Posted by: Nicholas Davis | June 8, 2011

The benefits of percolation (aka omg Greece aka vale Eurozone)

Note: I wrote this last weekend and didn’t post it as I wasn’t quite happy with it. Since then, according to some side mentions in the German press, it does indeed look like the ECB will agree to debt restructuring in the Eurozone periphery countries (despite ongoing official speeches to the contrary). Apologies for the length – too busy to write a shorter blog post...

One way in which I’m justifying the fact that it’s been 77 days since I last wrote a blog post is the argument that it is valuable to leave the brain fallow for a while. I’m a big fan of “percolation” – raising an issue or question, then letting a day or so pass before returning to a detailed analysis of the issue. So I like to think that what’s been happening these past few months is a crucial period of percolation prior to some awesome, insightful blog posting.

Of course that might be true if I hadn’t been destroying brain cells through excessive travel, lack of sleep and a fair amount of whisky consumption. Worth it though – since I last posted I’ve been to two fascinating conferences in Estonia and Oxford, spent almost 3 weeks in Australia attending my little sister’s wedding and meeting great people in Adelaide, Brisbane and Sydney (not to mention attending a lot of late night phone conferences), and kicked off an exciting new project titled The Political and Economic Implications of Resource Scarcity. And I’ve enjoyed a fair amount of Springbank and Ardbeg, my two favourite whiskies along the way.

However of all the big things percolating in my brain over the last few months, the biggest is what’s going on around me here in Europe at the moment. Not sexist E. Coli, but rather Europe’s sovereign debt crisis that I’m worried is about to get less theoretical and more real in the form of a European banking crisis.

It seems that both markets and politics are finally catching up with the underlying economics of Greece and Ireland’s debt situations: namely, that both are technically insolvent with almost zero chance of paying back the money they’ve been lent, even given the large bailout packages they’ve already received and the austerity measures they’ve been forced to adopt. For the background story to Greece, see Michael Lewis’s Vanity Fair article “Beware of Greeks bearing bonds”, and for the same on Ireland (both told amazingly well by the way), see his companion article “When Irish eyes are crying“. Highly recommended articles.

Right now, thanks to investor jitteriness, the cost of debt to these countries is so high that they can’t even “ponzi” their way out by paying old debts with new borrowing. That means that as their various debts become due they will simply be unable pay them without help, leading to a default on the debt and some big problems – namely the flight of capital from those economies and the negative impact on European banks that are holding these countries’ debt, which will in turn need recapitalization. So, everyone agrees, help is needed. That help could come in two forms – by agreeing with the people they owe that they’ll pay less, or slower than originally agreed (a “restructuring” of the debt), or by receiving ongoing handouts from non-private investors such as the ECB, effectively meaning that taxpayers in the rest of the Eurozone take those debts on.

The problem has been that neither of these options have been taken seriously until now – the Germans and European Central Bank have been resisting any suggestion of restructuring (claiming, at least until recent talks, that restructured debt would no longer count as collateral against official support in the forms of current and future loans needed for liquidity), while politicians and populations in the rest of Europe see open-ended support and continued bail-outs as both politically undesirable (the conservative Germans paying for the profligacy of the Greeks!?) and potentially impossible anyway (while Greece could be saved, under current structures and trends, there is just not enough money in the combined bail-out mechanisms to cover Greece, Ireland, Portugal and Spain, to say nothing of Italy).

As Martin Wolf said on Tuesday, the Eurozone is now in a situation of intolerable choices – it seems politically impossible to create the financial integration and ongoing fiscal support that the region would need to cope with the debts in periphery countries (though Trichet is now hinting at Euro authorities taking over running the Greek economy!), yet it is economically almost unimaginable to see how an exit from the Eurozone by any country (Germany on the strong side, the PIIGS on the weak side) wouldn’t result in complete chaos. My fear is that it is politically “easier” from a domestic point of view to push for exit (which might be achieved unilaterally, for populist reasons, by a single country), than it is to corral support among member states and create even greater integration, particularly after what has happened so far.

I’m now convinced (though would be very happy to be proved wrong) that the central scenario and strategy espoused by the ECB and others of fiscal austerity, economic restructuring and sales of public assets combined with continuing (but limited) financial support from the EFSF, EFSM and IMF is almost completely implausible, even given the measures being discussed now to create new bail-out packagesAccording to an excellent report by Bruegel it is nigh on impossible for the Greeks to pay down their debt. Bruegel calculates that to reduce Greek debt to a more sustainable 60% of GDP by 2034, under an “optimistic” growth scenario the Greeks would need to run a primary surplus of 8.4% of GDP for the next 20-odd years. Under a “cautious” scenario the surplus required is 14.5% of GDP. To put that in context, the Bruegel report points out that “over the last 50 years, no OECD country (except Norway, thanks to oil surpluses) has sustained a primary surplus above six percent of GDP”. And until recently Greece has been running massive fiscal deficits – EIU data says that in 2007 Greece’s deficit was 6.4%, growing to 9.4% in 2008 and a massive 15.4% in 2009. With estimates of continued deficits of 9.7 and  8.1 over the next two years, you can see how hard it will be for Greece to pay back its creditors.

So, I’m calling that we will see some form of restructuring of Greek debt soon (not called restructuring, but “re-profiling” perhaps), combined with even more draconian measures on the ground, including fire-sales of state-owned assets and wage cuts. We might even see the Greek’s agreeing to some loss of sovereignty in the form of central management of their banking sector and public finances by the EU.

However even with I’m not sure that this will work. At the end of the day, what is needed is that the PIIGS economies create a situation where their citizens wake up and are productive in supplying goods and services to one another and the rest of the world in such a way that there is a surplus for their governments to tax in order to pay back their massive debts. And, as I’ve argued above, with the threat of ongoing public unrest, the psychological pain (and deflationary impact) of cuts to wages and living standards, and opportunities for populist grand-standing, the pressure in my mind is towards a Eurozone breakup in some form rather than the deeper financial integration that would be required to make it work. Scary stuff.


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