The Euro money supply

I agree with Ambrose Evans-Pritchard and Jacques Cailloux. It's what I was trying to say yesterday. And on Thursday. It's probably gotten too big for Germany, France, the IMF, whoever, to fix. Only the European Central Bank has enough money to fix the Eurozone problem; because it can print it. What's ironic is that what they call "The Nuclear Option" is what first year economics textbooks describe as the normal way that central banks increase the money supply. We call it "Open Market Operations". Print money and use it to buy Eurozone government bonds.

But I don't think that will happen.

It's not so much the rules about what the ECB is and is not allowed to buy, or accept as colateral, (which, despite commenter JP's help, I still don't really understand); it's because it is ultimately a political decision. Who has the authority to say that the ECB may risk its seigniorage revenue on buying Greek or other countries' sovereign junk, when that revenue belongs to all Eurozone governments? Nobody. The Eurozone is not a real country. There is no central fiscal authority behind the ECB. That decision would have to be reached by a political consensus of all Eurozone countries, and I don't see that happening.

If Greece had a central bank of its own there is no doubt it would now be buying Greek bonds. But it doesn't; at least, not a real one that can print money.

Eurozone commercial banks hold Eurozone government bonds as assets. With the drop in those bonds' values, many commercial banks (inside and outside the Eurozone) will become insolvent. There will be (and already are) runs on those banks, as depositors seek to transfer their deposits to safer banks, if any can be found, or withdraw currency, if they can't.

The first year textbook says this fall in bank deposits will cause a fall in the money supply, and that this fall in the money supply will cause a recession. And the general fear of financial assets will also cause an increase in the demand for money which will exacerbate the problem of a declining supply. And the solution is for the central bank to do whatever it takes to increase the money supply by however much it takes to eliminate the excess demand for money.

I don't see how the ECB will do this, if it can't buy bonds, can't lend to insolvent banks, and can't lend against junk bond colateral.

Instead, the ECB will point to its nice low interest rate target and say "Look how loose monetary policy is!". And it will be low, because the only people who can borrow at that rate won't need to, and all those who desperately want to borrow at that rate won't be allowed to.

The fall in the Euro money supply will cause a worsening Eurozone recession. As I, Scott Sumner, Bill Woolsey, (and others) have been saying all along, central banks' nominal interest rate targets are not a good measure of the stance of monetary policy. But others will explain the same facts differently: they will say that a recession caused a fall in money demand. Which of course is true, in a way; when the money supply falls, the recession has to get bad enough so that money demand falls enough to match the reduced money supply.

We will know the truth when some Eurozone governments start paying their workers in new monies they have printed themselves, because they have run out of Euros, and can't borrow any more. If there were no shortage of Euros, who would ever accept those new monies as media of exchange? But if there's a shortage of Euros, accepting payment in New Drachmas will be better than nothing, and you will know that others will also be short of Euros and so will accept them from you in turn. When that happens, Greece (and it is unlikely to be alone) will have left the Euro.

If the ECB won't create enough money, some Eurozone governments will eventually start creating their own.

Comments

[Kosta]

If the ECB won't create enough money, some Eurozone governments will eventually start creating their own.

I was insistent that Greece would never voluntarily leave the Eurozone; I could never see the upside to departing. But your excellent post finally made it clear to me; it's all about the money. Thank you.

[Patrick]

Conjures visions of a banker, besieged by angry depositors demanding their money, standing in an empty vault saying "... but interest rates are low!".

[JP Koning]

This might help clear things up. The ECB normally engages in open market operations, but these are in the form of repurchase agreements. It buys a security from a bank, holds it for anywhere from a day to several months, at which point the bank repurchases it from the ECB as per the prearranged agreement, and cash is withdrawn from the economy.

The "nuclear option" is a different kind of open market operation; outright purchases. The ECB buys bonds from banks outright ie. with no promise of repurchase. These bonds will be held on the ECB's balance sheet till they mature (at which point they can be rolled over, perhaps perpetually). This sort of open market operation is much more permanent than repurchase open market operations, since the ECB doesn't precommit to withdrawing currency as it did upon the expiration of repos.

I believe that shifting from repos to outright open market operations is a decision that can be taken by the governing council of the ECB. It doesn't have to go through members' respective parliaments. See: http://www.ecb.int/ecb/orga/decisions/govc/html/index.en.html. Of course, given the broad representation on this board the debate will be very political.

[Sam]

We will know the truth when some Eurozone governments start paying their workers in new monies they have printed themselves

.. just as California has already done with state income tax refunds and some payments to suppliers. Has California left the dollar zone, or is it just on its way?

[Patrick]

Sam: Not the same at all. For one, Texas can't refuse to send unemployment insurance or social security checks to California, and Californian can't refuse to pay federal taxes. But Germans will never pay a dime in automatic stabilizers to Greeks, and Greeks will never pay taxes to Germany.

[Bob Smith]

"Greeks will never pay taxes to Germany"

Or, so it seems, to Greece.

http://www.wealth-bulletin.com/portfolio/tax-trust-and-legal/content/1056530676/

[Patrick]

To be fair ... If I were Greek, I'm not sure I'd want to pay taxes to the Greek gov't either. It doesn't exactly have a stellar record of providing public goods (or good to the public).

[rogue]

If California is sinking in debt, and the Fed is not going to print more dollars just to help bail it out of its debt, its people will just move away, and go to perhaps, Oregon or Texas, where the state finances are healthier, and they don't have to suffer austerity measures. Same with Canadians, who can move provinces. If the ECB is not going to print more Euros just to help bail Greece out of its debt, can people just move away, and go to Germany or France?

[TigerPaw]

Except that mobility within Europe is somewhat illusory ... can Greeks speak French or German? Will the French/Germans hire workers that they can't talk to? Not to mention different social customs etc. etc.

It isn't the same as someone in Alberta moving to BC, or someone in California moving to Oregon.

[x man]

helicopter drop

[Nick Rowe]

Kosta: Thanks! Yes, I can't see any way that Greece (or any country) would *voluntarily* leave the Euro. But I can see it *involuntarily* leave the Euro.

Paul Krugman has just posted a very similar sort of view. Actually, I think his narrative is a bit better than mine.
http://krugman.blogs.nytimes.com/2010/04/28/how-reversible-is-the-euro/

JP: the way I see it is that a repo is essentially a loan to the commercial bank, with the government bond just acting as collateral in case of default by the commercial bank. While an OMO is an outright purchase. But I can see the other way of looking at it. Yet, as you say, the degree of *permanence* may be different between the two. How long is the loan/repo for? When will the bond/TBill mature?

Sam: I'm still not sure how far one can stretch the analogy between Greece and California. One big difference is that the US Federal government exists. There's no federal government of the Eurozone.

[Too Much Fed]

A little off topic but about currency denominated debt and I assume the need for low interest rates.

From:

http://globaleconomicanalysis.blogspot.com/2010/04/shelby-seeks-to-end-casino-atmosphere.html

"Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job ;) amazing how good I am in convincing myself !!!" Tourre said in an e-mail to Serres in January 2007.

"It's bizarre I have the sensation of coming each day to work and re-living the same agony - a little like a bad dream that repeats itself," Tourre writes. "In sum, I'm trading a product which a month ago was worth $100 and which today is only worth $93 and which on average is losing 25 cents a day ...That doesn't seem like a lot but when you take into account that we buy and sell these things that have nominal amounts that are worth billions, well it adds up to a lot of money."

Is that really God's work?

[Jon]

Yes, I think its the permanence that matters; however, even outright operations unwind. For instance, the dollar weighted maturity of the Fed's portfolio is/was around 4yrs.

Clearly, something becomes outright as a consequence of the confidence that will be rolled-over, and over.

Its a bit fascinating that, the BoJ which all these years has never been able to induce inflation, is fixated on the overnight repo market.

[Kosta]

Nick: Thanks for the Krugman link. His narrative is conscice, but I prefer yours. You've done an excellent job of illustrating some of the dilemmas with the present situation (like low central bank rates but no one being able to borrow and more importantly the fact the EU isn't a country, but no Eurozone countries have central banks).

Also, when comparing repos versus outright purchases of bonds. Couldn't the Eurozone countries start issuing very short term debt (bills and notes), then have their banks buy this debt and then use it as collaterol with the ECB in repo agreements? If the ECB then extends their repo durations to 6 months to 2 years, this has the effect of the ECB buying the bills or notes (with a small haircut).

It would lead to each participating nation having a much shorter maturity for its debt, but as long as the ECB was committed to entering into repo agreements, there would be no problem in rolling over new debt.

Admittedly with Greece's 2 year yields hitting 16%, it would be expensive, at first. But with the ECB entering the market, the yields would drop.

Would this work?

[Andrew F]

Has the BoJ really been trying to induce inflation? They have a target of 1%, which might be too low (I don't know). Seems to me they could print Yen to reach their desired level of inflation. They sure can't cut rates much lower.

[wjd123]

Isn't Greece already paying taxes to Goldman Sach. Didn't its government put up dedicated revenue streams as colateral on Goldman's loans. And weren't the loans structured as currency swaps in order to get around EU rules.

If Greece is to be punished for what it did, than what about its enablers. Shouldn't the EU be looking for ways to punish Goldman Sach as a warning to banks that would undermine its authority. Have we found out if Goldman was shorting Greek bonds?

[Finster]

Please research the ECB money creation process thoroughly before writing on it.

The ECB creates money through tender operations. It's main refinancing operations MRF are running 1 week, conducted weekly and cover about 75% of the total central bank money creation. Since 2008 and the Lehman crisis they run quantitative tenders with full allotment for the bidding banks at a key interest rate (the other 25% being 3month operations for financial institutions with longer term financing objectives).
Actually receiving the allotment requires collateral in the form of elligible securities (mostly government bonds, but the ECB has leeway in choosing what it accepts as collateral). Repo actions are only done for fine tuning and are not a usual means of money creation in the ECB system.

Applying 'quantitative easing' as opposed to credit easing (which the ECB has already done) will put the bank squarely into the political battlefield between the German hawks and the doves regarding inflation targetting. Besides the ECB has a very indepenent mandate and more leeway than the BoE or the Fed, while political institutions which might apply pressure to it are deadlocking themselves.

Regards from Germany, an avid reader

[Nick Rowe]

Kosta: "Also, when comparing repos versus outright purchases of bonds. Couldn't the Eurozone countries start issuing very short term debt (bills and notes), then have their banks buy this debt and then use it as collaterol with the ECB in repo agreements? If the ECB then extends their repo durations to 6 months to 2 years, this has the effect of the ECB buying the bills or notes (with a small haircut)."

Dunno. I don't see how this is really different from what the ECB and Eurozone countries are currently doing. But if (say) Greek bonds are worth only 75 cents on the Euro (I nearly said "on the dollar"!), and German bonds are worth 100 cents on the Euro, I don't see anything in this process that would bring Greek bonds' prices back up. Who is on the hook if the Greek bond defaults? Is it the commercial bank, or the ECB? In an outright purchase, the ECB must take the loss.

Finster: "Please research the ECB money creation process thoroughly before writing on it."

That's what helpful, informed commenters like you are for! Blogging is a 2-way street.

