What's Greek for "Erfüllungspolitik"?

Today came the news that Greece (again) missed its deficit targets, with the red ink growing in September. Slow growth is typically blamed, and surely austerity doesn't help much in stabilizing growth. How do we make sense of the grim determination paraded around by the Greek government, and round after round of austerity? One interpretation says - it just can't be done, the cuts are too much for growth and tax collection plummets with GDP. The other interpretation thinks of the current posturing by the Greeks as theatre: Look, it really cannot be done, so please spare a few billion euros (insert transfer from the EU/debt forgiveness here).

My money is on the latter interpretation. It's pretty clear that only a small part of the overall fiscal mess can be attributed to slow growth. An inability/unwillingness to go after tax dodgers, throw them in jail, and make them pay (to encourage the others) is more than half the story. I think the Greeks are taking a leaf from the book of another country with monumentally high debts, and then failed to repay them: Germany.

After World War I, Germany was saddled with reparations payments of unspecified magnitude. The politicians charged with running the country's first full democracy didn't like it any better than the right-wing nuts who would have liked to say no, with a good chance to start the war. Their solution? Trying to convince the Allies that it really cannot be done. Taxes went up, inflation was soaring, and still, the Germans didn't manage to generate surpluses, and transfer them successfully to the victors of 1918. The attempt was better than half-hearted, but a good deal less than whole-hearted. It had a name -- "Erfüllungspolitik", the politics of fulfillment. For a country that had just been forced to reduce its army to 100,000 men, it's hard to think of an alternative (which didn't stop right-wing extremists from murdering politicians in charge, such as Walter Rathenau, the then foreign secretary). The cost, for sure, was terrible. By 1923, inflation had destroyed middle class wealth on an unimaginable scale, and output was still below 1914 levels.

And yet, in terms of its primary aim Erfüllungspolitik "worked". By 1924, everyone realized that Germany needed help and a respite. The solution - a big loan from the US - ushered in Weimar's only halcyon years. The Greeks seem hell-bent to demonstrate to the world that they cannot pay, as did the Germans; and they are equally good at destroying their economy along the way.

Europe after the End of the Euro

[this is the English original of my article published in Le Monde]:

Europe after the Death of the Euro

For years, countries struggled to defend the rigid link between their currencies. Speculators attacked; country after country implemented austerity programs to make debts sustainable, to win the trust of international investors. At the same time, the economic downturn deepened. Unrest became more common; political systems buckled under the strain of more cut-backs, surging unemployment, and unsustainable debts. And still, the common currency was widely regarded as the best way to assure stability. Without it, no trust in governments, in economic management, no end to economic turmoil, or so the refrain went. And then it all disappeared, almost overnight. Countries abandoned the common currency. And the earlier they did so, the faster their recovery. None of the terrible predictions about the end of the world as we know it actually turned out to be true.

            The time? The early 1930s. The common currency? The gold standard. What sounds like a description of modern-day Europe is actually very similar to the drama played out some 80 years earlier. Cutting the link with gold turned out to be the single best policy measure politicians could take. Britain left early – in 1931 – and only suffered a mild downturn, compared to the US which stuck with gold at the old parity until 1933, or France, which hung on even longer. Where the link with gold was severed, deflation and austerity measures came to an end, debts became more sustainable, growth recovered, unemployment fell. And when people looked back at the interwar gold standard, they soon asked – how could we be so wrong? Sacrifice so much for such a misguided policy?

            Europeans after the end of the Euro will ask the same questions. Why did they waste more than a decade with interest rate policies that were too high for some, too low for others, creating boom and bust as well as unsustainable debt burdens and banks that eventually implode? How did they stomach all these austerity programs and bailout packages, for so little gain? Presented to electorates as a policy without alternative, the Euro is actually a poorly designed currency arrangement that was always more about political symbolism than about sound economics. Today, member countries of the EU have eleven currencies – the euro and ten national ones of members states that have not joined EMU. The European Union will not fall apart if eleven currencies become twelve or fifteen. The Euro can only survive if the German, Austrian, Dutch and Finnish taxpayers are willing to sign a blank cheque; or if economic reforms and austerity packages on a truly frightening scale are implemented. Neither option is politically feasible. It may take a few more rescue packages and a few more years for politicians to finally realize this, but electorates in Europe are already growing restless. Once the true economic and political costs of “rescuing the Euro”, again and again, are fully understood, it will need to be abandoned.    

