Europe’s path of least resistance

What is the road of least resistance scenario, and thereby the most likely scenario, for the Eurozone financial crisis? To solve this conundrum, we need to map the major elements of high resistance around which the road must navigate and the areas of low-resistance towards which the road will flow. These are:

  1. (high resistance) It is actually politically very hard for any country to leave the Euro. If, say, Greece announces it leaves the Euro then one should expect a bank-run overnight with Greece deposit holders cashing in their savings and putting it in foreign Eurozone banks. Moreover, it might easily take a year before Greece could physically re-introduce its own currency, during which time the uncertainties and capital flight accumulate: money-machines have to be changed, accounts have to be converted, export contracts have to be re-written, and a system of converting anything valued originally in Euros into the new currency has to be negotiated. Apart from being a major hassle requiring expertise many countries do not have, it would give all the other countries an immediate excuse to stop paying that country any transfers. Young ambitious Greeks should be expected to shun a defaulting Greece. It is hence quite costly in the short run to step out of the Euro, as well as virtually guaranteeing a severe deepening of the recession overnight. This is equally true for any other country in the Eurozone: leaving the Euro is a bold and courageous step, unlikely to be witnessed any time soon. The road of least resistance therefore does not include any single country leaving the Euro.
  2. (low resistance) The political costs to defaulting within the Euro are, when one reflects on it, surprisingly low. Greece has in effect been defaulting for several years now and has been handsomely rewarded with transfers and debt-write-offs. It was certainly the road of least resistance within Greece to steer straight into default. So too will the governments of Italy and Portugal be calculating that any default on their debts is a viable scenario and preferable to major internal upheavals that could be blamed on the government of the day. For what are other countries actually going to do when governments default on their debts? Not much. There is no mechanism via which they can kick countries outside of the Eurozone or the EU, so barring a whole set of richer countries deciding to set up a new EU and abandoning the rest, the Euro countries are stuck with each other. Countries cant kick each other out, nor can they really force any sanctions within the system. If, say, Italy decides to only pay back the government bond loans to its own banks in order to prevent them from going bankrupt but defaults on any loans held by foreigners, then the other countries have no other course of action than to protest and take the hit. They might retaliate by not honouring any loans to Italian banks but, again, apart from a wholesale break-up of the EU, they actually have surprisingly little means to punish any country. This incidentally is true even under the newly proposed stability pacts: if a country simply refuses to pay any fines then there is not much the other countries can do. Hence, defaulting is a low-cost option for individual countries.
  3. (high resistance) The political costs for the rich countries to start a new EU of their own, the so-called rump-Europe scenario, is surprisingly high. Think firstly of how the richer countries benefit from the current union: because they suffer less from civil-service-demanded wage growth, their countries are more competitive precisely because they are in a currency-union with countries that do suffer more from civil-service driven wage inflation. This guarantees them higher levels of employment and exports, a brain drain of the less well-organised countries towards them, and very low interest rates at which to borrow, all advantages that would disappear if they cut the ties. Also, cutting the union would not in fact mean that their own banks would no longer be linked to the government bonds of other countries so cutting political ties does not actually stop the financial ties. Hence the economic benefits are neither immediate in the short-run, nor obvious in the long-run. Then think of the politics by thinking of the mechanism involved in breaking away: the countries would have to formally abandon the EU, would have to negotiate their relation with the Eurozone with those remaining in the EU (!!), then set up a new treaty for a new zone and introduce a new currency or convert the Euro into a Euro-plus that would hold for their region. Each step has to go through all the parliaments involved, virtually guaranteeing years of wrangling about the shape of a new treaty. Now, this scenario is certainly imaginable, but would take years to go into effect and hence cannot be sold by any politician as the solution to anything. Hence, a break-away by the rich countries would only be assured to lead to short-term economic loss (the countries being set loose would have to default almost immediately, with all the consequences associated to that) without clear long-term gain. It is therefore not a viable scenario. What rich countries can do is to ensure their own banks and economies are less exposed to those of the high-debt countries, but that is a slow process that takes years.
  4. (low resistance) The European Central Bank’s determination not to become a printing press is, probably, brittle. Mario Draghi, the president of the ECB just last week reiterated how countries must help themselves. At the moment hence, the ECB is sticking to the line that it is there for price stability in the Eurozone and is refusing to write blank checks to over-spending governments.  It is quite openly gambling on the current crisis to force governments into tighter spending regulation, with, it might be said, some apparent success. Yet, if the going gets really tough and neither commercial banks nor governments have the cash to pay back their loans to each other and to outsiders, is the ECB really going to refuse to bail out governments and the financial sector by means of printing money? It would seem highly unlikely that the ECB would indeed keep up its refusal for massive capital injections if its back was against the wall because it really is the only institution that can do it. More probably, it would indeed take on the role of the American Fed and simply print money on a massive scale to prevent widespread bankrupcies of governments and banks.

