Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Tuesday, May 18, 2010

John Cochrane on a Euro-Greek Tragedy

An excellent piece today by John Cochrane in the WSJ here. Here it is (in case you do not subscribe).

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Last week the Greek bailout ballooned into a gargantuan 750 billion euro (nearly $1 trillion) debt stabilization fund, including a $39 billion line of credit from the International Monetary Fund. This coincided with the European Central Bank (ECB) announcement that it would immediately begin purchasing junk-rated Greek debt.

It won't work. The problem isn't liquidity, psychology or speculators. Germany and France simply cannot borrow or tax enough to cover Europe's debts and looming deficits. So, barring a fiscal and growth miracle, we will either see sovereign defaults (larger and more chaotic for having been postponed) or the ECB will have to print euros to buy worthless debt, leading to widespread inflation. Since inflation lowers the value of promises to state workers and pensioners, and also is easy to blame on others, it will be an especially tempting escape.

Notice who is missing: Greek bondholders are not being asked to miss a single interest payment, reschedule a cent of debt, suffer any write-down, take a forced rollover or conversion of short to long-term debt, or any of the other messy ways insolvent sovereigns deal with empty coffers. Those who bought credit default swaps lose once again.

But why? The reasoning behind the Greek bailout is founded on several myths that need exploding:

Saving the euro. We're told a Greek default would imperil the euro.

The opposite is true. Allowing Greece to default, or to renegotiate with bondholders, would be the best way to save the euro. A currency union is strongest without fiscal union. Then
countries are no different from companies. If they borrow and cannot pay back, investors lose money. The currency is unaffected.

The euro could become a monetary union with full fiscal union. I hate to think what EU budgets and taxes would look like if they were all run from Brussels, but at least that system might impose some discipline on national governments' incentive to borrow, spend, and demand bailouts.

But the euro will be a disaster as a monetary union with loose fiscal controls and constant speculation about will-they-or won't-they (or can-they-or-can't-they) trillion-euro bailouts and ECB financing. The Europeans have found the worst possible combination.

How did this happen? The euro's founders wrote rules against sovereign bailouts. They almost created a perfect currency: an international standard of value and medium of exchange, with a central bank mandated only to maintain a stable price level. The euro was not to be devalued to wipe out government debts or to gain temporary (and often illusory) trade or employment
advantages. In the next U.S. inflation crisis, the euro might have succeeded the dollar as the international reserve currency.

But the euro's founders also set debt and deficit limits. The problem is not that these limits were too loose. The problem is having them at all. The mere existence of the limits says, in effect, that politicians will have a hard time resisting bailout pressure. So the markets lent at low rates and gave high bond ratings. The EU rediscovered that it's much harder to grow a spine in the middle of a crisis.

The euro founders should have said instead, "Go ahead, use our currency if you like. Rack up any debts you want. We don't care, because we are not going to bail you out—we've set it up so we can't bail you out. Bond buyers beware."

The euro founders never decided whether they were creating the perfect currency without fiscal union, or if they were creating a fiscal union on the way to political union. They never decided if the euro was going to be the national currency for a future United States of Europe or a gold standard for the modern age. Now they have neither.

Contagion.

We're told that a Greek default will lead to "contagion." The only thing an investor learns about Portuguese, Spanish, and Italian finances from a Greek default is whether the EU will or won't bail them out too. Any "contagion" here is entirely self-inflicted. If everyone knew there wouldn't be bailouts there would be no contagion.

Systemic risk.

We're told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn't even any collateral to dispute or assets to seize. This isn't new finance, it's plain-vanilla sovereign debt, a game that has
been going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.

Saving the banks.

We're told that Greece must be bailed out, or large banks will fail. Savor the outrageous irony of this claim. Apparently, two years after the great mortgage meltdown, Europe's army of bank regulators missed the fact that large, "systemically important" banks had made firm-threatening bets on Greek debt. So much for the idea that more regulation will keep complex banks out of trouble.

If the claim is true (which I doubt), the right answer is to save the specific "systemically important" banks (or, better, their "systemically important" activities), not to bail out every Greek bondholder and the Greek government and to paper over the vast bank and regulatory failure that set up the problem.