Those tender operations you describe are just a way of the ECB making collateralised loans to commercial banks, right? With competitive bidding by the commercial banks, so that the bank that bids the highest interest rate gets the funds. And a repo is effectively just another form of collateralised lending to commercial banks? Because even if Greece defaults, the repo agreement requires the commercial bank to buy back the bond, even if it is now worthless.

So, simple story: The ECB creates money by collateralised lending to commercial banks. Right?

(When I looked at the ECB balance sheet, I did notice it had some percentage (around 30%?) of its assets listed as Eurozone government bonds. My guess is that this was the original allotment when the ECB was set up?).

"Applying 'quantitative easing' as opposed to credit easing (which the ECB has already done) will put the bank squarely into the political battlefield between the German hawks and the doves regarding inflation targetting."

Does the ECB have the kugels to enter that minefield?

[Finster]

Correct to a degree. Until 2008 the ECB mostly used interest rate tenders, in which central bank money was auctioned off to the highest bidder. Since 2008 the ECB went back to fixed rate tenders at full allotment, meaning that banks will get as much central bank money as they bid for, provided they have sufficient elligible collateral:

http://www.ecb.int/stats/monetary/rates/html/index.en.html

The HP of the ECB is very helpful for researching this and the institution is by far the most transparent central bank of the world.

The important point being that the ECB creates money on a short term basis via tender operations and except for the credit easing operations and some fine tuning all central bank money creation is a short term and self retiring mechanism. Based on this central bank money the commercial financial institutions create money on their balance sheets (private money, roughly 90% of the grand total of Euro circulation).

[Finster]

Thinking more about it the problem is such:

Modern central bank money is highly synthetic stuff. Creating more of it is absolutely no problem. A hit on the return key will do. However if an excess ends up in the hands of the non-financial institutions aka M3 (this includes governments) it creates inflation. This genie is very hard to tame once it's out of the bottle and at the same time it does not address the 'pushing on a string' problem of credit: if the private sector is maxed out in mortgages and cannot post any more collateral, all the central money creation in the world can't get the banks to lend (as they _should_ not under those circumstances).

Greece meanwhile is a totally different matter: locked to the Euro it operates under a 'gold standard' by other means. It's caught in one currency with Germany or even more precisely it doesn't have an own currency, because arguably the Euro is the currency of France and Germany and reflects their competativeness and productivity. So any adjustment in Greece will have to take place on a post WWI Great Britain/France/USA model, meaning deflation to restore productivity. Precisely that regime prompted Keynes to demand an end to the Gold Standard, precipitating in Churchill's comment that restoring the Gold Standard post WWI in GB was his worst policy blunder (albeit at wrong parity to the US Dollar).

I might have strayed off topic here, but to my mind there is too much interpreting off effects going on as to understanding causes. And this maybe is the strongest case for Greece leaving the Euro for its own good, because otherwise it's back to the history books and british unemployment of the 1920s, without taking into account the specifically british willingness to endure hardship to pay your creditors.

[Nick Rowe]

Finster: not really off-topic. But your main point, in the middle paragraph, the analogy to the Gold Standard, I take as read. It is part of my background assumption when writing this post. I spent more time on this sort of issue in my earlier posts on the Eurozone.

[Kosta]

Nick: My suggestion about using repo agreements of bills and short-term notes to replicate outright purchases was meant to highlight that the ECB already has the capability to effective purchase debt. In other words, the 'nuclear option', which you referred to, is already within the ECB's capability.

If the ECB made a credible commitment to "purchasing" (repo-ing with maturity while the ECB still holds the collaterol) all short-term Greek debt, there would undoubtedly be a large price effect. By taking this stance, the ECB would be guaranteering that Greece would meet all of its funding needs indefinitely. As long as the commitment is maintained, investors would be assured that Greece could roll over its debt, and they would be willing to hold short-term debt, which would raise prices and drop yields.

My comment is really technical, I was just trying to point out that in addition to the 'nuclear option', the ECB has the ability to accept all Greek debt, regardless of rating, as collaterol. If they do so with a credible long-term commitment, it's the equivalent of the 'nuclear option', but with a maturity shift in the debt.

On to another topic, Simon Johnson and Peter Boone have another post on The Baseline Scenario where they outline a massive expansion in the size of the IMF. I'm ambivalent about their proposal (I think the ECB should do the heavy lifting), but it might work. One element of their suggestion was the need for a new IMF head, and they recommend drafting Mark Carney. And while I'm open to Canadian tax dollars supporting the IMF, I think they should keep their hands off our BoC governor :)
http://baselinescenario.com/2010/04/29/to-save-the-eurozone-1-trillion-european-central-bank-reform-and-a-new-head-for-the-imf/

[JP Koning]

My understanding is that the ECB's main refinance operations are conducted in the form of repos. ie it is auctioning of repos ie. the tender operations are repos. The crux of the "nuclear option" issue as I understand it is the potential switch from short term repo tender operations to long term outright operations.

"So, simple story: The ECB creates money by collateralised lending to commercial banks. Right?"

It's not that easy. Repos look and act like loans, but from an accounting and legal sense they aren't loans, but purchases/sales. When you lend money to someone, you don't bring the corresponding collateral on to your balance sheet. It stays with the borrower. When you do a repo, you do bring the collateral onto your balance sheet.

From a legal sense, central bank law differentiates between lending operations and purchase/sale operations. Different sorts of collateral requirements may apply to either, so it is important that repos are properly classified. The BoC in 2007, for instance, illegally extended the wider collateral requirements governing its lending operations to its repos, and had to withdraw when confronted.

Anyways, this repo stuff is moving away from you main point, which seems to me to be the potential (or not) for new drachmas.

[Panayotis]

The ECB is run by strict mainstream economists and is not going to follow any innovative advice.Part of the problem is that it requires the collateral of national bonds to be of investment grade as rated by private rating companies. There is no democratic accountability with EU institutions greatly removed from EU voters and parliaments. The whole crisis in Greece started when the Greek central bank under instructions of the ECB pressured Greek banks to limit their participation in refinancing tender operations, especially the 12 month maturity kind in December 2009 and explained (!) that downgrades of Greek debt will limit the ability of Greek banks to borrow. Immediately spreads begun to rise. Furthermore, they raised the short float period to t10 days and allowed naked short sales with the right to withdraw without penalty!

[JP Koning]

Ok Kosta, I see what you're saying. One difference between the nuclear option and your short term repo option is that the participating banks face different risks under the two scenarios.

In the first the private banks buy government debt and sell it outright to the ECB, end of story. Bank has cash, ECB hold Greek risk.

In the second the banks buy government debt and repo it to the ECB. But with a repo, when the value of the collateral falls, the banks must pay up the difference to the ECB. Banks would much rather sell bonds outright to the central bank, especially Greek ones, since they no longer have exposure to Greek risk.

I think it boils down to... why would the banks agree to participate in a trade that exposes them to Greece? Out of nationalism and pride? Are they forced too? Is there some sort of carrot involved?

[Nick Rowe]

Lovely comments above!

Kosta: like JP, I now see what you're saying. And I have JP's same response.

And that, Panayotis, is an interesting new (to me) fact.

JP: I can see why the leagl angle on repos might matter. But why does it matter how the accountants describe it? "Who's on the hook if the bond defaults (the bank or the ECB)?" seems to me to be the key question. And if it's the bank, as you say, then a repo is economically equivalent to a loan.

[Nick Rowe]

Kosta: Yes, I was just reading the Boone and Johnson piece, and trying to get my head around it. Why, for example, does it have to be the IMF that supplies the funds? If there's a run out of Greek (and other) bonds, what's it a run *into*? If it's Euros, then why can't the ECB supply the funds? And it would only be a run out of Euros into (say) dollars if the Eurozone had serious liquidity problems, which could be fixed by the ECB?

[JP Koning]

The accounting matters because if a repo is treated as a purchase/sale, you don't have to keep the collateral on your balance sheet. Its a good way to get rid of a risky asset but still own it indirectly through the promise to buy it back ie. off-balance sheet financing.

If the repo is treated as a loan, than the collateral stays on your books and you have not succeeded in transferring the risky asset off-balance sheet.

But from an economic sense, you can't go wrong treating it as a loan.

[Kosta]

Nick: I had similar concerns with what they wrote (and Johnson undoubtedly favours his old organization). They did mention possibility of the ECB providing the necessary "liquidity", but write "this is exactly the process that always and everywhere brings about high inflation. The Germans would fight hard against such a policy, although it would prevent default."

I believe they're subscribing to:
the ECB will point to its nice low interest rate target and say "Look how loose monetary policy is!". And it will be low, because the only people who can borrow at that rate won't need to, and all those who desperately want to borrow at that rate won't be allowed to.

An expanded IMF could work, but having the ECB change policy seems to be the easier move.

With regard to the short-term repos, if the ECB makes a credible commitment to continuing its repo operations indefinitely, the risk of the collaterol falling in value will be small. As Panayiotis pointed out, one of the contributing factors to the most recent episode in the Greek crisis is concerns and manouevering about what Greek debt the ECB will accept. Similarly if (when) Moody's finally downgrades Greece, Greek debt will not be accepted. The ECB could relieve a lot of pressure on Greek debt by simply suspending it collaterol requirements. If the commitment is credible, the trade will become nearly risk free, so why wouldn't banks participate?

Of course, politically dropping the collaterol requirements is probably the equivalent of the 'nuclear option'

[Finster]

I repeat, the ECB does not create the main part of EMU central bank money supply through repos, but via credit to bidding banks in the form of tender operations, which require collateral in the form of elligible bonds/securities.

Repo operations are used for fine tuning purposes if an additional need for liquidity arises between main refinancing operations. Yes, it is bizarre that the elligibility of the collateral depends on private rating agencies whim, because obviously as a central bank the ECB should be able to analyze securities itself. Let's describe this as a legacy function of a disfunctional regime.

The real question at the ECB will be: Who do we credit central bank money to and what will happen with M3? Will the ECB in whatever way be engaged in government financing, which is not allowed according to the maastricht treaty. Monetary union central banks are forbidden from creating money and crediting the balance to their government. The ECB will not engage in anything similar.

[Kosta]

Finster: you wrote:

the ECB does not create the main part of EMU central bank money supply through repos, but via credit to bidding banks in the form of tender operations, which require collateral in the form of elligible bonds/securities.

I am definitely not an expert in these matters, so I appreciate your input. I was wondering if you could comment on how Greek banks (and I assume other Eurozone-member banks) have over the past year or so purchased debt from their own gov't's and then used this debt as collateral at the ECB to obtain additional funds at a lower interest rate. I've read about these transactions numerous times and always assumed that it was completed through some sort of a repo operation. I also assumed that Greece (and other nations) used these transactions as a major mechanism to fund their fiscal deficits. Were these repo operations? And did they not create a substantial portion of the "money" in Europe?