With this contour map in mind, the road of least resistance is starting to come into view. Given the current levels of low growth in Southern Europe and the unlikelihood of growth re-emerging soon because of all the spending cuts, it is clear that there are many countries with governments and banks that cannot pay their debts. This certainly includes Greece that is already in default, but now also quite clearly includes Portugal and probably Italy too: Italy can only pay back its debts if the interest rates are kept low by someone else.

Suppose these countries default, then the levels of loans that other governments have to extend to their commercial banks goes up, pushing countries like France and Eastern European countries closer to defaults too. This further undermines growth and pushes countries like Italy and Portugal into near-certain default. As the default-cascade gathers pace, the richer countries will find they do not actually have the means to stop these defaults and a communal appeal is made to the ECB to simply bail out the lot in exchange for a greater degree of fiscal integration and budgetary discipline in the future.

Hence, the ECB really only has the option of bailing them out heavily later on or at a creeping pace now. Which is what is happening:  the ECB buying up Southern European government bonds keeps the interest rates of these bonds manageable and thus hides the real risk of default. At the same time, the EU is gradually moving towards a system in which future deficits become less likely with stricter budget controls. The grand bargain – money-printing bailout in exchange of future austerity rules – has thus been agreed to and is underway. The ECB is printing enough money to prevent an open and massive default by Southern Europe, but only as long as those countries are playing ball, i.e. by agreeing to strong reforms and future austerity. It is a difficult game that is being played by the ECB but they are playing it well.

How does the bail-out fund, supported by the IMF (with the IMF in turn supported by the ECB, a one-two that helps to circumvent the sensitivities around the ECB mandate) fit into this scenario? One would have to say that the IMF\EFSF is going to be the means via which the ECB prints money rather than a means of organising loans to tie countries over: one can organise new loans as much as one likes, but if countries and banks cannot pay them back then one is in hand-out mode whether one admits this or not. The size of the hand-out needed is such that richer EU countries simply do not have the capacity to bank-roll them, whilst it would be naive in the extreme to expect other countries outside the Eurozone to foot the bill. Hence, one way or another, the bailout will never be paid back. Only central banks have the capacity to keep handing out money that is not paid back so it is there that the eventual funds will have to come from, however it is dressed up.

Summarising, the road of least resistance is for the EU and the Eurozone to remain as it is, for the ECB to slowly hand-out large sums of newly printed money to mainly Southern-European countries and the banks that have lend to them, and to have an emerging set of institutions wherein it becomes slightly harder in the future to have large government deficits. While a Tobin Tax would be a good addition to the European institution’s ability to raise taxes and Italy/Germany/France want it, it is hard to see how one can politically implement it whilst the UK is still in the EU. The city of London would be mad to allow the UK government to exit the EU because the remaining countries would immediately coordinate on somehow taxing the city of London, so the Brits too will stay right where they are: inside the EU simply blocking any move towards communal taxation.

