“Whatever it takes”

This is the bold pledge made by the governor of the European Central Bank (ECB), Mario Draghi, in reference to what the Europe’s central bank is willing to do to help stop countries leaving the euro.  This statement of intent was made at the end of July but investors had to wait until the beginning of September for the details of how far the ECB was willing to go.  And the ECB has brought out the big guns to prove its resolution but it remains to be seen whether the full might of the ECB will be enough.

The central part of the new policy was that the ECB would purchase an unlimited amount of bonds of indebted countries suffering from high interest rates.  The fact that the ECB has set no limit on funds available for bond purchases is meant to stop investors selling bonds of European governments in the expectation that the interest rates will rise (interest rates get higher if bonds are sold off and their price falls).  If the ECB is always ready to buy bonds, the price of bonds is less likely to fall and this will create an environment where other investors will be motivated to also buy. 

And in theory, it is a good time to buy.  The worries that a breakup of the Eurozone will prompt governments to default on their debt have prompted investors to sell off the bonds of countries such as Spain who are expected to have difficulties in paying their bills.  If the fears of default can be soothed, the prices of bonds will seem cheap.  So, the ECB is betting on its ability to calm the nerves in the market and could actually make a profit on its buying of bonds.

This new stance is not without its problems.  The help for troubled countries from the ECB is not unconditional and governments must agree to reforms to the economy which would be supervised by the EU and the IMF for the ECB to buy their bonds.  Spain is seen as a prime candidate for this support but the harsh reality of having to submit to orders from others has made the government reluctant to seek assistance. 

 

The ECB could be caught in a dilemma if a country does not toe the line after having their bonds propped up by the ECB despite having signed on for reforms.  If the ECB stops its bond purchases for such a country, default would be highly likely and this is exactly the result that the policy is intended to stop.  There are concerns with the ECB along with the EU and the IMF having control over governments which have been democratically elected by their citizens.  While an undesirable outcome of the sovereign debt crisis, the greater power of these unelected bodies is the result of governments being unable to sort out the problems themselves. 

But perhaps the biggest concern is the slim possibility that that the unlimited firepower of the ECB will not have enough punch.  Pessimists may bet against the ECB to test its resolve.  There are numerous parties which are unhappy with the new position taken by the ECB.  In particular, policies makers in Germany have made public their displeasure and this will grow with the amount of funds which the ECB uses to buy up bonds increases.  Investors will also second-guess the efforts of countries receiving support as to whether they will stick to what is expected of them by the ECB.  The policy of the ECB has been compared to a bazooka – if you have a big enough gun, no one will mess with you.  But there is the smallest chance that even a bazooka may not be big enough faced with an army of doubters.  

Another dose of medicine but will it help…

Vital signs suggest that the global economy in 2012 is not healthy.  Europe is the main cause of concern as politicians argue about the right course of action with regard to the sovereign debt crisis.  But problems in other major economies such as the United States and China are also adding to the ailments of the global economy.  This deteriorating outlook for the global economy has also sapped the willingness of many firms who operate on a global level to spend and invest.  The typical economic prescription in cases where a lack of optimism dents spending by firms and consumers is Keynesian – the government is to step in and increase spending to cover the drop in demand from elsewhere.

But governments in many countries such as the United States have their hands tied due to large amounts of government debt which limits further spending.  Central banks have also tried the textbook response to a weak economy by cutting interest rates to close to zero.  But this has had little effect as business will not borrow even at low interest rates if the prospects for the economy are dim. 

So central banks have been pushed to try less conventional medicine.  The new prescription is referred to as quantitative easing and involves the central banks printing money and using this to buy bonds issued by their government or by businesses.  This acts to further lower interest rates on the bonds and the lower return for investors in bonds prompts some of them to move their money to other investments such as shares which acts as a shot in the arm for the stock market.

