A Letter to Angela Merkel

Dear Mrs Merkel

I know that you have a lot to deal with at the moment so I thought I would send you some ideas on how you could manage the problems in Europe to do with Greece.

I understand that you are in a difficult position as the chancellor in Germany and a leader in Europe.  Of course, your first responsibility lies with the German people and you must defend their interests first and foremost.  But as the leader of Germany, you also have a crucial role to play in Europe.   And leadership in Europe is needed now more than ever.  Do you want to be remembered in history as the German Chancellor that let Europe crumble or as the saviour of 60 years’ worth of post-war integration in Europe? 

I can understand your stance up until now.  To forgive countries that have spent too much during the boom and have been caught out when the economic tide turns is to make the same behaviour likely the next time around.  It is not easy to be the stern taskmaster in a time of crisis but you have made a stand on principles that in many respects deserves to be applauded.  

However, I would argue that circumstances require a change of tact.  Greece is on the verge of jumping ship and exiting the euro.  While Greece has some responsibility for the mismanagement of their economy, even you must realise that the measures that have been imposed as the conditions for the last bailout package have left the Greek people with a bitter taste in their mouths.  The popularity of the anti-bailout political parties in the election this month is a reflection of this, and if this mood prevails, Greece is sure to depart the Eurozone. 

We both know that, while tough on the Greeks, Greece leaving the euro in itself will have only a minimal impact on Europe.  But it is what may follow that is the real concern.  Once one country leaves, fears that others may follow will wreak havoc in Europe.  Investors will dump the government bonds and savers will race to grab cash from the banks of any country that is seen to be in trouble and one country to the next - Ireland, Portugal, Spain, Italy, and maybe even France – could be targeted.  The domino effect would see the country fall one by one while the pressure builds up on the next in line. 

Only the solidary of Europe as a whole can stop this from happening.  The indebted countries need to be backed by an overwhelmingly large reserve of funds (much more so that what has currently been made available) and by unwavering support from yourself and the other leaders in Europe.  While I would not like to see Greece exiting the euro as I believe the consequences would be too great, I would not begrudge a decision where Greece is left to its own devices.  If an example is to be made of at least one country, then it is the misfortune of the Greeks to have been the worst of a bad bunch.  But it must stop there or worries will only mount up and panic will ensue.

Now is the time for concessions.  You must consider implementing Eurobonds even as just a temporary measure.  Eurobonds will ease the pressure on the struggling countries by lowering their debt payments, and by making concessions with regard to this, you will be able to get other countries to agree to new fiscal rules which will stop excessive government spending in the future.  The recent change in focus toward growth following the election of the new French president François Hollande should help provide you cover for the change of stance. 

To stay with the current framework is courting with disaster.  Germany’s tough stance will leave it isolated in Europe.  The process which has brought about the integration of Europe may not recover and the single market may disintegrate.  Germans will lose out – they just don’t know it yet.  It is time to use your popularity in Germany and make a case for a softer approach toward Greece and others before it is too late for them and for Europe.

With my best wishes

Your Neighbourhood Economist

“Should I ask to be paid in pounds?”

A friend who had recently moved from the UK to a new job in Europe recently asked the question which is the title of this posting.  While the question may have been half in jest, it did reflect concerns about what will happen to the euro if Greece was to leave.  The reply was that there was not much to be worried about and here’s why.

For starters, Greece is very small in comparison with the rest of the Eurozone.  The GDP of Greece is only just over 2% of the GDP of the Eurozone.  A larger currency union means that people would have more reason to hold money in that currency and this would increase demand and the value of the currency.  But because Greece is so tiny and not central to business in Europe, the effects on the value of the euro from its exit would be minimal. 

Forgetting about other factors, the departure of Greece may even be a boost to the euro as it would end a saga that has brought a cloud over the euro.  However, it is the possible follow-on effects more than the actions of Greece itself that are the real concern.  If one country leaves the euro, it sets a precedent and makes it easier for others to follow.  Investors then begin to worry about this and move their money out of any struggling country which in turn makes it tougher for these countries and increases the likelihood that they also may have to leave the euro.  People in those countries would start withdrawing money from banks due to fears about losing out with the change to a new and weaker currency. 

The fears about other countries leaving the euro then become a self-fulfilling prophecy and one country after the next may become the target of this.  In this manner, first, the smaller countries of Portugal and Ireland, then probably Spain, followed by Italy, and even maybe France could fall like dominos.  If such a chain of events begins, it is difficult to know where it might end. 

What would be required to stop this would be the leaders in Europe drawing a metaphorical line in the sand to state that Europe stands behind a certain group of countries.  The leaders in Europe need to show conviction in standing behind the struggling countries and earn the trust of investors who will not bring their money back until they think it is safe.  As obvious as this sounds, it is not something that Europe has managed so far and still may be beyond their leaders.