[JP Koning]

I'm pretty sure the main refinancing operations are conducted with repos. See for instance:

http://www.ecb.int/pub/pdf/scpwps/ecbwp1052.pdf
http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp157.pdf
http://www.ecb.int/pub/pdf/scpwps/ecbwp359.pdf

I quote from the last: "The ECB conducts repo auctions as weekly main refinancing operations (MRO) with a (bi)weekly maturity and as monthly longer term refinancing operations (LTRO) maturing after three months"

[Panayotis]

Again, I must point out the absence of democratic accountability and control in EU institutions, the absence of EU fiscal authority in coordination with the ECB and the absence of full employment and growth mandate for the ECB monetary policy. These are at the core of the European problem, regardless of the operational mechanics of refinancing measures. The EMU is a regime of a nonconvertible fiat currency with flexible exchange rates externally and a gold standard with fixed exchange rates internally and national fiscal authorities that are revenue constrained. Is it realistic to base policy on internal deflation/fiscal austerity and debt restructuring? If national debt of member states cannot be purchased by the central bank and/or is under threat from private rating downgrades, restructuring with a haircut is the only choice rather than austerity measures with a bail out that bring a debt deflation feedback loop. At the end the bail out is forced to become a debt restructure at worst terms for all.Notice that restructuring is already validated by mark to market revaluations in portfolios so it is really neutral in its effect.

[Kosta]

Panayiotis: "restructuring with a haircut is the only choice rather than austerity measures with a bail out that bring a debt deflation feedback loop"

I'm not sure about the legitimacy of any type of debt restructuring without Greece first doing its utmost to put its fiscal house in order. And that means austerity. It may very well be too late for Greece to cut its budget sufficiently to stabilize its finances, it may very well push Greece into an inescapable debt deflation feedback loop, but ultimately it's Greece's responsibility to do what it can to stabilize its own finances. The austerity has to happen first, and especially before any debt restructuring, with or without haircuts. Otherwise, it would appear that Greece is getting a free lunch, courtesy of those creditors foolish enough to buy Greek debt. What creditor would voluntarily agree to a haircut while knowing that Greece could still cut its own budget? If they're forced, while knowing that Greece could still implement austerity, what party would ever extend Greece credit again?

[Panayotis]

Kosta,

Thank you for your comment. Restructuring is a fact of business life. It is an admission that the original conditions of any agreement no longer apply and terms need to be changed. The creditors agree in order to avoid total loss if default occurs especially when there is no collateral to compensate them. Austerity measures will worsen the situation as they will lead in a deflation spiral and at the end will make things worse even for the creditors. Furthermore, thete is collateral damage upon the population and a moral hazard because the poor, the workers and the unemployed, who are not at fault, will have to pay so the creditors can collect their money in full. When you lend you take risk and you must pay for the outcome of your credit decision. As about lending again, my point is that Greece has the means to turn to domestic savings, which are substantial, for its borrowing needs as Greek private sector has less debt as ashare of GDP than in most other developed economies.. It is not healthy to have 82% of debt owned by foreign creditors as the income drain during the severe recession that follows will make things worse! Furthermore, notice that most creditors have validated loses in their portfolio of Greek debt because of mark to market accounting and also have transferred some of the expected loss on the ECB that holds a substantial amount of Greek debt as collateral of refinancing facilities.

[Kosta]

Panayiotis,

We both agree that there needs to be a large adjustment in Greece for that country to escape this crisis. It seems that you are suggesting that the pain resulting from that adjustment should be bourne by the foreign creditors instead of by Greece. I don't think that can happen, first off because Latvia and Ireland have both chosen austerity, but perhaps more importantly because the credit was originally offered to Greece based on misrepresented financial statements. Are you suggesting that Greece should be given an exception because it cheated?

Greece is not in a strong bargaining position here. The foreign creditors are the ones with alternatives. In particular if Greece defaults the ECB and other Eurozone countries will likely bail the private creditors out to prevent the financial system from collapse. Instead you are suggesting that these creditors should take a haircut when it was Greece that has presented misleading fiscal information for the past decade. Recent precedents in Europe (Latvia and Ireland) are clear, austerity is plausible. It will be painful for Greece, but ultimately it's Greece's responsibility.

In any case, haircuts will not solve the problem. I posted a link earlier to a study exploring haircuts, and even with a sizeable cut in the foreign debt, Greece would still have to cut it's own fiscal expenditures by 7.5% of GDP to stabilize its debt. Even if Greece tries to turn to domestic savings in this scenario, at what rate will these loans be made available? Can Greece survive without cheap loans from abroad?

[Patrick]

Paul Krugman: The Euro Trap

IMO, the morality play presentation is not entirely accurate or helpful.

[Nick Rowe]

Paul Krugman's two posts on this are very good. The one (important) thing he has missed is the "Lender of Last Resort" problem. And I mean LLR not just to prevent a run on the commercial banks, but to prevent a run on government bonds.

Sure, in principle, the ECB could act as LLR to banks and governments, but there's the political question. Who pays whom? Will Germans pay for Greek banks and government? That question was bad enough within the US, for example. But at least there is a US Federal government that can decide one way or the other.

German Tea Party, anyone?

[Kosta]

About Greek bank runs, I saw this on Bloomberg's "Deposits in Greek banks fell for a third month in March, leading to a 4.5 percent drop in the first quarter. That coincided with a fourth monthly increase in deposits held in Cyprus by local branches of Greek banks on the island." http://www.bloomberg.com/apps/news?pid=20601087&sid=a1oOwudcKN2g&pos=2

It's not a full blown run, but the trend is continuing.

Also Nick: in principle, the ECB could act as LLR to banks and governments, but there's the political question. Who pays whom? Will Germans pay for Greek banks and government?

It's a good point, but if the LLR is effective, then it should make a profit, having bought at the lows which its intervention created. Just consider the record profits the US Fed has been making these past few quarters. I think the political question devolves down to which country takes ultimate responsibility if the LLR's intervention fails? In the case of failure, Germany will be paying for Greece?

[Panayotis]

Kostas,

I do not agree with your mainstream views or your assessment of the situation in Latvia and other countries where austerity measures were implemented! You are also wrong on your assessment of restructuring. Even conservative economists like Feldstein,Johnson,Roubini and many others propose similar opinions to mine! You are a victim of a lot of propaganda regarding Greek budget reporting which was audited repeatedly by the EU anf fount acceptable! A viable program for Greece will be based on tax collection and waste control in addition to a haircut of about 30% and a maturity extension. I have proposed an elaborate program to high government officials and politicians who prefer to represent foreign banks rather than their own voters. As far as domestic debt is concerned earning 3-4% in Greece is much higher than what banks are offering in deposits.You seem to be more interested to have banks that access their risk to be paid in full rather than innoccent citizens who according to your prescription will end up paying dearly with the austerity package. On the dilemma who will pay, I say the banks first, the tax evaders second and waste control third, the last two follow because thet are long term policies!

[Panayotis]

Kosta,

The deposit figures in March show a much smaller decline, mainly reflecting seasonal and recession factors. There is no run on greek banks as I know first hand!

[Patrick]

Latvia is suffering a terrible depression. I wouldn't wish that on anyone.

The morality play formulation cuts both ways. One could argue that Greece's creditors should be punished for making a dumb decision to lend money to Greece. And no doubt many of Greece's creditors would be classified as sophisticated investors. They should have known that Greece was not a sure thing. If they wanted a sure thing, they should have bought US T bills.

Seems to me that the responsible thing to do at this point is to do 'all of the above': restructure Greece's existing debt, implement tough but reasonable 'austerity' measures, and the EU should provide reasonably priced financing. They might as well work out a formula everyone can live with, because they're probably going to need to apply it to Spain, Portugal, and Ireland - and note that Spain and Ireland were running surpluses prior to the financial crisis.

[Kosta]

Panayiotis,

The bank numbers show a trend where deposits are leaving the country. You may be right that the trend is entirely seasonal; it would be best to compare these numbers to previous years. On the other hand, banks in Cyprus are showing an increase in deposits. Is the Cyprutian seasonal trend up in Jan-Mar while the Greek trend is down? Are recessional factors different in Cyprus from Greece? Or is there a trend towards deposits moving out of Greece into Cyprus?

With regards to Greek budget reporting, it is well established that Greece falsified its reporting to gain entry into the Euro. It is also well established that more recently Greece has entered into currency swaps to conceal the size of its own debt (note, other EU countries also participated in these swaps). Most importantly, as late as last Summer, the Greek gov't was reporting a fiscal deficit on the order of 4% of GDP. After Papandreaou won the elections, the deficit climbed to 12%. While changes in estimates of deficits are common around elections, an 8% increase is much larger than can be attributed to forecast errors. All of these facts are well established, none of this is propaganda. Greece has routinely provided misleading fiscal information, the magnitude of the problem only came to light last Fall. The fact that the EU accepted previous Greek fiscal statements extends the culpability to the EU, but does not excuse Greece from being misleading in their reporting.

With regards to the restructuring of debt, I assume we are both discussing the scenario where Greece does not default. If Greece defaults, the debt restructuring question takes on a different tone. My main issue is the impracticality of a debt restructuring. Is it supposed to be voluntary? Or is the EU going to force a debt restructuring on the banks? If it is forced, is that not tantamount to a default? If it is voluntary, why would any creditor acquiesce to a haircut? You've presented this issue as the creditor choosing between 70% and 0%. That's a false dichotomy. The choice really is the creditor can insist on 100% repayment with a chance that Greece will default, or 70% repayment with a smaller chance that Greece will default. In either case, if Greece defaults, the creditors will be bailed out. Maybe not 100 cents on the Euro, but they'll get something back. So why would a creditor choose a haircut?

I don't mean to say that debt restructuring can't be part of the solution, I'm more pointing out that a voluntary debt restructuring seems impractical, and a forced restructuring will involve a default. The other issue with debt restructuring is that by itself, it won't solve Greece's problem. Even with debt restructuring Greece will still have a very large fiscal deficit which much be closed (7%-10% from the studies I've seen). The way your proposals have sounded, very little effort will be made on the part of Greece to close this deficit, but without this deficit being closed, Greece's fiscal problem will not be solved, but just postponed until the debt climbs again.

If Greece put forth a credible plan to close its deficit, then debt restructuring could be part of the solution. But unless this plan reliably closes the deficit, I fail to see the incentive for creditors to voluntarily take haircuts? And note, difficulties with previous Greek fiscal reporting detracts from Greece's credibility; that's part of the reason the IMF was called in.

There are some very good reasons why haircuts to the creditors should be avoided. Most importantly, we all need the banks to funtion normally. A forced haircut and/or default could potentially lead to a repeat of Lehman's failure with loans being recalled system wide and forced selling all around. No one wants to repeat that. Second, we want the banks to as assured as possible that they will always get their money back because that leads to the banks lending at lower interest rates. A lower cost of capital spurs economic growth, which is something Europe needs righ now. I suppose an argument can be made that the cost of capital was priced too low the the past decade, and that forced haircuts would teach banks to not lend at such advantageous rates, but do we really want banks to revalue risk and to raise rates by 1% across the board across Europe and North America? Is that your suggestion? Forcing banks to take a haircut, who will penalize the rest of the world, so that Greece suffers less pain? Is that your solution?

Arguably it is better for Greece to suffer the pain, so the rest of Europe can recover quicker to pull Greece along.

Ultimately, the responsibility for what is happening lies with Greece. I think you need to accept this. Instead of blaming the EU for approving Greek fiscal statements, and instead of blaming foreign banks for extending credit to Greece, why not look at your own society and ask why the heck did your country get into this much trouble? That's my problem with the haircuts, and that's my problem with the bailouts. It's Greece that has to change, not the rest of the world. Greece is the one that needs to sort out its finances, whether by spending cuts or clamping down on tax evasion, or making the wealthy pay their fair share. Once that happens, I'm all for debt restructuring or bailouts, but until Greece takes ownership of its problems, why should the rest of the world help?

