needs to devalue its currency as the country is fundamentally uncompetitive, and the level of institutional dysfunction makes me sceptical that what is called an ‘internal devaluation’ could ever be achieved. Such a policy would require large cuts in wages across vast swathes of the Greek economy and the scenes in Athens suggest the Greeks are not so up for that. Default and devalue is, probably, the best of a bad bunch.
OK, so leaving the Eurozone may be the best option for the Greeks. How bad would it be for me?
I have absolutely no idea, but it could be very bad for the global economy. This is for three reasons – first, European banks have an awful lot of Greek debt on their balance sheets, which would be worth pretty much zilch. Even if it were the case that they remained technically solvent, the way we regulate banks has the unfortunate consequence of kicking off a kind of ‘death spiral’ which I will attempt to describe. We regulate bank ‘capital’ ratios, which is essentially the net value of the bank against the gross value of its total assets, weighted according to a measure of its risk**. When a bond defaults, what happens is that the loss is ‘absorbed’ by reducing the capital, and therefore reducing the ratio of capital to assets. If the bank was already at the minimum, which they often are, then the bank either needs for regulatory reasons to a) increase its capital or b) sell some assets. Option a) is expensive and for many banks impossible unless the equity is taken by the government (which it some cases undermines the financial credibility of the government, and may give rise to a technical breach of EU competition law), so most banks choose option b). But the problem with option b) is that if everyone is selling assets, the prices of those assets often fall substantially. So they make more losses, and have to sell more assets… and here come the four horsemen, fiery lakes of burning sulphur etc.
Secondly, while derivatives have gotten a bit of a bum rap, they do contribute to the interconnectedness and complexity of the financial system. Financial and non-financial institutions are constantly ‘hedging’ risks that they face, in order to make their position ostensibly neutral with respect to that particular risk. They accomplish this by essentially swapping the risk with another company. The problem is that this introduces a different risk, called ‘counterparty risk’, which is the risk that the other company can’t afford to pay when they owe you under the contract. The kind of financial disruption posed by a country leaving the Eurozone will put a lot of financial institutions directly under stress, and the fact is nobody knows who all those firms are, who all their counterparties are, and who all their counterparties’ counterparties are etc. If someone hasn’t done their counterparty hedging right, consequences could appear pretty much anywhere in the financial system and we have no way of predicting where. Derivatives also have their own special ‘death spiral’, which is that as companies get downgraded by ratings agencies they have to put more collateral against their derivatives contracts, which often means they have to sell assets, which means that asset prices fall and they make more losses and get downgraded again… you get the picture.
And finally, there will be lawsuits. Tons of lawsuits – especially if the Greek government was to decide that foreign creditors would not have the power in Greek courts to enforce legal claims on Greek companies that owe money in foreign currency. Or if other Eurozone countries co-operate with the Greek government to ensure that capital taking out of the country by Greek citizens gets returned to the country. And who knows what other legal uncertainties could come out of such an event, because no one was writing any contracts with the possibility of it in mind. There is literally no existing legal mechanism for a country to leave the Euro, leaving little to no guide in international law as to how all the claims ought to be settled.
What is ‘contagion’? Why is everyone worrying so much about Italy, Spain etc.?
Italy has a very high debt/GDP ratio (although the creditor base is a lot more stable and consists of more Italian households and less foreign investors), and whilst Spain has a lower ratio more of the funding comes from abroad and its banks are sitting on enormous losses related to the property market. Like much of the rest of the European banking system, these losses have yet to be fully recognised on their balance sheets. Contagion takes hold because one European government having a debt problem a) puts other countries on the hook, as they are always going to try and prevent default for the sake of the continental banking system (this is made much worse by the structure of the bailout fund) and b) economic problems in a major trading partner are going to be bad for them, and therefore for tax revenues and future deficit control. The EU has also pretty clearly demonstrated that the decision-making mechanisms are utterly inadequate to the task of managing a crisis. If investors start worrying about the capability of a country like Italy to service its debts, then it can be a self-fulfilling prophecy as investors sell Italian bonds, raising the rate Italy has to pay on its debt, which increases the deficit (Italy is going to have to refinance c.£250bn of debt next year), which makes investors more worried… and we’re back to the death spiral.