Growing concerns that the global economy is on its sick bed have jolted the central banks in the United States, Europe, and Japan into ordering a further dose of medicine.  The European Central Bank released plans to buy as many bonds of indebted countries as necessary to help out the sick patients of Europe after its pledge to do “whatever it takes” to support the euro (more on this in a future posting).  The Federal Reserve in the United States followed suited and announced it would buy an unlimited amount of bonds until unemployment began to come down.  The Bank of Japan also jumped on the bandwagon with its own plans to buy up bonds.

 

This new consensus among central banks has not pleased everyone.  There are concerns over the new roles for central banks who have traditionally been bastions against inflation.  Inflation is seen as a negative influence as it reduces the value of money which hurts savers.  Central banks have killed off inflation by increasing interest rates but this has been possible due to the targeting of inflation by central banks.  But attempts by central banks to revive flagging demand through quantitative easing also could result in the resurrection of inflation.  As quantitative easing also involves central banks creating money for nothing, it also acts to drive down the value of the currency (as will be described in a future posting) and this is controversial as a weaker currency boosts exports at the expense of other countries. 

Even if the quantitative easing by central banks is seen as a necessary evil, there are further fears about whether the policies themselves are having the desired effect.  Because quantitative easing involves buying bonds in the hope of influencing investment decisions of other buyers of assets for investment, the effects are not clear and the continuation or even worsening of economic problems suggests that the policies are not a cure-all.  This is reinforced by the fact that, for example, this will be the third round of quantitative easing in the United States (hence the abbreviation “QE3” in the newspapers). 

In effect, there are few differences from when Your Neighbourhood Economist first started this blog in November 2011 (So what is going on…???).  The problems that central banks are grappling with are beyond the scope of the current understanding and available tools.  It remains to be seen if the unlimited resources now being tapped by the central banks will in fact be enough to resuscitate the major economies.  There is not much else that can be done.  Even Your Neighbourhood Economist does not know what to expect in twelve months’ time.

Back from Vacation in Greece

Upon returning from holidaying in Greece, Your Neighbourhood Economist typically has gotten a quizzical look from people when the choice of holiday destination comes up in conversation.  “How was it?” would be a standard response with the expectation of tales of squalor coupled with rebellion being rampant amongst the locals.  But except for stories of idyllic islands and endless sunshine, there was nothing much else to tell.

While there are stories of hardship coming out of Greece, for many life goes on.  While 17.7% of the working population are unemployed, there are still 4.1 million workers in jobs who generate GDP worth 215 billion euros giving Greece a per capita income which is higher than Portugal, Croatia, and the Czech Republic.  Much of the hurt that the country is experiencing comes not from absolute poverty which does exist as it does in many other richer countries.  The real pain comes from what has been lost due to the debt crisis and from a future that looks considerably different now than would have been the case five years ago when the entry to the euro had seemingly ushered in a new era of prosperity.

Some readers with a sympathetic disposition toward the people of Greece may consider the stance of Your Neighbourhood Economist to be harsh.  But the trouble that Greece is in will require pain to be inflicted on someone and it is essentially the Greek people that ran up the bill.  Blaming an irresponsible and unrepresentative government only goes so far when considering that the Greeks have left these politicians in power.  Investors who hold Greek debt have endured a portion of the pain in the form of the debt write-off that was part of the previous bailout (see Another Bailout for Greece).  But the Greek people are even now living beyond their means considering the small primary budget deficit in 2011 which means that government spending still exceeds its income even when interest payments on its debt are excluded despite the austerity measures already implemented. 

The cash and the solutions are available to solve the debt problems in Greece and elsewhere but sharing out the pain is the issue that politicians are negotiating.  To let Greece off the hook too easily would create a moral hazard – setting a precedent whereby costs of bad decisions are borne by others.  Despite the rioting and protests, Greeks have shown a willingness to accept a considerable share of the burden after a small majority voted for parties which supported the bailout and the accompanying austerity in elections in June 2012 (which was a bit of a surprise to Your Neighbour Economist - Greece Set to Rebel and Dump the Euro).  And even Angela Merkel has shown some flexibility in allowing the European Union to move toward a banking union whereby funds will be available to prop up the banks in the different countries.  But taxpayers in Germany are still loath to stump up cash for the Greeks who are seen as proliferate when German workers have made do with limited wage increases to maintain competitiveness. 