[Patrick]

"... why not look at your own society and ask why the heck did your country get into this much trouble"

This makes no sense. You need to read Krugman's posts. The morality play angle is NOT accurate OR helpful.

[Patrick]

Why would anyone want to duplicate these performances is beyond me:

http://www.indexmundi.com/spain/unemployment_rate.html
http://www.indexmundi.com/ireland/unemployment_rate.html
http://www.indexmundi.com/latvia/unemployment_rate.html

[Bob Smith]

Panayiotis: "A viable program for Greece will be based on tax collection and waste control in addition to a haircut of about 30% and a maturity extension."
Well, setting aside the question of a haicut for lenders, what's the viable program for tax collection and waste control? If the Greeks could pull that off, it's creditors wouldn't be freaking out. The problem is tax evasion is rampant in Greece as is public sector waste. While it's fun to blame foreign lenders, at the end of the day Greece's problem is that it's been living a lifestyle over the past decade that it can't afford and that it's citizens (however much they enjoy it) don't want to pay for. Giving Greece's lenders a 30% haircut and maturity extension won't change that (although it might cripple large chunks of the EU banking system).

Panayiotis: "As far as domestic debt is concerned earning 3-4% in Greece is much higher than what banks are offering in deposits."
That may be true, but on the other hand, if you invest in German bonds, you can earn the same 3% and not risk taking a 30% haircut when the government defaults. Unless you're proposing to restrict capital outflows from Greece, why would Greek savers invest their money in Greek Bonds (or Greek banks, for that matter), when they can get the same return with far greater certainty in Germany/France/US/Canada/etc? And don't tell me it's out of patriotism since those same Greeks who you think will be lending money to the Greek government are also the ones hiding their money abroad and evading their taxes.

Panayitois: "You seem to be more interested to have banks that access their risk to be paid in full rather than innoccent citizens who according to your prescription will end up paying dearly with the austerity package."

Personally, I'm of the school of thought that says investors take their chances. Greece is a borderline third-world country and the fact that it's part of the EU doesn't meant that investors should have lent money to it at goofy low interest rates. But the reality is that that Greece's "innocent citizens" (who lived high on the hog on other people's money during the boom years) are going to be taking a hit no matter what, because the lifestyle they've been used to over the past decade simply isn't within their means. Frankly, rather than calling the proposed reforms an austerity package the government should be calling it a reality package.

[Kosta]

"This makes no sense. You need to read Krugman's posts. The morality play angle is NOT accurate OR helpful."

Patrick, I am of Greek descent and have lived in both Greece and Canada, and am in fact a citizen of both nations. I have friends and family in both countries. I have also read lots of Krugman, who loves to moralize when it suits him. I am not moralizing as a Canadian telling the Greeks they are in the wrong. I am pointing out, one Greek to another (as my compatriot knows from my name), that there's something systemically wrong in Greek society, and that Greeks need to figure it out and fix it.

Am I out of place to say such a thing seeing as I live in Canada? Perhaps, but I have had the fortune to live in both countries, do business in both countries, and pay tax in both countries, which gives me a perspective that most do not have.

And yes, there are problems in Greek society that led to the present situation, and hopefully Greeks will correct these issues as they fight their way through this crisis.

[Kosta]

Patrick wrote:

Why would anyone want to duplicate these performances is beyond me:

http://www.indexmundi.com/spain/unemployment_rate.html
http://www.indexmundi.com/ireland/unemployment_rate.html
http://www.indexmundi.com/latvia/unemployment_rate.html

Those numbers are gruesome, but what's the alternative? How about default? Have you looked at Argentina's numbers post their default in 2001?

http://www.indexmundi.com/argentina/unemployment_rate.html
or
http://www.latin-focus.com/latinfocus/countries/argentina/argunemp.htm

[Patrick]

Kosta, your personal views are what they are. But can any of us say that we're free of moral defects? I'm Irish, so I know all about moral defects ;) How much of Canada's relative good fortune of late is attributable to moral rectitude, and how much of it is due to dumb luck? I'm in the 'dumb luck' club.

The general point I'm making is that it's easy and makes us feel superior to get on our high horse, hand out hair-shirts, and moralize; telling Greeks, Irish, Spanish, etc that it's for their own good that they have to suffer mass unemployment and deflation, but the fact is that it's real people who had nothing to do with the Greek gov't mismanaging public finance (aided and abetted by Goldman), who end-up suffering. And the damage could potentially last decades. Would paragons of virtue like me and you condemn an entire nation to such a fate when alternatives exist? For my part, I say no.

[Patrick]

Krugman wonders: Why Isn't Britain In More Trouble?

[Bob Smith]

"it's real people who had nothing to do with the Greek gov't mismanaging public finance"
Except for voting for those governments and all. That's the bummer thing about living in a democracy, you can't just blame the government for all your ills because, at the end of the day, you choose the government.

In any event, the Greeks are going to take a beating not because they're morally wicked, but because they're living beyond their means. Sticking it to Greece's lenders doesn't get them out of that situation. In Euro terms their wages are too high, their productivity is too low, and their government is too profligate. They're going to take a beating because they've put off making difficult decisions for too long. How do we bring our real wages into line with our productivity? How do we bring our productivity into line with that of Germany or Sweden (which they have to so long as they're on the Euro)? Do we raise (and actually pay for a change) taxes to pay for the public spending we want? Or do we really want that much public spending? Do we increase pension contributions so people can continue to retire in their 50's (or even 40s) or do we do what everyone else in the world does, and put off retiring into our 60s?

[Kosta]

Patrick,

You've missed the point of my 'moralizing'. First, if you go back to where you found my 'moralizing', you'll note the context where it was made. It flowed from an argument where I was highlighting how the previous Greek commenter was fixing blame for Greece's problems on external agents, rather than looking internal to Greek society. The point I made then, and I will repeat until I'm blue in the face is that Greeks would be better served to examining how they got themselves into such a fix, rather than continuing to blame the EU or Germany, or undemocratic institutions at the ECB, or foreign creditors. The issue runs deeper than a single gov't spending too much, it is truly a societal problem and that they need to deal with it. Perhaps I should use 'we' instead of 'they', but the point remains the same.

More broadly, you do raise a very good point about whether it is right of me to hand out hair-shirts. As one Greek, speaking to another (as I was to Panayiotis), I think it was. But looking at the list of countries you raised: Canada, Greece, Ireland and Spain; what differentiated these countries. You say luck. I think it's more than just luck.

I'll grant you that Canada was lucky this past few years, while the others were not. Spain, by all appearances managed both its finances and regulations well, but is still in trouble (bad luck). Ireland managed its finances well, but allowed its banks to get too big, and nearly collapsed when the bad luck hit. Greece managed its banks well, but mismanaged its finances. And by mismanaged, let's be clear, in addition to overspending, Greece has a track record of presenting misleading fiscal information to conceal this overspending.

Now it would indeed be virtuous of us to rescue Greece from its mistakes, accepting its solemn vows never to repeat them. Should we also rescue Spain? And Portugal? Perhaps Italy too? That would be very virtuous of us, but who would pay? Can anyone afford that bill?

More importantly, what shall we do with Ireland who has already taken its lumps regarding the banks it allowed to get too big? Ireland was somewhat complicit in the problems it faces, as Ireland let its banks get too big. But Ireland did not misrepresent itself to the world repeatedly, not like Greece. Nor was Ireland recalcitrant when it came time to pay the piper, not like Greece has been. Ireland accepted its errors and has tried to rectify them. Given Ireland's precedent, can we expect anything less than Greece? Or should we be virtuous and rescue Greece when we didn't rescue Ireland?

Indeed, given Ireland's acceptance of its problems, and its willingness to do what it takes to rectify them, I am very sympathetic of that nation. I am extremely sympathetic towards Spain and Portugal, who simply appear overwhelmed by the crisis of the past two years. I am not nearly as sympathetic towards Greece, as Greece manufactured much of their own crisis by concealing the extent of the their debt. And I am even less sympathetic towards Greece because that nation continuously evades responsibility for its situation.

Or maybe I am being hard on Greece, because having lived amongst them, I know what Greeks are like, and I know when they're evading responsibility.

[Patrick]

Kosta, I'm not at all arguing to bail anyone out unconditionally. I'm arguing that it's in everyones best interest to find a way to work out the problems and share the pain. I suspect that means some combination of Germany et. al. lending money below market rates, creditors taking a haircut, and some pretty severe austerity. Most importantly, they need to lay the ground for recovery. The short term worry for me is the European situation blowing-up one of their big banks and sparking another episode like fall 2008/winter 2009. And historically mass unemployment in Europe tends to have severe and bloody political consequences.

They might as well get the formula worked out now, because I suspect Ireland, Spain and maybe Portugal and Italy are going to need help. Latvia is horrible mess too.

[Kosta]

I agree that it would be best if everyone figured out a way to work out the problems and share the pain. We share the same fears about some European bank blowing up. The problem is how does one share the pain? How is to be divvied up?

Now I've taken a hard line with Panayiotis, and by extension with Greece, because his proposals have seemed to shift the burden of the adjustment to foreigners and away from Greece. In Panayiotis defence, this is the attitude of most Greeks (believe it or not, I watch Greek news a couple of times a week, well less now, as they're often on strike). The expectation in Greece is that others will save them, and that they won't have to bear any sacrifice. This evasion of responsibility is where my 'moralizing' stems from.

About Latvia, it's a mess, that's true, but let's not judge Latvia too early. There's a good chance the structural reforms implemented last year were successful. It might be important to see the strength of Latvia's recovery before passing final judgment. The question that I think will be most interesting is whether Latvia's maintenance of the Euro peg contributed to their recovery or hindered it.

[Panayotis]

As far Bob Smith is concerned,he knows nothing about Greece except some propaganda he read in tabloids! He deserves no answer!

As far as Kosta is concerned, he is entitled on his opinions on Greece and probably these views are the reason he left Greece! I respect that!However, since I live in Greece a lot of my time these days (and I have also lived in Canada many years ago) I have a different opinion on Greeks who will end up paying for the austerity measures. These are pensioners and workers/public employees that live on 1000 euros a month and the rising number of the unemployed!Who told you that Greeks are paid high wages or the unit prime costs are high in Greece? Are these people living beyond their means? There are other reasons for existing productive inefficiencies that are not addressed by cutting wages and raising VAT and sales taxes among many stupid measures imposed by austerity terrorists!

I do not know, Kosta if you are an economist but you obviously do not realize the implications of a deflation spiral. There is no case in economic history that a severe austerity program has brought a country into a path of prosperity but only brought decay! Even the IMF has come to realize the errors of their ways!

Bankers, the EU, the ECB, the IMF and the OECD, all knew the economic realities of Greece so nobody fooled them. Actually what Greece did was done by other EU governments! As about restructuring is not default but a step before that and is recommended by many economists and not only be myself. I explained all I need to say on the subject and I cannot reveal more details for the program I have recommended at this point for confidentiality reasons. Again, banks will accept a partial haircut exactly because they will have a minimal loss, which, by the way is already validated by mark to market accounting and ECB involvement as I mentioned in my previous comment.

