Painting the World Red...

On old maps, the British Empire was always shown red... well, I thought I would color the world according to where our applicants for next year (so far) come from. As you can see, there are still some white spots, but we already have students from 33 countries who have sent in their applications...

All Greek to me...

So there is a solution to what some people have called a "Greek Tragedy" after all. In true Euro-fashion, it's a bit of a fudge -- IMF involvement in the way the Germans wanted, but some Euro-bailout, too, with a role for the ECB and EU Commission. Loans are to be at market rates, or so one reads. I wonder what to make of all this. The origins of the Greek problem are clearly not a sudden speculative attack or disequlibrium in bond markets. If you lie, steal, and cheat long enough, you get caught. Try to lie about your FICA score (for Americans) or Schufa history (for Germans) for about 10 years, and NOT see a change in your interest rates after lenders catch up with what you have been doing. So a big package via the IMF that says "boooh" to some nasty speculators is not going to do the same trick that worked so well when Brazil was in trouble in the early 2000s.

Fiscal austerity will now be reinforced by the IMF. In an earlier post, I raised some questions if that is going to work -- it's a bit like root-canal work without anaesthesia. Everybody else is trying to spend more, in a bid to ward off depression. If budget cuts are too big, you get more recession. Today brought the news that Ireland's GDP fell even more in Q4 than in Q3, which puts it on a very different trajectory from everybody else. This tells you that very severe budget cuts can backfire, as Chancellor Brüning of the late Weimar Republic could also tell you. Given the size of the adjustment needed in Greece, I doubt that public finances can be cut back to health.

So, just before we all despair, four German economists writing in the FT come up with a real solution (indirectly). They remind us that the German constitutional court put a lot of emphasis on the no-bailout clause in the Stability Pact; its last ruling said that, if violated, Germany would have to leave the Euro. Should aid to Greece really go ahead, I expect someone to sue the German government. Sure, German lawyers and judges sometimes find ways of bending the law if it suits those in power (just try watching Roland Freisler in action, or reading "Der Führer schützt das Recht", a treatise by the brilliant Carl Schmitt on why Hitler's massacre of the Nazi Party's left wing was perfectly legal). Today's bunch will of course do nothing so outrageous (and I am not trying to say that declaring "too bad" and ignoring earlier EMU rulings would be comparable to Schmitts and Freisler's transgressions. I am just trying to point out that creative lawyers and judges can justify anything -- they did award Freisler's widow a bigger pension after she sued, because he would have had a brilliant career in West Germany had he not been killed by a bomb in 1945). So there is a non-zero chance, given its earlier rulings, that the Constitutional Court would actually oblige the government to either stop support to Greece, or get out of the Euro. If you take a deep breath for a minute, and dispassionately think about the consequences, this may be actually good solution for everyone (except, perhaps, the ECB bankers who would presumably have to move away from Frankfurt). The new Deutschmark would probably revalue by a lot. The soft-currency countries who now dominate EMU would get their beloved pesetas, francs, and escudos back, but with a common design on the pieces of paper. Policy could be as loose as Spain, Portugal, Greece, Italy, France, and Cyprus like; Germany could engage in its preferred policy of reducing unit labor costs, and running big current account surpluses. Every time they get too big, the Euro would devalue against the DM, the way the lira et al. used to. Everyone is happier. Probably, countries like Holland and Austria would shadow the new DM, as they did before EMU. Now, to be realistic ... if history teaches you something, it's that countries will stick to a silly monetary standard for way too long, especially if it's seen as the ultimately proof of adulthood in terms of currency. Just think of how long it took countries to abandon the gold standard in the 1930s... and as a beautiful paper by Sachs and Eichengreen showed many moons ago, you can explain most of the variation of when countries exited the Great Depression by when they abandoned gold.

Is Merkel Putting Her Money Where Her Mouth is?

I just gave an interview about the Greek debt situation to Swiss Radio. No idea when they will broadcast it, but one of the things I suggested is that, if Mrs Merkel (and Mr Sarkozy, et al) really think that Greek debt is suffering from a "speculative attack", they should use their own money to buy Greek bonds. This would serve as a public vote of confidence, and she should make money hand-over-fist if her reasoning is right. Greece's 2040 bond is still trading at only 77 cents on the dollar in Berlin, Frankfurt, Munich, Stuttgart. If one really believes that the decline from 100 in mid-2007 is simply "speculation", then a buy-and-hold investor should salivate at the 6.3% return promised. If Merkel and friends are right, that'll be risk-free, if you hold the bond till 2040. On top, you get the upside of the bond rising back to where it should be (if you believe it is worth more than 77) sometime before 2040. Why do I like this impractical idea? First, it shows that Greek's travails have nothing to do with speculation. Problems with incentives in financial markets are plentiful, but this particular episode has nothing to do with a bear attack. Second, once Mrs Merkel and friends own tons of Greek debt, they cannot possibly use taxpayer funds for a bailout...