But these negotiations have dragged on for too long as the leaders in Europe hope that minimal measures will suffice.  The trials and tribulations that Greece is being put through to ensure that it bears its share of the pain are causing the problems to fester such as delays in a possible bailout to Spain as well as sluggish economic growth in the Eurozone acting as a drag on the global economy.  Europe’s leading politicians and its central bank have been more proactive of late (more on that in a future posting) and hopefully the end of austerity is not too far away with the Greek government hoping that cuts to spending in 2013 and 2014 will be the last of it.  If the country pulls through without much more turmoil, it will be the Greeks that will have earned themselves a holiday.  

Bracing for Impact!

The ongoing sagas in Europe can seem at times like a multi-car pile-up.  It begins with just a car or two spinning in circles after having been swiped but soon escalates as drivers are surprised by what they encounter.  Onlookers try to warn the oncoming traffic but the drivers are distracted and everything seems to happen in slow motion.  Just as people wince as they wait for what seems to be a major collision (fresh elections in Greece on July 17^th), eyes are averted to the potential for even more carnage – a banking crisis in Spain.

The turmoil in Greece and Spain appear similar but stem from different causes.  The government in Greece had too much debt before the global financial crisis came crashing into our living rooms.  The Greek government had borrowings of more than 100% of GDP in 2007 and this quickly rose to over 160% of GDP in the four years as tax revenues plummeted and government spending proved difficult to trim.  The government in Spain, on the other hand, was comparatively a model of virtue with debt of than less 40% of GDP in 2007.  Even as worries mounted, the level of government debt in Spain was still less than 70% in 2011. 

Yet Spain has been shunned by investors due to concerns over its banking sector.  Spain has fallen victim to a property bubble and it is typically in banks where the first symptoms show.  People or companies take out a mortgage using their new real estate purchase as collateral, and when prices are rising, everyone is happy.  However, when the market turns sour, property prices drop and prospective sales are not enough for the banks to recover the value of the debt. 

Dealing with a banking crisis like this is tough enough as it is.  The government needs to shovel money into the banks to stop them from collapsing under the weight of all the bad debts.  Write-offs are required for money that won’t be recovered and considerable time and effort is necessary before banks can get back to operating as per normal.  Typically, the government would just step in and put up the money to bolster the banks.  Bankia, Spain’s four largest bank, was recently bailed out by the government at a cost of 19 billion euros with the rest of the banking section expected to need around another 45 billion euros.  Compared to the level of government debt in 2011 of over 700 billion euros, putting up the cash is manageable and the debt to GDP ratio would still be less than 100%. 

Yet, Spain has more obstacles in the road in front of it than just a banking crisis.  The high interest rates on Spanish government debt (around 7%) means that the government doesn’t have the access to the funds it would normally have.  And the government is short on cash as it cuts spending to lower the government deficit.  To add to this, the economy is in recession with real GDP expected to fall by 1.5% in 2012 and 0.1% in 2013 with the austerity measures and banking crisis likely to make things worse.  The deteriorating economy also hits property prices, exacerbating the problems at the banks.  And on top of all this, the possibility of Greece dumping the euro means that Spaniards are taking their savings out of the banks and putting it under their mattresses due to worries about a return to the peseta.

As well as being short on funds, the Spanish government has lacked the creditability in dealing with its banks after having underestimated that cash that would be needed to bolster Bankia.  Help is on offer via a bailout for its banks from Europe and the IMF but Spain is wary.  While the money would be welcome, the conditions would not be and the saga in Greece are a reminder of this.  There have been some positive moves such as deliberation over whether Spain should be given an extra year to reduce its deficit to 3% which would help (as suggested previously – Spain and the Long Hard Slog).  But with both Spain and Greece now playing chicken with the leaders of Europe to try and ease their share of the burden, expect the carnage to mount.

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.