Again, you are misrepresenting any flight of capital and deposits from Greece, I hope out of ignorance. Again, I can assure that is not true! As about waste control nearly 10% of GDP is involved in waste (not wages!) and tax evasion is a very serious problem when 40% of GDP goes unreported! Programs addressing these issues can drastically cut the budget deficit although discretionary public spending is neccessary for development purposes to increase productivity and replace the absent private sector investment.As about domestic borrowing, Greek banks offer 1-2% on short term deposits ( Greek banks carry 368 billion euros in deposit accounts!) and in the past Greeks did buy popular discount bonds with tax advantages. As for Greeks prefering to invest their savings abroad a lot has to do with tax evasion and there are methods to find and repatriate any funds invested in foreign assets that have not being reported! Italy had such a program and nearly 100 billion euros returned back and were taxed at a reduced rate. There are estimates that Greeks have between 200-300 billion euros abroad

[Panayotis]

KOsta, So Latvia is a success story after 2 years of suffering? Have you talked to Latvians? Have you talked to Hungarians who just kicked out of power the "socialist" government that brought them the IMF? Or maybe you have been in the Ukraine, or Roumania and Boulgaria who even have their own currency although pegged to the euro?

[Kosta]

Panayiotis,

I'll start with your second comment first. It's interesting that the countries you list all have their currencies pegged to the Euro (is that true for the Ukraine?). I have significant doubt that any of these countries will have strong rebounds because of the currency peg. What that says for Greece, and by extension, for Spain, Portugal and Ireland, is not pleasant. I agree that there is need for the ECB to loosen monetary conditions, but in my post I was arguing that the jury is out till we've seen the recovery, or lack of one, in those countries.

With regards to Greece, lots to address.

You wrote: Again, you are misrepresenting any flight of capital and deposits from Greece, I hope out of ignorance. I'm not misrepresenting the start of a flight of deposits out of Greece. The two pieces of data we've seen, the first reported in the FT and second confirmed in Bloomberg's, indicate that deposits in Greek banks are down 5% Jan-March. Deposits in Cypriot banks are up during this same period. This looks like the start of deposits leaving Greece. You have suggested that it is related to seasonal and recessional factors. It could be, but it's hard to imagine seasonal and recessional factors which would push deposits down in Greece but up in Cyprus. You also suggest that you've seen information (which I assume is confidential) that indicates deposits are stable in Greek banks. Hopefully your information is correct, but if you would like to refute the evidence I've provided, you could provide some counter-evidence. Given that you've seen the deposit numbers, and they are stable, why not find a public source and present those numbers. Otherwise, the only data we have available suggests that the deposits are starting to leave Greece. This is not a misrepresentation, this is the data we've seen.

With regards to your suggestions on Greece can save money by cutting down on waste as well as raise money by clamping down on tax evasion, I don't much care how Greece gets its budget back in order, as long as it does. But at first reduction, does it matter if Greece reduces tax evasion compared to Greece raising the VAT and other taxes? For instance, a major portion of tax evasion in Greece is through people avoiding paying the VAT, usually by not having the transaction recorded (i.e., no receipt) in return for paying a discounted price. Now Greece could clamp down on this form of tax evasion, and say collect 20% more tax receipts. Alternatively, Greece could simply raise its VAT by 20%, and just collect 20% more tax receipts from the transactions it normally collects from. Ignoring that there may be additional tax evasion and/or the costs of preventing the tax evasion as well as the potential inefficiencies of applying the taxes unequally, the two approaches are functionally equivalent. In both cases, tax receipts are raised 20% because taxes have been raised. In the first case, they've been raised by enforcing the tax on more transactions, in the second case, they have simply been raised on the transactions already taxed. In both cases, taxes are raised. The effects, at first reduction, are equivalent.

So on one hand, you have complained about raising the VAT, and yet on the other, you talk about how tax evasion will be curtailed. The first order effects of curtailing tax evasion are equivalent to simply raising the tax rate -- in both cases, taxes are raised. Both actions will hinder economic growth as money is taxed out of the economy. As I noted, I am indifferent as to how Greece should increase it's revenues, and if they can manage it by curtailing tax evasion, then great. But let's not fool ourselves. Curtailing tax evasion is the same as raising the tax rate. So, is raising the VAT any worse?

You also mention plans to curtail wasteful spending by the gov't. I think that's a grand idea. But what do those plans entail? One obvious place is to cut spending on services which are not needed or duplicated. I think you'll agree with me on this. But if you cut these services, what do you do with the people that the gov't employed to carry out these services that have been cut? Are they laid off? Terminated? Or perhaps kept on at reduced salary? I would argue that they should be terminated (which is terrible), but would you be happy with the gov't letting employees go? So on one hand you're saying wasteful spending will be curtailed, but on the other you're insisting that there shouldn't be cuts to salaries (or by extension, employment). Again, I am indifferent to exactly how Greece gets its budget in order, but if it plans to cut wasteful spending, then it will be cutting jobs in its bureaucracy. And from what I've read, and seen of Greek bureaucracy, there is a lot of waste that could be cut, but that would mean a lot of the staff would be let go. In other words, cutting wasteful spending is austerity, why not just call it austerity.

You also wrote: Bankers, the EU, the ECB, the IMF and the OECD, all knew the economic realities of Greece so nobody fooled them. Actually what Greece did was done by other EU governments!

Panayiotis, it is known that some of methods Greece used to hide the magnitude of its deficit were replicated by other EU gov'ts (particularly the swaps). But did any other gov'ts put out fiscal numbers suggesting a 4-5%GDP deficit June 2009, and then revise them to a 12-13%GDP deficit in October 2009? Did any other EU nation misrepresent an 8%GDP change in its fiscal deficit? I don't think so.

Are you also suggesting that the Bankers, the EU, the ECB, the IMF and the OECD all were aware that Greece, under Karamanlis, was underestimating its deficit by 8% of GDP? Are you trying to say that these organizations were complicit in the deception? That none of them thought an 8% GDP miscast should be addressed, or announced? If you could demonstrate such complicity, I will happily recant everything I have written and support you wholeheartedly!

You also wrote: As about restructuring is not default but a step before that and is recommended by many economists and not only be myself. I explained all I need to say on the subject and I cannot reveal more details for the program I have recommended at this point for confidentiality reasons. Again, banks will accept a partial haircut exactly because they will have a minimal loss, which, by the way is already validated by mark to market accounting and ECB involvement as I mentioned in my previous comment.

I also addressed at length the problems I have with the voluntary restructuring of debt. It would definitely help Greece if it does happen, but my main concern remains that as long as the restructuring remains voluntary, the foreign creditors won't accept it. You comment on how the restructuring has already been validated by mark-to-market accounting, but if a bank restructures at mark-to-market prices, it would give up much of the potential upside. And why would a creditor give up his upside, when he knows that the ECB is about to intervene, an intervention which would make him whole anyways.

Moreover, mark-to-market accounting is probably not applicable for all of the creditors. If the creditors have designated their Greek debt as Hold-to-Maturity, there is no need for these creditors to account for unrealized losses in the price of the debt. And while the price of Greek debt has dropped these past six months, these creditors do not have to recognize the price changes, not without a permanent impairment. On the other hand, if these creditors take a haircut, they'll have to recognize the change in price. In fact, these creditors have an incentive to NOT take a haircut; as long as there is some chance for Greek debt to rebound, they don't need to recognize any losses, but a haircut would force a loss on them.

There is also the issue of why would a creditor agree to restructuring when he's still not assured that Greece will avoid a default? If Greece successfully implements an austerity package, debt restructuring might make sense. But until Greece's long-term viability is assured, the motivation to restructure is unclear. In other words, unless Greece takes ownership of its problem and makes strides towards extricating itself from this situation, it's unclear why the foreign creditors would help.

Again, I remain unconvinced of the incentive of foreign creditors to accept haircuts, especially without assurances of Greece's long-term viability. Now you seem to be privy to internal discussions on the matter, which are undoubtedly confidential. I hope your suggestions come to fruition, but I fear that they are just wishful thinking.

You also wrote: but you obviously do not realize the implications of a deflation spiral. There is no case in economic history that a severe austerity program has brought a country into a path of prosperity but only brought decay!

I'm not sure about your claim here.

Where does Canada fit into this history, with Canada's 1994-1998 slashing of it's fiscal expenditures. Canada survived, and prospered, and even weathered a downturn in commodity prices from 1998-2002. Of course Canada had the luxury of its own currency and could devalue.

There are several European counter-examples as well. There's Greece's own experience from 1989 to 1994, where it moved from a primary balance of -6%GDP to +4.8%GPD over 5 years (2.2% per year). Denmark, from 1982 to 1986 had an even sharper fiscal adjustment, from a primary balance of -1.3% to 8.7% in four years (2.5% per year). Sweden, when its financial sector collapsed, adjusted from -2.5% GDP to 6.5% GDP in 5 years (1.8% per year). You can find other smaller examples here http://www.voxeu.org/index.php?q=node/4949

So its pretty clear that austerity programs can work, although looking at Latvia, they can be painful.

Panayiotis, I have many friends and relatives in Greece, and yes, I am aware that they will be hurt, some of them badly, by an austerity program, as will most people in Greece. But as Bob pointed out, Greece is a democracy, and in the end, the people are responsible for the gov't. In the end, it is the Greeks of Greece that are accountable, and responsible for solving Greece's problems.

But it goes deeper than this. Many, (I'd say most) people in Greece are complicit in the problems plaguing Greece. I look at my friends and family. All of them evade taxes, some of them egregiously so. I have a cousin who retired with full pension at 48. I have a family friend who retired with full pension at 38. I have witnessed many family members engage in corrupt behaviour with the Greek bureaucracy. My friends and family have all contributed to Greece's dysfunctional fiscal culture, and are all partially responsible for Greece's present state. Many (most) Greeks have taken advantage of Greece's system to live beyond their means or at least the means of the system. And now the system has broken down and there needs to be a change.

But what are the alternatives. The EU is not going to bail out Greece without an austerity package. How can it, after putting Latvia and Ireland through austerity (also, if the EU did bail out Greece, they would have to bail out Portugal, Spain, and probably Italy, and the EU can't afford that).

The other alternative, which is the issue that Nick Rowe raised in his post, is that Greece might choose to leave the Euro, as well as default on its debt. Is this option viable? The dislocation of leaving the Euro and defaulting (or defaulting and then leaving the Euro) would be tremendous. But at some point, it might be viable.

But that is choice before Greece, either adjust, as painful as it will be, or leave the Euro.

[Kosta]

Felix Salmon has a piece on Greece possibly hiring restructuring advisers http://blogs.reuters.com/felix-salmon/2010/05/01/has-greece-hired-restructuring-advisers/

This would seem to imply that Greece has been shopping around this mandate for some time now, and has already settled on Lazard as the bank it’s going to go with. ... But the mere decision to hire advisers sends the message to the market that default is more than just an option. Greece, it seems, is happy to spend serious money on high-priced bankers right now to work out whether and how to do it.

Hey Panayiotis, any chance that you work for Lazard?

[Panayotis]

Kosta,

I do not work for Lazard although I have some information regarding their involvement. I am not privy of any other plans except my proposals which is a multiyear structured program with rescheduling and long trem repayment tranches with performance "kickers" that can avoid eventual loss!

You have mentioned many things but not dealt with my points. First, austerity measures have a social cost that transcend the "consolidation" cost in terms of poverty, loss of skills by the unemployed, political unrest waste of underutilized resources, etc.