Greece got in to trouble when it tried to sell new debt to repay its maturing short-term debt, just as Bear Stearns and Lehman Brothers did. If Greece had sold long-term debt, there would be no sudden crisis. In all the talk of restructuring euro finances, nobody is talking about forcing governments to borrow long-term, nor of managing the crisis by forcing short-term debtholders to accept new long-term debt rather than cash.

Letting someone lose money on sovereign debt is the acid test for the euro. If not now, when? It won't happen in good times, nor to a smaller country. The sooner the EU commits, and other countries and their lenders come to terms with the fact that they will not be bailed out, the better.

The current course—ever-larger and less-credible bailout promises, angry German voters who may vitiate those promises, vague additional fiscal supervision (i.e. more of what just failed miserably)—is not the answer.

The only way to solve the underlying euro-zone fiscal mess (and our own) is to slash government spending and to focus on growth. Countries only pay off debts by growing out of them. And no, growth does not come from spending, especially on generous pensions and padded government payrolls. Greece's spending over 50% of GDP did not result in robust growth and full coffers. At least the looming worldwide sovereign debt crisis is heaving "fiscal stimulus" on the ash heap of bad ideas.

12 comments:

  1. the wsj & bloomberg have both started acting like the bonafied free press lately. It must be really bad.

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  2. Thanks for posting this (particularly since I don't have access to WSJ). This article presents some fairly clear thinking on this issue.

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  4. Good piece. I wish I shared Cochrane's optimism that 'fiscal stimulus' was being heaved on the ash heap of bad ideas.

    Frankly I'm surprised at how much broad support still exists for discrete fiscal stimulation. I'm also a little surprised at how few people seem to recognize that there is absolutely no consensus on the merits of discrete fiscal stimulation within the economics profession.

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  5. This comment has been removed by the author.

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  6. While I do agree that fiscal stimulus has very little to do with succeeding to keep economic activity alive and that it can be detrimental to acountry's growth in the medium and long run, I cannot see why Greece's default on its debt could help the Eurozone. Under reasonable conditions this article would be a great manifestation of the moral-hazard issues arising in repeated games. But the thing is, contagion is not an abstract issue nowadays, but something having to do with the fact that banks are sitting on a bubble worldwide. I think John Cochrane does not have the chance to sit often with decision makers in central banks (and especially the ECB), to see the fear in their eyes, every time an academic macroeconomists throws the same rhetoric about moral hazard and low debts. After chatting with these people, it is apparent that they know things about commercial banks that we do not know (and it is, perhaps good we do not know such things...).

    We do not have a clear theory of banking. In fact, that we do not know the dangers hidden inside a balance sheet of a commercial bank, especially nowadays. This is exactly where we cannot unfold what is being done...

    I mean, the naivete of many colleagues (especially those who work in central banks using post-keynesian tools) is enormous. But advisors of politicians are not silly after all: there is only one explanation that led to making these decisions so firmly in Europe (and especially with Germany advising strongly against these decisions, although central bankers such as Axel Weber have calmed down very strong opponents of the Greek bailout, such as Hans Werner-Sinn), and this is that there is something wrong with the investments of commercial banks...

    Actually, the Europeans will re-design the Maastricht Treaty very soon. I think that they did save the Euro with the bailout plan, and that this crisis will be a chance for the European South to do some fiscal house-keeping.

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  7. C: Very interesting.

    I am not entirely sure what you mean by "the fact that banks are sitting on a bubble worldwide."

    Is this a fact? Where might one find the data to support it?

    I agree with you that we do not know the dangers hidden inside the balance sheet of banks. Having said that, most of us have no idea what sits on the balance sheets of most companies or governments. (Jurgen von Hagen once told me, way back in 2002, that the balance sheet reporting of European governments would make the Enron fiasco seem like a tiny fib).

    What sort of redesign of the Maastricht are you expecting? Hope they get it right this time!

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  8. The Law protects commercial banks from revealing who they have been lending an also for what purpose. This is where there can be no data to us and the public for something like this. Yet central banking policy makers (and only very few select high-rank policy advisers) get to see some of aggregated/comprehensive data with internal estimations of hazard rates for banks. This is no urban myth: ask, for example, some high-rank officers in the Fed St Louis; they will give you no details for anything, yet you will notice they know more.