How strong will the new fiscal institutions be that the ECB is enforcing? Well, the golden rule in Europe is that if it would require a round of referenda or new elections then it is not going to happen. So the institutions will by necessity have to be of the wishy-washy variety, not really binding anyone’s hands. Just like the Maastricht criteria were happily ignored by both Germany and France, so too should one expect any new rules to be fairly toothless. The best they might hope for is to have a system in place with large mutual investments (a kind of future fund for Europe) that itself becomes hostage to the behaviour of the governments, i.e. you forfeit your share of the future fund if you go bankrupt. However, such a future fund would need to be funded with surplus government money and that is not going to be floating around in Europe anytime soon. So the real stick-behind-the-door is going to be that a Southern European country goes bankrupt the moment they are out of favour with the ECB. That bankruptcy will not just mean they cannot pay foreign banks back their loans but, much worse, will have to default on the bills to their own citizens because their deficits are that high. As long as the Southern European countries are indebted to the degree that they would have to default on their own population (i.e. a running deficit), these countries can be forced into greater austerity and rules on future budgetary control. The moment these countries think they can default just on the foreign part of the loans is when the ability to force them into any new rules is going to disappear.

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JC
JC
9 years ago

Paul

There’s no money. They are even having a hard time funding the EFSF because the market simply doesn’t believe they would backstop it, so any of the funding solutions they come up with is being waved down by the credit markets.

The IMF money is simply not enough.

There are only two solutions to this mess, or three if we include a breakup, which is unlikely.

Take the hit and default or the ECB prints around E2 trillion over the next 12 to 24 months. However the Germans, being the dicks they always have been and continue to be are basically nixing that.

People seem to have high hopes that the 36 months unlimited repo that comes out tomorrow will help, however that isn’t QE, as the ECB will sterilize the money demanded (at the auction).

Paul Frijters
Paul Frijters
9 years ago

ehmmm, I am not sure I understand what you are saying since, for me, this is more of a game between governments rather than markets (the markets are just second-guessing the governments), but I certainly agree that the ECB bailout is the only way. Indeed, your other options revert back to it: even if they initially let Greece, Portugal and Italy default, that would itself lead to a default in France and other countries when those countries are forced to prop up their own banks. There is no way the ECB can let such a cascade occur, whatever the Germans are saying now. That is why you are seeing the ECB buy up hundreds of billions in government bonds: the prevent the cascade. They are buying up just enough of them so that Italy doesn’t have to default immediately, which is a clearly politically inspired gamble on the concessions they can get in return for a slow bailout.

The only question is thus how and when the ECB is going to print money, not if. Money for Greece is being printed right now, because the ECB and others possess Greek bonds that can never be paid back in full.

KB Keynes
KB Keynes
9 years ago

pardon the pun but I think David Glasner via DB is on the money

JC
JC
9 years ago

ehmmm, I am not sure I understand what you are saying since, for me, this is more of a game between governments rather than markets (the markets are just second-guessing the governments),

Don’t you think the governments are the ones basically reacting to the markets?

Money for Greece is being printed right now, because the ECB and others possess Greek bonds that can never be paid back in full.

They may actually be paid back, as the Europeans governments are doing the dirty on the private bondholders here. What I understood from the Greek debt restructuring a few months ago was the private debt holders were going to get reamed while official holders like the ECB etc weren’t and they kept the face value or the average value of the portfolio. This had the effect of basically making CDO’s purchased to protect the risk essentially worthless. I don’t think there’s been any further developments in this area other than a few weeks ago when the Greeks held another meeting pushing the banks/private debt holders to take even harsher haircuts.

The ECB’s bond purchase program isn’t money printing as far as I understand it because they essentially sterilize all these activities up to now.

Paul Frijters
Paul Frijters
9 years ago

David Glasner is not on the money at all. He is in dumbo-land if he thinks a Southern European country leaving the Euro would be similar to leaving the Gold Standard.

That piece fails to see the long game that these players are forced into via the EU/Eurozone construct. These countries are stuck with each other and hence its a game of chicken. The only weapon the ECB has is the threat of no bailout which it would be folly to give up without as much political concessions on the side of future budgetary discipline as possible. If the ECB goes for massive money printing now, its fair game for over-spending governments. The trick for the ECB is to keep as much of the government debt inside the countries it is trying to bail out, i.e. to only bail out the foreign bits.

JC
JC
9 years ago

Homer:
Merkel “gets it”.

Her compatriots don’t. At the present time they would string her up from the nearest tree if she agreed to QE of joint issuance. This isn’t going to happen.