Second, The adjustment programs you have mentioned included devaluation capacity and were milder programs. Even the Greek example you mentioned and it took 7 years with help from the EU cohesion program before a gradual and slow growth resumed! Are you sure that in the cases you mentioned, the eventual turn around was caused by austerity measures? Are primary budget balance improvements mean growth and full employment of resources? Are you familiar with the clear cases of hysteresis experienced by European countries? I doubt it from your analysis and I can argue against it!

Third, none of your long discussion regarding your relatives and friends denies my proposed program about waste control and tax collection measures. My program is not an austerity program!!! I do not see how you suggest raising VAT and sales taxes on businesses that report their income is equivalent to collecting taxes owed by those who have unreported income! Apart from the distortions involved it will raise prices and reduce disposable income of those affected and cause more hardship. How is the tourist industry going to compete with these higher taxes? Or, real estate taxes not based on income but ownership value even without income, depressing property values and net worth of the private sector!

Fourth, the analysis of deposit liabilities of Greek banks have been analysed and reported by the Greek banks and the Central Bank of Greece and they have explained it to my satsfaction. I have also read a report by the Central Bank of Cyprus that denies that there have been any significant inflows of Greek deposits.
Fifth, you continue the tabloid myth that Greeks leave beyond their means! Greek wages and unit prime costs are close to the average in the euroland. Greek people are savers, owning real estate free and clear( not like in Canada!) and have lower private debt burdens than most developed countries (less than 90% of GDP). You want to compare their prudential household policies with those in other countries? Actually, the severe austerity measures will destroy this situation and they will be forced to liquidate assets and go into debt, so they will have not only a public debt problem but also a private one as well!

[Nick Rowe]

Kosta and Panayotis: just wanted to say I find both your comments very informative and insightful. Probably other readers do too. Carry on.

[Kosta]

Nick, I've been thinking that I've been making an a** of myself, thanks for letting me know that at least one other person has appreciated what I've written.

Παναγιώτης, έχασα την ψυχραιμία μου σε προηγούμενα μηνύματα, λυπάμαι. Θα προσπαθήσουμε να διατηρήσουμε αυτή τη συζήτηση πιο πολιτών.

Panayiotis,

I'm surprised that you feel I haven't addressed your points, I've tried my best to do so. I do feel that you are not addressing my counterpoints. But I think this is part of the problem of debating over the Internet.

So I will change the format of my reply, and just start fisking. This way we can make sure we address everything.

You wrote: First, austerity measures have a social cost that transcend the "consolidation" cost in terms of poverty, loss of skills by the unemployed, political unrest waste of underutilized resources, etc.

I actually agree with you that austerity is very painful, and something to be avoided if at all possible. I think what we're arguing about is whether Greece can and should avoid it. My positions is that it can't, and it shouldn't. I will add that I also think the EU, ECB and IMF (and Germany) should go out of their way to assist Greece, but this assistance should be conditional upon and supplemental to whatever austerity measures Greece undertakes.

You wrote: Second, The adjustment programs you have mentioned included devaluation capacity and were milder programs. Even the Greek example you mentioned and it took 7 years with help from the EU cohesion program before a gradual and slow growth resumed! Are you sure that in the cases you mentioned, the eventual turn around was caused by austerity measures? Are primary budget balance improvements mean growth and full employment of resources? Are you familiar with the clear cases of hysteresis experienced by European countries? I doubt it from your analysis and I can argue against it!

The adjustment measures I listed are all examples of countries, most of them European, which undertook austerity measures in the face of recession and high debt-to-GDP ratios. These examples refute your earlier claim that "[t]here is no case in economic history that a severe austerity program has brought a country into a path of prosperity but only brought decay!" We can debate whether Greece's present situation is similar to those examples I already listed, but it is undeniable that countries have in the past successfully implemented austerity packages and resumed to growth.

You raised some issues, specifically whether the austerity packages caused the resumption of growth, whether the primary balance improvements meant growth and full employment of resources, and whether I was aware of clear cases of hysteresis. To be quite honest with you, I can't answer all of those questions, nor do I need to. The record is clear that austerity packages have been successfully implemented in the past.

But I think what you're driving at is whether the examples I listed are applicable to Greece? Greece's fiscal sistuation is worse than any of the examples that I listed, and Greece can't devalue its currency. But Greece is still a member of the Euro, which means Greek interest rates will be low, once the situation is stabilized, much lower than if they had an independent currency. Greece will be given acess to funds at a much lower interest rate than of the listed examples. Finally, I wouldn't be surprised if cohesion funds are made available to aid Greece in its adjustment. I think the jury is out whether Greece can return to growth after a round of austerity, but it will probably depend on whatever aid it receives from the EU and IMF.

I think I haven't made clear the reason why I feel austerity is necessary (although I've hinted at it more than once). The basic problem is that Greece's fiscal situation is not sustainable, and that Greece has to reduce it's budget deficit sharply (which means a large primary surplus). You've suggested that some combination of debt restructuring, waste control and tax measures will address these issues. I don't think your proposals go nearly far enough to correct the problem. We both agree there needs to be an adjustment, I am arguing that the adjustment should be much larger than you suggest, and the word austerity best characterizes the needed adjustment.

I wrote much earlier that I felt you should take a look at Greek society and think about what led Greece to where it is. I was wrong to write that in that way, as it comes across that I think Greece should be punished. I'm sorry, that was wrong of me to say. What I meant is that there are issues with Greek society that are counterproductive to growth. As one Greek to another, we're both aware of them. For instance an obvious one is how almost every Greek evades taxes (even I do when I'm there). My suggestion to you is Greeks should look at these issues in Greek society, and take advantage of the crisis to change them, to move forward and no loger participate in these ultimately counterproductive behaviours. You have chosen to live in Greece (and there are very good reasons why one would choose to live in Greece). I don't know if you are in a position of influence in Greece, but if you are, you could try to help Greece correct these issues.

You wrote: Third, none of your long discussion regarding your relatives and friends denies my proposed program about waste control and tax collection measures. My program is not an austerity program!!! I do not see how you suggest raising VAT and sales taxes on businesses that report their income is equivalent to collecting taxes owed by those who have unreported income! Apart from the distortions involved it will raise prices and reduce disposable income of those affected and cause more hardship. How is the tourist industry going to compete with these higher taxes? Or, real estate taxes not based on income but ownership value even without income, depressing property values and net worth of the private sector!

My long discussion of my friends and relatives was primarily to demonstrate that I have a vested interest in Greece, and hope that is successfully navigates this crisis. It also was meant to show that I have a good working knowledge of Greece and its society. Finally, I hope it added some colour for the others reading these comments ;)

With regards to my comparison of your suggested waste control and tax collection measures to austerity, I think you've missed my point. If you think about it, the two differ only by a matter of degree.

What is the difference between cutting wasteful spending and just cutting spending? Both result on a drag on the economy. Even wasteful spending is stimulatory to the economy; according to Keynes, burying money in the ground is stimulatory. Cutting wasteful spending is cutting spending! There are some issues about which cutting causes less distortion, but that's a secondary effect. The primary effect is less money is being spent into the economy. If you cut enough of the wasteful spending, it's austerity.

Similarly, what is the difference between improving tax collection to clamp down on tax evaders and just raising taxes? The primary effect of both is to remove money from individuals (and the economy) and to increase government revenue. Again there are secondary effects about distortions and efficiencies, but these are secondary. My point is if Greece clamps down on tax evasion and collects every tax on its books, it will be the same as austerity.

Let me make up some numbers to illustrate. For the sake of argument, let's say the average tax rate on the books in Greece is 40% (and this tax rate sums up all the income, VAT, property and other miscellaneous taxes). Tax evasion in Greece is rampart, so let's say Greece only manages to enforce its laws 75% of the time. The effective tax rate in Greece is only 30% after the tax evasion is considered. But now Greece hits a crisis and needs to raise revenues. Greece has two choices here, Greece could do the bidding of the IMF and raise the tax rate on the books to 53.333%, but not clamp down on tax evasion leading to taxes being collected 75% of the time. Greece's new effective tax rate? 40% Alternatively, Greece could follow your suggestion and clamp down on tax evasion by improving tax collection, and in this example, let's say Greece managed to collect taxes 100% of time. What's the new effective tax rate? Again 40%. Raising taxes or clamping down on tax evasion is equivalent.

My point is that it doesn't matter if Greece enforces already enacted tax laws that weren't enforced, or implements new tax laws, the effect is the same, people are taxed, money leaves the economy, and the government collects additional revenue. If Greece clamps down on enough tax evasion, it is functionally the same as austerity.

You ask how my VAT example compares to your income tax of unreported income, and suggest the VAT will raise price and reduce disposable income. I agree that the VAT will raise prices, although I'm not sure how it will reduce disposable income as it is a sales tax (but this is a minor point). On the other hand, you do realize that if Greece taxes unreported income, it will also reduce disposable income. That income may not have been visible to the tax bureau, but it means individuals in Greece who had money in their pockets no longer have it and can no longer spend it.
At first approximation, the two are equivalent. We could argue about whether a sales tax causes more distortions than an income tax, but enforcing either will reduce the money in the economy while increasing government revenue.

You asked questions about the tourist industry and real estate. I don't have the answers, but I think the questions are distractions. The primary issue here is how does the Greek government raise revenues. It can do so by enforcing already-existing tax laws to collect additional revenue, or it can do so by instituting new laws. Either method will be a drag on the economy. If either method is implemented sufficienty, it will be austerity.

I will admit that some tax choices (and some spending cuts) are better than others. The IMF recommendations are undoubtedly a blunt tool to force the Greek budget back into shape. I would encourage Greek policy makers to look to cut wasteful spending first, and to enforce tax laws which cause smaller distortions. And undoubtedly, some choices are better politically than others. That's all sound policy. But let's not take our eye off the ball, Greece needs to make a very large fiscal adjustment. Nibbling on the edges, such as trying to tax a few hundred million Euros that have fled to Cyprus, will not solve Greece's budget problems. Large adjustments must be made, and they will be painful.

You wrote: Fourth, the analysis of deposit liabilities of Greek banks have been analysed and reported by the Greek banks and the Central Bank of Greece and they have explained it to my satsfaction. I have also read a report by the Central Bank of Cyprus that denies that there have been any significant inflows of Greek deposits.

Panayiotis, I hope the information you have seen is correct, because Greece does not need a deposit flight. But I have posted links to two stories from reliable sources reporting a drop in Greek deposits. The protocol I am used to in these types of discussions is that if you wish to refute the data I have presented, then you should also post a link to data which rebuts my claim. This is the normal protocol, and if you can't provide a credible source (or credible counter-logic), then my original claim remains uncontested. (Does anyone else think otherwise? Nick?)

You wrote: Fifth, you continue the tabloid myth that Greeks leave beyond their means!

Actually Panayiotis, I also posted multiple anecdotes of Greeks living beyond the means of their society. Specifically, my cousin who retired on full pension at 48, and my family friend who retired on full pension at 38. How can Greece afford to pay these pensions? I will add the endemic tax evasion in Greece where Greeks demand services from their gov't but refuse to pay the taxes to pay for the services. I worded my previous statement carefully to make clear that Greeks were living beyond the means of their society. This is self-evident by Greece's large deficit and 120+% debt/GDP.