    This secrecy is a legitimate (and necessary) part of having fiat money and banks as match-makers. I recommend that researchers who have worked on matching models in labor try to model banks now, paying attention to the micro-foundations of matching (using queuing theory). All you will discover there is tremendous multiplier effects whenever aggregated hazard rates of default reach a limit: so, a tiny little country defaulting on its debt could, indeed, take down a series of banks through the breaking of matches (depositors would as for their money back).

    About toxic assets and sitting on a bubble: we all know that wealth has been mis-allocated to a non-productive housing bubble; we also know that as long as interest rates are low this problem is hidden; yet, we should know that with the world economy (and the housing market) being frozen for more about 20 months now, bad investments remain bad, and nothing has changed on the background. Even worse is the fact that the bubble has insured itself in the bubble; so, imagine the domino effect once you start pulling tho rope... It will take years of moderately higher interest rates (and a lot of luck) to come out of this without a broken nose...

    What Jurgen von Hagen was telling you about is the fact that part of the exploded fiscal debts in the 1980's in EU countries been financed through 25-30-year maturity bonds. These countries (including, for example, France), had to service that debt in the late 1990's, yet, they had to comply with the <3% deficit rule of the Maastricth Treaty in order to secure entrance. So, apart from exploiting a system of accruals rather than payments for constructing their national accounts (this was especially for military spending -- France and Greece had a lot of spending as percentage of their GDP), they also used financial products in order to essentially re-structure part of their debt. They promised to pay extra money to some mutual-funds companies in order to carry some of the debt to the future (using several financial products (there is a company I know that is involved into this, but I cannot find the reference in the press now)).

    But Jurgen von Hagen was aware of the loose standards that Brussels has been using in order to speed up the entrance of many countries in the late 1990's since the economy was still "hot".

    The new version of the Maastricht Treaty will be more german-oriented (this is a reason why Germany has agreed to pay more for the recent bailout: in order to be able to impose more of its own rules). The new Treaty will have a more detailed roadmap for each country and there will be an explicit abandoning of the bailout with explicit rules about the exit of countries from the Eurozone. Yet, many of us insist on rules about keeping a healthier fiscal debt-maturity structure, and high productivity indexes, indexes about the trajectories of the pension systems, competitiveness industrial policies, and other micro-level elements as criteria of good standing in the EU.

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  9. C:

    On the legitimacy of nontransparent bank balance sheets, I recently came across an article by Todd Kaplan: "Why Banks Should Keep Secrets" (Economic Theory, 2006).

    Yes, we know that resources appear to have been misallocated toward the housing sector. You say that a bad investment remains a bad investment, which is certainly true. But what is also true is that most people continue to service their mortgages.

    As for the new treaty, my only question is the one that I raised a long time ago at a CES-ifo seminar: How can any of these rules be made credible?

    By the way, if you wouldn't mind, could you please email me? I would like to pursue the line of enquiry you raise in your second paragraph (and this is not the place to do it).

    Thanks.

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  10. Yes, this paper of Todd (Kaplan) is excellent, in the sense that it uses standard principal-agent theory and textbook contract theory. What it lacks is a microfoundation of multiplier effects on hazard rates, which can be raised only through standard queueing theory (in my opinion).

    I have a non-stop traveling schedule until the beginning of July, but I promise to write to you about queueing theory and banking within July. Given your bckground in matching models you will grasp ideas very quickly. Thanks for your interest.

    On the credibility of the new version of the Maastricht Treaty: it is unthinkable, but some Brussels thinktanks have been asking game theorists for advice... It is a lot of fun (no macroeconomists), as the target is to have it ready for December 2010 (which I doubt)... Apparently they want to figure out efficient punishment mechanisms...

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  11. I always found it bizarre that the Euro-zone has a set of very detailed entry rules but to my knowledge has no rules for exit (or, in this case, kicking out members), like any club or institution should in my opinion. Second, who in their right mind would say that the Euro with Greece in it is stronger than the Euro without Greece in it? As a discipline we desperately need some macro-political economy unified theory to explain recent events - from a pure economics perspective they just make no sense.
    I believe "macro" should get much more "micro" as far as the government is concerned and model the incentives of its main parts seriously. Just putting G and tau in one's model doesn't cut it for me anymore.

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