Every single pundit, trader, investor I’ve heard thinks Merkel will relent. She’s not because she can’t. Germany is a national version of the Tea party movement in this respect.

Paul Frijters
Paul Frijters
9 years ago

JC,

as I explained in a Core Econ piece a couple of weeks ago, the markets are most definitely second-guessing governments. It is merely a political convenience to blame markets for making the bleedingly obvious visible to others.
There has certainly sofar only been a haircut on private borrowers, but that haircut simply is not big enough to get Greece out of trouble, so there is still lots of bonds that wont be paid back.

KB Keynes
KB Keynes
9 years ago

Paul,

you have not read the aerticle correctly.

KB Keynes
KB Keynes
9 years ago

That should read article!

oh and apart from Greece it seems to me what we have is merely a self-fulfilling negative bond bubble.

Patrick
Patrick
9 years ago

I think JC is right, and I think Paul is massively underestimating the German resistance to having the ECB act as a LOLR or a printing press.

I think the Germans have a long game in mind too. After all they returned to competitiveness after WWII and again they restored competitiveness in the 90s in the East (where is Merkel from again?).

From a German perspective it would appear that moral hazard is the worst enemy and that a bit of belt-tightening won’t hurt the lazy pricks in the South. One can see where they are coming from even if economists are horrified by it.

Paul Frijters
Paul Frijters
9 years ago

Patrick,

good, sounds like a clear divergence in predictions. I am saying that one way or another, the ECB will print money in order to prevent a collapse of the Eurozone. You and JC think German rectitude will mean no money printing, even if that means France and half of Europe slide into bankrupcy.

I think you and JC partially confuse the ECB with Germany and underestimate the degree to which Europe’s political elite is wound up with the European project. There is no way the ECB could let France go bankrupt when so many of the European civil servants are French.

Also, an ECB that is truly aloof would not be buying up Southern European government bonds, engaging in EfSF projects, or bring out media releases every other day on the issue. The ECB is watching closely, cranking through the scenarios. Yet, in the long run, given the negative growth rates and the high degree to which the countries are close to the tip of the Laffer curve already, the debt is simply too high and carries too high interest rates to be paid off.

The Great Recession does provide an important lesson relevant to the no-bailout scenario: countries defaulted on their debts to other countries and ….. nothing happened. Those unpaid government bonds still roam around in the vaults of the treasuries in the countries concerned. The US owes money, other countries owe the US money and history has forgotten about them. no one collects.

Paul Montgomery
Paul Montgomery
9 years ago

If JC is right and Germany will block QE, and Paul is right and the only other alternative is mass bankruptcy… which will fail first, the immovable object or the irresistable force?

Tel
Tel
9 years ago

The Germans have a very easy solution: work less, and pay less.

With respect to the currency, paper money is a promise. You cannot do anything with the paper itself, you can only spend it on something. Thus if you hold paper, you hold a promise of being able to spend it at some future stage. One of the things you can spend it on is to pay your tax (i.e. pay protection money to an armed and dangerous potential aggressor).

Printing money is equivalent to issuing more promises, and if that government is in any way concerned about future inflation, then one of the promises is that at some stage tax will go up (which is to say, people will be forced to give some of that printed money back under threat of violence).

All anyone wants is a currency where the issuer keeps their promises, and prices remain reasonably stable. The constitution of Germany insists on this, and so do the German people. Nothing unreasonable about that.

Tel
Tel
9 years ago

It is actually politically very hard for any country to leave the Euro.

I would argue that if widespread inflation starts to show up, it will be politically very easy for Germany to leave the Euro. They hold a bit of a grudge against inflation over in those parts.

JC
JC
9 years ago

I think you and JC partially confuse the ECB with Germany and underestimate the degree to which Europe’s political elite is wound up with the European project. There is no way the ECB could let France go bankrupt when so many of the European civil servants are French.

I just think they’re calling the shots with the ECB, Paul. This was made clear very recently when Draghi made some comforting comments in a speech just before the EU leaders meeting. Subsequently Merkel and Waigel basically reversed anything the market thought Draghi was implying specifically ruling out QE.

it will be politically very easy for Germany to leave the Euro.