You continued in point five: Greek wages and unit prime costs are close to the average in the euroland. Greek people are savers, owning real estate free and clear( not like in Canada!) and have lower private debt burdens than most developed countries (less than 90% of GDP). You want to compare their prudential household policies with those in other countries? Actually, the severe austerity measures will destroy this situation and they will be forced to liquidate assets and go into debt, so they will have not only a public debt problem but also a private one as well!

I will say that many Greeks in Greece barely get by with the amount they earn (particularly in Athens). An austerity package will be hard on many. But Greeks are an ingenious people and there are additional resevoirs of strength. For starters, the Greek family unit is quite strong. In times of crisis, I am sure Greek families will pull together and help one another. Most Greeks still have family, and even homes in the countryside, there is an additional source of support there.

But the smaller debt burden of Greek households argues that Greece is well positioned to handle a sharp fiscal adjustment. While you worry about Greek households being forced to liquidate and sink deeper into debt, I see it as a sign that the Greek households will be able to survive as government spending is sharply cut. As an example, if there was a sharp recession in Canada and I lost my job, I would lose my house and probably have to declare bankruptcy. Two out of three of my siblings are in a similar situation. But looking at my relative in Greece that are my age, only one out of eight is in fear that he or she might lose his or her house if they lose their job. In many ways, I think the Greek populace is better positioned to weather a sharp adjustment than the populations of most countries.

Ok I'm done with the fisking, let me try another tack.

As I understand it, you believe that the solution to Greece's fiscal crisis is for a debt restructuring coupled with some cutting of wasteful spending and some clampdown of tax evasion. I've objected for many reasons, but mainly because I'm skeptical that the creditors will accept the debt restructing and that because your fiscal measures don't go far enough. Rather than continue to argue these points, let me ask you a different question.

From the perspective of the EU, do you think your suggested course of action is credible? In answering this, address the role of the EU in assisting Greece's adjustment, and how the EU will then deal with Latvia, Ireland, Portugal, Spain and Italy.

To add some more details, I have pointed out before that Latvia and Ireland have already set precedents for sharp fiscal adjustments. The fiscal adjustment you're recommending for Greece is not nearly as sharp. If more lenient terms are given to Greece, does the EU then go back and provide additional support to Latvia and Ireland? Does the EU also then assist Portugal, Spain, and Italy? And if the EU does so, who pays?

Similarly, regarding your debt restructuring plan, lets assume the EU assists Greece in getting it implemented, perhaps even forcing by moral suasion the banks to take the haircuts. Does the EU then assist Portugal, and Spain, and Italy (with a 120% debt/GDP) in restructuring their debt complete with 20-30% haircuts? What about Ireland, does the EU revisit the debt restructuring that already ocurred? And finaly, assuming all this restructuring goes on, European baks will have written down hundreds of billions of Euros from their balance sheet. How are these banks recapitalized? Or does the EU let them fail?

[Kosta]

A bit of black humour from an Angry Bear blog

[T]he main issue the ratings agencies have is the Greek pension liability, and the main component of the austerity measures will end up being a reform of the pension system. The sovereign bond market is a curious place, where "He's willing to cheat his own grandmother, that one", can be a mark of the utmost probity.

http://www.angrybearblog.com/2010/04/tale-of-two-countries.html

[Panayotis]

Κοστα,

I do not have the time to continue this! However, I summarize as follows.

First, you do not seem to place much emphasis on the effects of tax distortions and incidence upon the economy. Second, you are finally coming around to see that austerity and growth of income and employment do not have a good relationship, instead your only concern is to achieve primary budget balance to put it mildly. Third, if Greece has state problems does not mean that Greek households have to suffer but rather cut waste and collect taxes, in other words correct the state problems. Actually, the private sector has competitiveness problems but not because of high wages! Austerity measures do not deal with these problems. The enforced program has practicaly no development/growth measures which are the only hope to raise tax revenues and deal with debt repayment!
Fourth, as far as deposits are concerned I said what I said and we will see how it turns out!
Fifth, Barry Eichengreen today joined the restructuring camp (Feldstein, Johnson, Roubini, etc.) which is growing! Restructuring is a realization that the previous contract terms are no longer sustainable. Do you think that the lenders prefer to recover 0% rather than 70%?
Sixth, you are finally coming to the erroneously theoretical point (I was wondering when you will bring it up!) of orthodox economics that these austerity measures will reduce interest rates leading to more investment and spending. Actually, in my own research I demonstrate analytically and mathematically that austerity measures bring output/income contraction, raise the expected loss given default, increase interest rates and invert the yield curve which is what is happening now!

[Panayotis]

Dear Κοστα,

Food for thought!

1. You consider equivalent the ex post moral hazard problem of possible but not definite fraudelent behavior against bankers as equivalent to the ex post moral hazard problem of causing collateral damage upon Greek citizens?
2. You imply that there is collective social responsibility or unlimited liability for the community for the private decisions of agents that capture public entities for their own interest? This approach can lead down a dangerous path!

[Kosta]

Panayiotis,

I don't have the time for this debate either, so cutting it short is probably best. But in your previous message you wrote that you felt that I wasn't addressing your points, so I did you the honour of responded with some 3000 words addressing every line of your previous meesage, as well as presenting the problem in a new way for you to address. I am fine if you don't want to address all of my counterpoints (I actually prefer it), but will you at least do me the honour of responding to my last questions? I'll repost that part of my comment:

From the perspective of the EU, do you think your suggested course of action is credible? In answering this, address the role of the EU in assisting Greece's adjustment, and how the EU will then deal with Latvia, Ireland, Portugal, Spain and Italy.

To add some more details, I have pointed out before that Latvia and Ireland have already set precedents for sharp fiscal adjustments. The fiscal adjustment you're recommending for Greece is not nearly as sharp. If more lenient terms are given to Greece, does the EU then go back and provide additional support to Latvia and Ireland? Does the EU also then assist Portugal, Spain, and Italy? And if the EU does so, who pays?

Similarly, regarding your debt restructuring plan, lets assume the EU assists Greece in getting it implemented, perhaps even forcing by moral suasion the banks to take the haircuts. Does the EU then assist Portugal, and Spain, and Italy (with a 120% debt/GDP) in restructuring their debt complete with 20-30% haircuts? What about Ireland, does the EU revisit the debt restructuring that already ocurred? And finaly, assuming all this restructuring goes on, European baks will have written down hundreds of billions of Euros from their balance sheet. How are these banks recapitalized? Or does the EU let them fail?

I agree with you that austerity is a terrible thing, but at this point, how does one address Greece's fiscal problems, in the context of the EU, without austerity? If your response includes debt restructuring and haircuts to foreign creditors, detail whether this restructuring will be limited to Greece, or include Portugal, Spain, Italy, Ireland, and Belgium? And explain how the European banks, after taking large write-downs, will be recapitalized.

[Kosta]

Panayiotis,

Regarding your food for thought questions, they're actually very good. Essentially, you're asking who should be held accountable for Greece's problems, and who should pay. My short answer is that unfortunately the Greeks citizens have to, just as the Irish citizens have had to pay for the errors made in Ireland and the Icelandic citizens will have to pay for the mistakes of their banks and regulators. It's terribly unfair, but ultimately the accountability resides with the citizenry.

Let's take the Iceland situation as an example, and the deposit insurance for the foreign depositors of Landsbankii. British and Dutch depositors lots some $4 billion when that bank went under, deposits which were insured by European Community regulations that Iceland was party to. Britain and the Netherlands reimbursed their citizens and are now demanding the money from Iceland? Should tiny Iceland pay that large amount, approximately $120,000 per citizen? Unfortunately, yes, because it was ultimately the Icelandic citizen's responsibility to ensure that their gov't was prudent in its management of its banks. Also, it was the Icelandic citizens who originally had benefitted by the overlarge banking system in their country. And finally, if Iceland does not pay, who should? Britain, Holland, their citizens? Britain and Holland are innocent in this issue, and their citizens have every expectation to have their deposits insured. Would it not be more wrong to force these latter parties to pay, when it was Iceland's error in the first place?

You wrote: 1. You consider equivalent the ex post moral hazard problem of possible but not definite fraudelent behavior against bankers as equivalent to the ex post moral hazard problem of causing collateral damage upon Greek citizens?
2. You imply that there is collective social responsibility or unlimited liability for the community for the private decisions of agents that capture public entities for their own interest? This approach can lead down a dangerous path!

I'll handle these questions together. Again, the short answer is yes, it's the Greek citizens that should pay. Why?

First off, you write as if the Greek citizens are entirely blameless in this affair. We know that's not true. There's the problem of endemic tax evasion in Greece, which demonstrates that most Greeks are participating in corruption that has contributed to the present situation. There's also the generous pension system in Greece, which is a significant part of the long-term fiscal instability. Many Greeks aim to retire by 50 with full pension, but if everyone retires by 50, who's left to pay the pensions? I could list to you many other anecdotes of how the daily public life in Greece, and especially in Greece's bureaucracy is incredibly inefficient, and you could undoubtedly respond with better examples, but let's just admit that most Greeks are complicit in, and take of, the inefficiency of the system in Greece.

But you specifically ask whether there is collective responsibility for the private decisions of agents that capture public entities for their own interests. The answer is of course there is. The first line of responsibility is with those specific agents acting corruptly. But if the problems can not be redressed by dealing with those agents, then the community must address the problems. Alternately, you can leave the problems unaddressed. But in this case, leaving the problem unadressed would mean that Greece defaults by mid-May.

Where else is the responsibility supposed to lie? Here's a silly example, let's say that in my father's village there's a tavern owner who dumps a huge amount of rotting refuse in the town plaza where the children normally play. How should this problem be handled? First off, the leader's of the village will get together and tell the tavern owner to clean it up. Let's say he refuses, or better yet, points to the EU and says that they approved of the disposal (after he sent them a disposal plan misrepresenting his true intentions). What should the village do? Should they accept his claims and start dumping their own garbage in the same spot? Should they call Germany, since Germany runs the EU who did not catch the mispresented plan, and ask for German garbagemen to come clean it up? Or should the community collectively clean up the garbage so that the children can play? If they're lucky, maybe Germany will lend them a garbage truck to help. In this example, it's the community that bears responsibility -- they let the tavern owner dump his garbage (what no one saw?), and it's the community that benefits most from cleaning up the plaza. The community should bear the burden or adjustment, or just use the plaza as a garbage dump.

Problems in Greece got out of hand. The Greek citizenry were complicit in many of the problems. Undoubtedly, some in Greece profited far more than others. But the responsibility for the problems lies within Greece. Greeks need to solve the problems. Greeks should evaluate why the problems happened, and if possible, make changes so that the problems don't happen again. Maybe this means changing the leadership of Greece; maybe this means changing the elite? But what it does mean is that ultimately Greeks must accept responsibility for the problems and correct them.

As for the private entities that abuse the system, it's the people of Greece who have to make sure that private entities don't have the opportunity to abuse the system again.

[Kosta]

Small correction, the amount Iceland owes Britain and Holland for the Landsbankii insurance is about $12,000 per resident, not $120,000.

[RSJ]

Kosta,

That is a creative reading of history. Billyblog has a nice article on this, referencing a recent WSJ source:

http://bilbo.economicoutlook.net/blog/?p=8581

http://online.wsj.com/article/SB10001424052748703936804575107653193288636.html

"There was no legally binding government guarantee of the deposits. The Icelandic government had fully complied with EEA regulations and set up a Depositors’ and Investors’ Guarantee Fund. If the resources of that fund were not sufficient to meet its obligations … then the Icelandic government was not legally bound to step in with additional resources. Thus the British and the Dutch governments had no authority to create new obligations on the part of the Icelandic government by paying their nations’ depositors."