Despite all the turmoil, the euro as a currency has held up surprising well.  Demand for the euro has stayed strong due to the size of the Eurozone which makes the euro a useful currency to have.  Even though there has been lots of selling of bonds issued by Greece and others, German bonds have been popular.  Big investors and others with lots of cash such as reserve banks in Asia like to spread their investments over many different regions and will always hold a large portion in euros.  Investors who want to make money from the troubles in Europe have done so by selling bonds of particular countries rather than selling euros.

So the euro has stayed around 1.30 vs the US dollar so far this year which is similar to where the euro was trading at the beginning of 2011.  A weak patch this week prompted the euro to drop to near 1.25 vs the US dollar and hit a two year low (or a three year low of 0.80 vs the UK pound).  It remains to be seen whether this is just a blip or whether investors have become fed-up with politicians and are moving money elsewhere.  Either way, my friend may lose a bit of money if he wants to convert it back to pounds but that all depends on the timing of the change as the euro is likely to recover at some stage.  However, it is not something to lose sleep over (yet).

Greece Set to Rebel and Dump the Euro

One of the reasons why Your Neighbourhood Economist has taken to blogging is because the media often hype up a story in order to entice readers.  Since the beginning of the crisis in Europe, headline everywhere have played up that Greece has been on the verge of collapse and the breakup of the euro has been just around the corner.  Yet politicians in Europe always seem to find a compromise.  However, the current situation in Greece means that the potential for a big bust-up this time is a real possibility.

Your Neighbourhood Economist had previously considered the chances of Greece ditching the euro to be small at best.  The reasons for this is are the massive costs involved.  Just switching from one currency to another is costly enough.  But in the case of Greece, its new currency would have a lower value than that of the euro as it would be money that no one outside of Greece would want.  But much of the debt of businesses and consumers is denominated in euros and this debt would balloon in size when changed into the new currency.  Banks would also have to deal with the likelihood of people wanting to get cash out before the switch to the new currency as the value of their savings would plunge.  And it would be tough for banks and other businesses as well as the government to get money again from foreigners due to the belief that Greece would take the easy way out and default again if times got tough again in the future.

A change in currency implemented in a rapid manner is therefore a recipe for chaos.  And that is just inside Greece.  Investors would panic and withdraw their money from any other struggling countries in Europe such as Portugal or Spain and people in these countries would be lining up at banks in a rush to take out money.  European banks would lose out from Greece defaulting on more debt and tax payers in Europe would lose the funds that have already invested to stabilise the situation in Greece.  So the potential consequences have been enough so far to prompt politicians in Greece and the leaders of Europe to do enough (barely) to stop this from happening.

But it has been the people of Greece that have had to bear the burden due to the mismanagement of their economy and it is a burden that many do not feel is justified.  And this frustration manifested itself in recent election results where voters punished the established political parties who backed austerity measures imposed as part of the latest bailout package.  The parties that did do well where those keen on dumping the euro and any measures imposed from the outside.  The outcome was that the mishmash of parties that did get into government were unable to form a coalition that could govern the country and so Greece will be voting again in the middle of next month.

An argument can be made for Greece leaving the euro.  There would be benefits in terms of its exports regaining competitiveness due to the weaker currency.  Other countries such as Argentina have combined a change in currency and a large scale default on debts and managed to soldier through.  But Argentina has a large export industry and abundant resources while the opposite could be said of Greece. 

However, most of all, Greece would gain a greater degree of control over its own destiny.  Germans have been adamant in their stance of not footing the bill for wayward countries in Europe.  But the harsh treatment of Greece has pushed the country and its people into a corner.  Likely to lose out whether staying in or leaving the euro, voters are likely to lash out again at those that they deem responsible – the leaders of Europe and the politicians in Greece that backed the bailout.  The resulting carnage of an exit from the euro may be seen as the Greeks being short-sighted.  However, it is the equally narrow-minded tax payers in Germany and their politicians who flinched at standing behind Greece and left the Greeks with few options.  Flexibility and perseverance is required on both sides with other measures such as Eurobonds needed (see previous blog - Conspiracy Theory for your Greek Holiday) amid growing disquiet to harsh austerity across Europe.  Or else, irrationality may be the only winner.

Another Reason not to Bank on Europe

There is a saying that “when it rains, it pours”.  And for Europe, there is a flood of doom and gloom.  A further concern that has not been dealt with yet in this blog is the state of the banks.  Life is not easy for bankers everywhere but the prospects for banks in Europe are a worry not only for the banks themselves but the economy in Europe as a whole. 

One reason behind the financial crisis was the excessive leveraging which involved banks lending too much with too little collateral.  But now the opposite process, deleveraging, has gripped Europe and the banks are scaling back their operations.  Part of this is a natural adjustment to having previously been too generous in their lending.  But there is a concern that the banks will go overboard and deny funds to companies that need to borrow money to expand or to get them through a rough patch.