Greece and 1+1 of debt dynamics

When is Greece going to go bust? It may sound a little harsh, but without help from the outside, I see very little hope for the indebted Euro member by the Aegan to avoid such an outcome. As we teach our students in the ITFD class on financial crises, one of the easiest ways to think about debt sustainability is to ask – what would it take to stabilize the debt/GDP ratio? If you start with debt of value x relative to GDP, then debt tomorrow will grow by the interest you pay. If there is growth, more debt in nominal terms can be supported more easily, and if you generate a surplus and repay some debt, it’s all honkey-dory. Pick a growth rate you believe is plausible, and an interest rate at which the government can borrow. The number you get is what the primary surplus should be to stabilize the debt/GDP ratio. Primary surplus doesn’t mean a fiscal surplus – it just means that your revenue is greater than your expenditure excluding debt servicing costs. If you play with the basic numbers a bit, you get something like this for the case of Greece.

Here, g is the growth rate, and i is the interest rate. If growth from now on is 2%, and the Greek government can borrow at 3%, then the government only needs a primary surplus of 1.1%. This is not too hard to achieve. If, on the other hand, interest rates go to 9%, then you need a surplus of 7.8% p.a. If growth dwindles, it gets ever harder to stabilize debt/GDP ratios. At 0% growth and 9%, we are talking 10.2% of a primary surplus. So just how bad is the situation in Greece? Needless to say, the government is currently not running a primary surplus – it’s in deficit, to the tune of 7.7% (thanks to DB Research for the figure). In the table, I have highlighted in bold the combination of figures that I think are plausible in the intermediate future. I am being optimistic here – even 0% growth is a good outcome given how uncompetitive the county is, and how bad the drag from fiscal consolidation will be. We are talking here of a swing of around 15% of GDP.

Overall, I fear this is a no-hoper unless the EU rides to the rescue on a white stallion. Fiscal consolidation on the scale required of Greece is beyond even the most cohesive states. I cannot think of countries other than after a major war producing such a shift in their public finances. Germanyin the early 1930s under Brüning tried to engineer a swing in the public accounts that was of a similar magnitude (it reduced nominal spending by about 1/3 from 1928-32). The budget cuts were so severe that Brüning became known as the ‘Hunger Chancellor’. Many believe that the program of fiscal consolidation enacted by his government undid the Weimar Republic.

Let’s get back to the little table. I think that a range of 5-9% for the interest rate is pretty optimistic, too – as creditors start to worry that Greece may not repay, they will demand ever higher interest rates. This creates a self-fulfilling dynamic, of the type that some politicians have branded “speculative attack”. It is, of course, nothing of the sort – nobody is manipulating markets here, rising interest rates just mean that, as a borrower looks ever worse, creditors are not keen to refinance them. Kehoe and Cole have a very nice paper, inspired by the Mexican crisis, on self-fulfilling sovereign debt crises, and Wei Xiong of Princeton has some new work on rollover risk (as applied to private firms).

So what should be done? Many equate default with a cataclysmic meltdown. This is not entirely without reason. As Rogoff, Reinhart, and Sevastano show in their paper on serial defaults, these can seriously damage your “fiscal health” – the state institutions you need to build a modern tax state. On the other hand, there is pretty convincing literature arguing that, since governments rarely sell contingent debt, defaults are a way to achieve market completeness. Investors de facto anticipate that things can go wrong, and the higher interest they receive beforehand compensates them for the risk. Defaults are when countries collect on the ‘insurance’ they bought before. Theories in the ‘excusable default’ vein (Grossman-Van Huyck, say) require that defaults happen in verifiably bad states of the world, and are driven by exogenous events. Half of that at least applies to Greece – things really are bad. One can argue if accounting fraud and an unwillingness to create a functioning tax bureaucracy qualify as exogenous. Be that as it may, it remains unclear why the burden of adjustment should exclusively fall on the Greek taxpayers, instead of bond holders.