So I would say, no, it is the responsibility of the British and Dutch citizens, not the citizens of Iceland. Iceland has already fully complied with its legal obligations, and the British and Dutch have determined that they want to provide even more support, and somehow force Iceland to pay for that, too.

[Kosta]

RSJ,

I object to your suggestion that my recitation was a creative reading. The summary was short, but it covers the facts accurately. I think it is incontrovertible that the British and Dutch deposits were guaranteed up to 20,000 Euros (or whatever the number was). You can (and you have) make the legal argument that the Icelandic gov't's responsibility stops at ensuring the Investor's Guarantee fund was funded to regulatory standards. You may even be right, but that's a rather legalistic argument.

However, I don't think the distinction takes away from my larger point. Ultimately, the responsiblity for the Icelandic banks devolves to Iceland, and to the residents of Iceland. Its the Icelandic residents who allowed their gov't to run lax legislation, and its the Icelandic residents who benefitted from the oversized banking sector up until 2007. It may be that in this specific instance, Iceland succesffully discharged its foreign liabilities by funding the Depositors' and Investors' Guarantee Fund, or it may not. In either case, the responsibility (be it large or small) still belongs to Iceland and its residents.

Oh, and I appreciate you posting the information on the Fund, and how Iceland may not in fact be responsible for reimbursing the foreign deposits.

[Panayotis]

Dear Κοστα,
I would ask you to read my food for thought points again and think them through again! In the first question I am asking you to compare and in the second to distinguish decision making between private interest and public duty that lead to different results. If you allow me to say you are moralizing a lot and seek to assign a collective guilt and penalty on Greeks for actions that private interests did. Is potential and not proven moral hazard losses of banks equivalent to collateral damage upon a whole population? Have you thought that these potential bank losses can be caused by adverse selection? Have the banks done their homework?

As about your previous comment which is moralizing again, I never said that if other countries in the Eurozone have problems, member states should not help in response to the solidarity principle! Again, as I said before, restructuring choice which by the way it takes many forms in response to different conditions of liquidity, solvency, cost of recovery and reorganization (yes, I have examined those theoretically!),is a realization by the parties to a contract that terms are no longer viable and enforceable! There is no moralizing in that but only business sense!

[Kosta]

Panayiotis,

I have tried very hard, and have written thousands upon thousands of words, to address your various comments. I asked you specifically to propose how you would solve the Greek fiscal problem in context of the remaining EU members, as well as the banks. Your response did not include any concrete suggestions, just generalizations, as well as accusations that I am being unfair, insisting on collecting punishment, and moralizing. I have tried to engage you in an intellectual conversation, as well as appeal to your desire make Greece a better society, and all you can respond with are platitudes. Perhaps I am a poorer communicator than I thought, but I am disappointed that I could not elicit a more constructive conversation from you.

It would seem that Greece has chosen to implement austerity, and that Germany will bail Greece out, making much of converation moot. Positive developments from my persective. I sincerely hope the Greeks of Greece weather the next few years successfully and return to strong and vibrant growth.

[RSJ]

Well, Kosta, I agree that there can be larger, implied responsibilities above and beyond the legal ones.

But at the same time, depositors have a responsibility to understand what types of guarantees they do and do not have. Especially when you are making a deposit for 7-10% interest rates in a small foreign nation. You are purposely leaving the safety of your national banking system in search of higher yields, and this is no different than buying junk bonds, IMO. I have a similar view of some U.S. depositors who made deposits in small Caribbean nations and then lost their money in this crisis.

It's a bit like how the U.S. stepped in to guarantee AIG's CDS guarantees, which primarily benefitted European banks. I guess you can argue that this was the responsibility of U.S. taxpayers as AIG is an American corporation. But honestly I don't buy it. We have bankruptcy and limited liability for a reason. The responsibility dies with the firm or organization, and does not pass on to citizens or descendants of the nation in which the failed organization operated.

However this does raise the issue of a lack of creditable deposit insurance in the Eurozone, which is a big problem, but not one that can be solved by Iceland, which isn't even an EMU member nation.

[Kosta]

RSJ,

My first response was a little testy, sorry, I haven't been getting enough sleep, I need to stop writing 3000 word responses ;). I think you're right that questions should be asked about whehter British and Dutch depositors, who were searching for yield, should have their funds guaranteed. On the other hand, Icelandic regulators allowed their banks to take these deposits, knowing that Iceland was party to the EEA regulations with depositor guarantees. You've added the wrinkle that it looks like Iceland is responsible to ensure the fund is funded to regulation. But there's another wrinkle that Iceland fully guaranteed its own citizens, while stiffing all foreign creditors (I think Iceland set a precedent by refunding its own citizens which should be applied univerality).

Although Iceland's situation is not much discussed, I think it is an excellent test case. To paraphrase one of Nick Rowe's comments from the IMF tax threat, Iceland is a great example of a small country encouraging its banks to take large risks, knowing there would be some kind of international response if those banks failed.

Yet what happened to Iceland is not pretty. To what extent should the internatinal community assist Iceland in its catastrophe? I don't have a good answer -- I alternate between insisting Iceland accepting broad responsibility and solidarity within the international community.

Here's another wrinkle. [T]he latest report from the Icelandic parliament, raising the possibility that the collapse of Iceland’s three largest banks is the result of “control fraud” where shareholders stole from their own bank in the same way as those convicted of looting from the American saving and loan banks in the late 1980s. http://www.voxeu.org/index.php?q=node/4965

There are some good details in the summary indicating that the largest shareholders looted the Icelandic banks up until their failure. This is actually a good example of one of Panayiotis questions where a small set of private actors have, through fraud, caused economic damage to a society, and beyond that. Who should pay for the damage if the private interests can't be held accountable? Who should pay for the foreign damages? Where does one draw the line and say the community has suffered enough?

[Patrick]

Interesting and slightly terrifying graphic from the NYT:

Europe's Web of Debt

[Kosta]

A quite note on the ECB changing policy to accept Greek bonds irrespective of the ratings.

The Governing Council of the European Central Bank (ECB) has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Greek government. This suspension will be maintained until further notice.
http://www.ecb.int/press/pr/date/2010/html/pr100503.en.html

This possibility was discussed earlier in the comments. In a sense it's a pared down version of the 'nuclear option', although the ECB is still only lending against these bonds, as compared to buying them outright.

But from the looks of what is happening in Europe today, it might not be enough.

[Nick Rowe]

Kosta: In the news this morning (forgotten where) I saw one economist quoted as saying he thought the ECB will soon start buying Greek (and other) bonds outright.

I'm not sure what will happen. If the ECB is prepared to buy Greek (and other) bonds outright, they can (I think) prevent a meltdown. I had thought that politics would prevent them doing this, because the Germans (and others) might go beserk.

(Economists' political predictions are perhaps even less trustworthy than their economic predictions!)

[Patrick]

Nick: Maybe this is what you're refering to?

I wouldn't toss out your predictions just yet. CalculatedRisk points out that the Germans aren't happy. Will the Greeks be able to implement austerity measured demanded by the Germans? Greek protesters storm Acropolis.

[JP Koning]

Regarding ECB purchases, here's something from an article in Bloomberg:

‘Anathema’ to Germany

Harvinder Sian, a senior fixed-income strategist at Royal Bank of Scotland, wrote in a report today that “markets should be alert to the risk of ECB bond buying, as early as today.”

While the ECB is prohibited from buying assets directly from authorities, it can buy them on the secondary market. Trichet said on May 2 that “at this stage, we have absolutely no decision on the purchase of government bonds.”

Such a strategy remains unlikely because it would be a “red line which the German government would not allow to be crossed,” said Marco Annunziata, chief economist at UniCredit Group in London. “Purchases of government bonds would be a straight monetary financing of excessive fiscal deficits, which is anathema to the Bundesbank and German government.”

http://www.bloomberg.com/apps/news?pid=20601087&sid=aMSO_VQTTzAU&pos=4

[Nick Rowe]

Damn! My comment just got eaten!

Good finds Patrick and JP.

[Kosta]

Nick: I'm not sure whether the ECB will actually start buying bonds, but it is the obvious next step, and I think you're right that it will go a long way to ending the crisis. Actually, the next step is to accept gov't bonds from every country regardless of credit rating, but after that it's the 'nuclear option'.

Good finds Patrick and JP, I've got another source arguing that the ECB is thinking about it. It's an RBS note via FT Alphaville. An excerpt:

ECB Pdt Trichet said “At this stage, we have absolutely no decision on the purchase of government bonds”. This is reminiscent of the “At this stage” answer Trichet gave when he was probed several times during the Q&A on the ECB collateral policy on sovereign paper at the March meeting. At that time, Trichet departed from his very firm statement made in January and actually hinted, in our view, at a potential change in the policy when he said that he had no comment to make “at this stage”. The change in the collateral policy was announced a few weeks later. Bottom line: Pdt Trichet has not rules out the possibility of bond purchase.(emphasis original)

[Kosta]

Another opinion on the ECB and the end game in Europe (Andrew Garthwaite of Credit Suisse, via FT Alphaville) .

. . The way out of this mess is: (a) a much weaker Euro; (b) a booming Germany- a one size fits all monetary policy has to be set at a level to help peripheral Europe, and that is going to end up being too loose for Germany (Germany has the least leveraged balance sheet in the developed world, the most undervalued property market and unit labour costs that are 10% too low – remember German GDP is 50% larger than that of peripheral Europe.); (c) the ECB buying peripheral European debt and (d) if necessary, EU/ IMF providing package to support Spain.

. . . We think that the ECB will be forced into the end game (buying peripheral European debt) and, if necessary, to ring-fence Greece by announcing a huge support package for Spain. We believe that the ECB has no other option. European banks hold, we believe, about $75bn of Greek, $46bn of Portuguese and $85bn of Spanish government debt (with around 80% of total Greek government debt being held by foreigners). In total, European banks hold $190bn of Greek assets, as well as $850bn of assets in Spain and $241bn in Portugal. (This is public and private and includes minority holdings) . . . (emphasis in original)

Looks like some more analysts are siding with Nick

[Kosta]

Another FT Alphaville blog has some interesting charts highlighting how Italy seems to be between the European core and periphery, at least from the debt perspective.

Italy really is the next shoe waiting to drop. It's quite amazing, given their already high debt load, that they've managed to add only minimal debt these past few years (and keep the confidence of the markets). But given the magnitude of their debt, that could easily change.

[Nick Rowe]

More good finds Kosta. Yes, my sense is that "expert" opinion is slowly coming around to the same sort of view on what would have to be done to avert (wrong word) a crisis. But will it be done, politically? It would still be a mess, politically as well as economically. It would be very sadly ironic if something that was supposed to bring European nations closer together (for damn good reasons) ended up driving them apart in acrimonious finger-pointing.

(And there's a lot of blame to go round, including economists, because even those of us who thought it might all end in tears couldn't really explain and prove that it would, so we couldn't and didn't give proper convincing warning.)

[Patrick]

More from Krugman:

Default, Devaluation, Or What?

And the political situation in Greece is getting worse: Greek protesters clash with police