The situation has been made worse by new regulations that have come into force since the financial crisis that aim to make banks less likely to get into trouble.  The revised rules make it necessary for banks to hold more capital reverses in case borrowers can’t pay back their loans.  Typically, banks would raise capital by issuing shares or bonds but this is difficult as investors have been scared away due to lots of dud loans at many banks.  So banks are tackling the new capital requirements by cutting back on lending.  Thus results in capital reserves increasing relative to its lending without the banks actually having to raise more capital.  But this has not been enough for some banks with Spain having recently nationalised Bankia, its largest property lender, due to bad debts. 

The European Bank has tried to help out by providing the banks with cheap loans (such mentioned in a previous posting - Economists save world for now).  While providing some relief, it also heightened the risks posed by banks and raised the stakes if anything is to go wrong.  This is because many banks in such places as Italy and Spain brought the bond issued by their own countries.  While the high interest rates on these bonds will boost revenues at the banks, the high level of government bonds at the banks increased the links between governments and banks in each country so that if either stumbles, both are likely to fall.  As a result, the size of any bailout will be substantially large.  And even if a bailout is not necessary, the funding from the European Central Bank needs to be paid back in three years which will likely involve a lot of selling of government bonds as the deadline for debt repayment draws near if the problems have not been sorted out by then.

And the deleveraging is not a process which will end anytime soon.  The IMF expects banks in Europe to reduce their lending by 2 trillion euros over the next 18 months.  But with that estimate only amounting to around 7% of the debt of banks, many expect that the IMF is being too optimistic.  Either way, the actions of banks, which typical boost growth by funnelling funds to where cash is need, will act as a drag on the economy of Europe for the next few years at least.  It is almost enough to make you feel sorry for bankers (but not quite).

Conspiracy Theory for your Greek Holiday

Much of the topics dealt with in this blog over its first six months were to do with the Eurozone crisis.  Looking forward, the next six months may be the same.  Strange as it may sound, one of the reasons for this is that many of Europe’s politicians want the turmoil to continue.  There are solutions that would considerably ease the burden of many countries in the grip of austerity measures but politics in Europe prevent their implementation.  To prove that this is not a weird conspiracy theory hatched by Your Neighbourhood Economist, let me explain.

One possible saviour for those in the midst of cutbacks would be something called Eurobonds.  Currently, all of the government bonds are issued by individual countries while, on the other hand, Eurobonds would be joinly back by all of the members in the Eurozone.  The benefit of this would be significantly lower interest rates on these bonds compared to those from individual countries as the Eurobonds would be backed by the whole of the Eurozone including the stronger countries such as Europe. 

The issuing of Eurobonds could be used to replace a large portion of government debt in such countries as Greece, Portugal, and Spain who are suffering under the burden of high interest rates, and as a result, are having to savagely slash their government spending.  But the stern Germans (and some other countries) are having none of it.  Their steadfast leader, Angela Merkel, is not keen on providing relief to the indebted countries in the hope that the pain will help the politicians there push through reforms that will make their economies more productive.  Such reforms are typically neglected when times are good and only get implemented during times of hardship and when politicians have someone else to blame.

It is like holding back food from someone who has grown flabby and pushing them toward starvation with the intention that this will make them change their ways and slim down.  But it is not something just for this dieter at this point in time.  Being tough on indebted countries now will make them and other countries in the Eurozone think before they build up debt again in the future.  This is also true of other pain relief measures such as the central bank in Europe taking a more active role in prompting direct or indirect buying of government bonds in Europe (as discussed in a previous posting - Economists save world (for now)). 

So it is a trade-off between short-term pain and long-term gain.  But that is not much comfort for the destitute who are bearing the brunt of the pain.  Needless to say, Germans are not popular among their fellow Europeans and the Greeks in particular.  Germans tend to flock to the beaches in Greece for their summer holidays but Your Neighbourhood Economist is planning to spend some vacation time in Greece on the assumption that it may not be so busy this year if many of the tourists from Germany stay away this year.  And it may even help a little.  I don’t need much more of an excuse to go back to the beautiful beaches in Greece.  Feel free to come along and spend a bit of cash as well.

Six Month Anniversary

Your Neighbourhood Economist has just past its six-month anniversary (if that counts as anything).

For those who had not been tapping into this useful source of information on the global economy

or those who have not been very good at keeping up with the posting,

here is a run down of the top five posting (as chosen by me)

Bond Markets aint all Bad

A good description on the workings of the bond market 

and why bond traders are causing so much trouble in Europe.

A New Year but Nothing to Celebrate

A bit of doom and gloom which is what economists are famous for 

but at least the bit about the double dip recession in the UK was on the mark.

Bigger than Berlusconi

Bigger than Berlusconi

A sign of how things can change - all eyes were on Italy in November

but now, under new management, Italy is seen as a role model 

Spain and the Long Hard Slog

Spain and the Long Hard Slog

All eyes on Spain now and it seems as if Europe won't be sorting itself out any time soon.

The King is Dead - Long Live the King

A posting on the demise of Sony and why we shouldn't worry.

(it also shows that I did learn something other than how to use chopsticks during my time in Japan)

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