With the Euro gone, we will see a return to the currency world before 1999. Some countries will follow German monetary policy, either by sharing a currency or by copying everything that Frankfurt does. This is the future for Holland, Finnland, Austria, perhaps the Scandinavian countries. The southern European countries will probably stick with a rest-Euro. Interest rates will be set appropriately; growth recovers; unemployment falls; asset price bubbles become less likely. Some countries may default, and banks in several countries may need to be nationalized, as they were in Scandinavia in the early 1990s. The euro will devalue against the new Deutschmark; exports from Italy, France, and Spain will be more competitive, and German export surpluses will shrink, reducing economic imbalances in the European Union. At the same time, vacations by the Mediterranean, French wine and Italian cars become cheaper for the Dutch, the Danes, and the Germans. This is not a vision of economic apocalypse – it is the way rebalancing should work.

What does this mean for Europe’s political future? Surprisingly little. To be sure, many prominent European politicians will have a lot of egg on their faces. Megalomaniac fantasies about the “United States of Europe” will be laid to rest. The so-called bicycle theory – that Europe has to move ahead or crash – will be forgotten. We will have more pragmatic policy-making, with Brussels starting to look out for the things that actually matter, and trying much harder to make them work. What matters are the single market – free trade, freedom of movement, intellectual exchange, fair play for European companies trying to compete for government contracts elsewhere, or trying to buy another firm.

Instead of the grand visions and grand pronouncements, Brussels will have to focus on the hard, boring, beneficial nitty-gritty. Implementation of existing rules and schemes is important, and Europe currently leaves much to be desired. The single market works only in part; mutual recognition of degrees, for example, is often only a legal fiction. My dubious Oxford PhD cannot be validated in Spain, for “technical reasons”. Don’t ask why it needs to be “validated” at all. Germans are not allowed to buy holiday homes in Denmark; European governments often stop the sales of companies to foreign buyers for no good economic reason; and so on. European integration should be guided by what is good for its citizens and companies.

Sharing the same pieces of paper in the wallets of Europeans turned out to be a bad idea. It has failed at its only conceivable purpose, making the lives of Europeans better than they otherwise would be. Giving up the Euro now will do less damage to the European project than several “lost decades” of unemployment, stagnation, austerity, and riots. The European Union is much more than monetary union, and Europe is so much more than the EU. European citizens know this, but politicians need reminding that this prestige pet project is not the same as Europe’s future.

if this is private sector pain...

I want some. The EU finally got its act together: There will be a selective default to make the private sector pay... but the banks and insurance companies that agreed to the bond swap are not the only private investors out there. There was news that vulture funds were buying Greek bonds for 50 Eurocents on the € in early July, and now, the EU deal is making some people out there a lot better off. Some of the price action today:

Greek Eurobonds, inflation-indexed, 2003 (25) + 28.9%
EO-notes 2009 (19) + 21.1%
EO-notes 2009 (14) + 14.4%

...and so on, across the entire maturity spectrum. The rally started at a very low level, as we all know, and the 2009(14) for example is still trading at 63% of face value, for a yield to maturity of 24.9% p.a. That's down from over 35% a few days ago. Over the last year or so, every additional aid measure has been greeted with a relief rally, only to be followed by an ever-deeper slump. Will this one come to stay? I think it just might. Once markets factor in the lower bond yields, debt sustainability will look a lot better. That justifies lower yields, and so on. The mountain of debt hasn't gone away, but paying for it will have become just that much easier so that, together with the EU generously sprinkling aid on Greece, an outright default might not be on the cards after all...