Could the US/UK turn into Greece?
Not in the way Greece has turned into Greece. Whilst we have all borne witness to the somewhat unbelievable risk that the US could default voluntarily through grossly irresponsible congressional politicking, there are a few key differences between the Greek situation and the US/UK. First, the Greek economy has structural problems way beyond anything we might have here or in the US. Secondly, the US and the UK have the enormous advantage of their very own central banks. One of the reasons Greece has become Greece is because the appropriate monetary policy for them is completely different to that for Germany. If we were facing the kind of economic difficulties Greece has, our central banks would pursue a substantially more expansionary monetary policy that would make balancing the budget at least economically (if not politically) feasible. But Greece’s central bank is the ECB, which appears to suffer from a very German pathology – that is to say, an irrational fear of moderate levels of inflation.
How exactly has monetary policy affected the crisis?
On the basis of the current received wisdom that a central bank ought to ensure stable and low rates of inflation, the ECB is setting decent monetary policy for Germany but at the expense of screwing the Eurozone as a whole. In order to explain how exactly the ECB has completely abrogated its responsibilities over the last few months, I’m going to have to take a short detour around how monetary policy works.
The single greatest economic misconception shared by an astounding number of highly informed people – even those trained in economics! – is to equate the stance of monetary policy with the nominal interest rate. Ceteris paribus, monetary policy is indeed ‘looser’ (i.e. more money, more inflation) if the interest rate is lower and ‘tighter’ (less money, less inflation) if the interest rate is higher. But interest rates are the price of credit, and credit would exist in the economy whether or not there were central banks. Therefore, the stance of monetary policy is the interest rate the central bank sets relative to what the interest rate would be if the central bank did nothing. Central banks affect the price of credit by essentially printing money and buying bonds when the market rate is above the target rate, and by selling bonds and destroying money if the market rate is below the target rate***. Therefore, if there is a change to what the prevailing market rate would be without central bank intervention, then the level of monetary stimulus changes as well even if the central bank has not changed the interest rate. If the natural rate increases, there is more monetary stimulus at any given policy rate, and vice-versa.
What this means is that even when it looks like the central bank isn’t doing anything, it could in fact be making things worse. This is, in my view, exactly what has happened in the Eurozone in the last few months. This graph is the ‘five year, five year forward inflation breakeven rate’, but all you really need to know essentially shows a market expectation of future inflation. The last ECB interest rate hike was in July, but expectations continued to trend downwards reflecting the fact that the ‘natural’ rate of interest was falling as the central bank rate remained the same^. A substantial portion of the blame for the escalation of the crisis in the last few months can be laid at the feet of the ECB, and its failure to maintain the inflation expectations commensurate with macroeconomic stability for the Eurozone as a whole. Low inflation expectations are especially problematic when you are facing a debt crisis, as lower inflation means that the real value of existing debt is higher.
Was the whole idea flawed from the start?
Yes, it was pretty much always going to be impossible to do good monetary policy for the whole region.
Is there anything else I need to know?
Greece is a lovely place to visit, and you’ll be able to afford to go there soon.
* The precision of this analogy is the result of a sophisticated proprietary financial model which you should absolutely believe I didn’t just make up
** It also just so happens to be the case that the risk-weight for sovereign debt was zero, which meant the banks had to hold no capital against them. This is a hugely important factor for explaining how much of the stuff has ended up on their balance sheets. In an outcome that ought to shock absolutely no one, governments have regulated the financial system in such a way as to make it easier to finance their own deficits
*** It is in actual fact more complicated than this, but that’s the gist of it
^ The rate hike in July was also – and I’m using technical monetary economics term here – completely batshit insane