Surprise of the day... another bad idea

from the EU. This time, the collected EU finance ministers seem to think that by buying back Greek debt at depressed prices, they can really make those irritating, overpaid bankers pay. There may be clever ways of engineering such an outcome, but the basic idea doesn't work. In one of their classic papers, Bulow and Rogoff (QJE 91) show that buying back debt is no way to reduce the burden of too much debt. Open market buybacks, at least, "allow creditors to reap more than 100 percent of any efficiency gains". Why? A country's repayment capacity is its repayment capacity. As you buy back debt, you effectively spread that capacity over ever fewer bonds - there is more blood, sweat, and tears squeezed from the Greek taxpayer for each bondholder remaining. The secondary market price of debt rises as repurchases proceed. Most likely, the market value of all bonds outstanding stays roughly constant as the face value declines. So, what to do? Maybe buy-backs are the answer, but to get it right, get a good advisor to design the process - like Paul Klemperer of Nuffield, Oxford, who advised the UK government on G3-spectrum auctions.

tear gas and "chicken"

Nathaniel Rothschild allegedly said that one should "buy to the thunder of cannons and sell to the sound of trumpets". I guess, the modern-day version would be to trade to the smell of tear gas, which has been wafting across Athens recently. Closer to home, in the beautiful park next to the university that houses the Catalan parliament, ministers and MPs were surrounded by Spain's own indignados movement... which made it just that touch harder to be in the office on time this morning, with riot police blocking many of the streets leading to the campus. It was pretty calm as things go, with no violent clashes, but the image of ministers being ferried in by helicopter reminded me a bit of President De La Rua's last day in office.

Back to the issue of trading: Even popular financial advice sites like marketwatch are now offering suggestions on how to make $$$ from a coming Greek default. I would say, not so fast... we are mainly witnessing a public game of "chicken" between the German finance ministry and the ECB. Some of this is squarely aimed at the wider public -- "look, we are trying to get tough with private creditors". While the EU has an amazing talent to screw up things, I would say -- uncharacteristically, as those who know my pessimistic side might think -- that this one is too important to go wrong, and that a deal will eventually get done, with no more than a bit of a Vienna-style initiative imposed on the creditors. Now, if only the Greek government will actually stay in office for long enough to see through the implementation of the next round of austerity...

What's really going on with Greek debt?

I have been thinking a lot about the Greek debt problem. About a year ago, I looked at the numbers and decided that on economic logic alone, this one will end in a restructuring -- the primary deficit was just too big, and the debt too high. Now that the markets and politicians are debating with ever greater intensity if "reprofiling" or a "soft restructuring" will take place, I am beginning to think that we might actually see this one settled without a default. What's changed? Apart from my contrarian instincts, I think it's important to remember that there are many moving parts here -- the European governments, financial markets, the Greek government, the ECB, and the electorates of Greece and the EU member states stomping up the cash. It's all a bit like a Ruby Goldberg machine, really. The spread on Greek debt has been soaring of late, and the EU needs to decide on some course of action now that the IMF and EU missions are checking that Athens is doing its share. I get the sense that some operators in financial markets are, in a way, lobbying for a default event - anything that allows people to cash in on their CDS.

I think they may be disappointed. I may be wrong, but the rhetoric coming out of Berlin (and recently, Paris) about reprofiling seems more designed to put pressure on Athens than a good predictor of events to come. I am not saying that a restructuring couldn't happen, but given that the ECB is vociferously opposed, and that no EU politician wants to be responsible for the next Lehman disaster (as predicted by the ECB if Greece defaults), I think the current discussion is more designed to get the Greek government going - or, more precisely, to give the Greek government an excuse to tell its electorate that there is nothing that can be done to avoid lots more austerity.

My money is on the following: 1. Tough budget cuts and markedly tougher privatization requirements for Athens, maybe in the form of a semi-autonomous agency a la the German Treuhand that handled sales of the East German assets 2. Fresh loans by the Europeans 3. A "voluntary" roll-over agreement with the banks so that they agree to take fresh Greek bonds as the old ones expire. Some of this will be painful in the short term for Greece and for the banks, but it will save the Greek financial system and keep access to outside funding open. As I have said before, making the tax system less distortionary is good for growth. Also, if the confidence trick works, Greek savers may start putting some money back in their own banks, which will help with recovery... and once hedge funds and private individuals in the markets see that Greek bonds offer 25% and are effectively guaranteed by the EU, yields will come down. That was the hope a year ago, and it didn't work. But that doesn't mean it cannot pan out this time...

Investment bankers discover solution to the Euro debt problems

The solutions spells M-O-N-E-Y. German money. Lots of it.

The American journalist H.L. Mencken once joked that for every difficult problem, there was a solution that was simple, elegant, and wrong. That is what I was reminded of reading the increasingly hysterical comments being issued by various people in the I-banking community. Euro area debt problems? The end is nigh? Let's get a bailout. We have had three years of effective "blackmail" by the markets, where governments have caved in every single time, making bondholders whole at the expense of the public. The German government some weeks ago felt that enough was enough. Now the rise in bond yields is creating a crescendo of voices arguing that a "fiscal union" in the EU will solve this problem. Bloomberg ran a full story composed of nothing but London-based investment bankers sagely advising that this was the only solution. Among the more bizarre suggestions, the idea that some 350 billion of Greek, Portuguese and Irish debt gets transferred to the core countries to bring debt burdens down... I think these people are based in the wrong place.

Anyone with any knowledge of German politics will tell you that a gigantic bailout - much as our underpaid friends in the City would love it - will not happen. The whole Euro experiment was sold to the German public via a million holy oaths that this could not happen; the already weak consensus behind the euro will crumble before we see a fiscal transfer union or massive debt shifts. Some commentators are always advising that the Germans and French are just bailing out their own banks. True, in part. But that used to favor bailouts in the past; it is now becoming much harder as a political sell. Yet more money for bankers? Not the message you want to send as a politician. And don't forget -- Germany's export performance is largely built on selling to the rest of the world. While most of the EU mostly trades with the rest of the EU, Germany does sell in significant amounts to the US, Brazil, China, and the rest of Asia. Compared to that, exports to Portugal, Ireland, and Greece are miniscule. Germany needs Europe much less today than it did 20 years ago. The second mistake that people make when thinking about incentives for a bailout is to say that Germany is benefiting hugely from other EU countries not being able to devalue against a Deutschmark. True, but the point of Germany's export surpluses is to accumulate foreign assets for the day when the population is dominated by pensioners. A stronger Mark will facilitate buying up assets elsewhere, from factories and stocks to holiday homes in the sun. Bottom line - much of the current chatter about Germany having to step up to the plate for sure is, in my view, a bunch of I-bankers whistling in the dark, hoping that their trades will finally turn around...

Too much...

...going on these days. Last week, we had Mike Woodford (Columbia), who talked about how we can make sense of what the Fed (and many other central banks) were doing by tweaking their balance sheets and buying financial sector assets. It's actually surprisingly hard to break the equivalent of the "nothing matters" equivalent of Modigliani-Miller theorem. Mike gets there by a combination of the banking system doing funny things (sometimes worrying too much or too little about credit risk), and massive heterogeneity amongst agents. It all adds up in a Neo-Keynesian model... and amazingly, it was all done without anyone having worked it out beforehand. What was the old Keynes comment about policymakers being beholden by a defunct economist? Here, it worked the other way around, with practitioners going first, and theory following.

This weekend, we had a CREI-CEPR conference on the Political Economy of Economic Development. Held in the beautiful monastery in Manresa, there was an embarrassment of intellectural riches, with Tim Besley speaking on the emergence of state capacity, Jim Robinson presenting joint work with Daron Acemoglu about the monopoly of violence in Venezuela, and a whole host of other interesting papers (from local elite capture in China to war and genetic relatedness).

At the same time, we had news about the biggest bailout in history being finalized. After a mini-bounce this morning, Greek bonds have started to trade lower... it seems that the last few weeks of flip-flopping have unnerved investors a great deal. I wrote some months back that the game was entirely political - that the economics were hopeless, and that only a political decision to make Greece whole could stave off default. It seems that markets came around to that view, and now find it hard to believe that the political solution is at hand. As exercises in "shock and awe" go, this one is as yet not very successful...