I think they would be horrendously worse off. Their financial system would suffer an intolerable hit and their export markets would dive as a result of sudden currency appreciation. They would be in the same boat as Switzerland, which a few months ago was forced to peg to the Euro at 1.20 after it saw the Franc strengthen to 1 with the Euro.

Perversely I think that Italy would be the country leaving the Euro would suit the most. Their budget deficit is around 4%, they have a bigger primary surplus than Germany which next year will be around 3.5% of GDP. I read their pension system is underfunded by a paltry .5% by 2050 and their bond market is 60% domestically owned.

If they left the deprecation of the new currency would likely be around 30% and they would have a lot more flexibility. Their manufacturing base is around 30% of GDP about equal to Germany I think. They could end up killing the Germans and French in the export markets as they compete in the machine business and high luxury goods with both.

JC
JC
9 years ago

I think the ECB could easily play chicken with the Germans ans win.

Bill Posters
Bill Posters
9 years ago

If JC is right and Germany will block QE, and Paul is right and the only other alternative is mass bankruptcy… which will fail first, the immovable object or the irresistable force?

Default happens. We have already seen effective Greek default – just not enough of it. There needs to be more “haircuts” or there will be a proper, out-in-the-open default. As Paul points out, you can default and stay in the Euro – and why not? So that’s what would happen.

JC
JC
9 years ago

Bill

I don’t think Spain and Italy need to default. Unlike the other “PIG’s” (instead of PIIGS) these two may not be insolvent. They may be illiquid sort of normalized sense. The problem though is that there’s not enough money being put on the table to make it appear they’re ring-fenced and so they may move from the illiquid side of the page to insolvent.

Look, we’ll soon find out. There are some pretty decent tranches of debt needing to be rolled over in January for both Spain and Italy and we’ll see what happens. We may find that the banks will use the unlimited 36 month repo that opens to bids tomorrow will be used to purchase sovereign debt, or least some people are suggesting this. If that’s the case and it’s done in size then the crisis could actually be over tomorrow for the most part. Literally. Let’s see.

conrad
conrad
9 years ago

“I don’t think Spain and Italy need to default”

conrad
conrad
9 years ago

“I don’t think Spain and Italy need to default”

Spain certainly doesn’t need to — they even once paid off some of their debt, and their bond rates don’t look horrible either.

Tel
Tel
9 years ago

I think the ECB could easily play chicken with the Germans ans win.

With the Bundestag? Probably yes, for a while. With the German people? Certainly not.

It remains to be seen whether the Bundestag follows the will of the people, or the will of the bankers, but Germany has those rolling regional elections (an excellent idea) and there has been a very consistent swing away from Merkel, mostly toward the Socialists.

Will the Socialists play nice with the bankers of Europe? Hmmm, I guess we will see how that one goes.

Marks
Marks
9 years ago

An additional default (although not often seen as one) is notable amongst all this. That is the reduction in pensions paid to public servants in various countries in the EU.

These pensions represented part of the employment agreement, and reduction of those pensions after the work has been done by the employee in logical terms is no different in concept to a government saying to ten year bond holders – “Gee the rates we offered you six years ago were generous, we will cut them now”.

That is not to say that cutting the pensions was/is not necessary or bad policy – merely that it is a default. It is also an easy default to put in place politically – who ever lost an election on the platform of cutting benefits to public servants?

What is notable are the following:

1). Most pundits have not really seen it as a default – and a big one.
2). It is happening in the Pigs, but also has extended to England.
3). It is classic ‘thin end of the wedge’ stuff, inasmuch as governments can point to one part of the electorate as having taken pain, and so perhaps you bond holders should take some more too, and you contractors who have negotiated profitable contracts should take some default too – after all, if a government can default on a contract of employment term, why not on the payment terms of other types of contract?

The conclusion, it seem to me is that the default process is happening faster than most recognise. So maybe there is a middle ground where there is actually lots more ‘soft default’ (inflation, advantageous loan restructuring, repudiation of some obligations like pensions and extremely hard contract payment decisions to contractors) and QE for the balance.

Paul Frijters
Paul Frijters
9 years ago

Marks,

agreed, the pension freezes, such as the non-indexation of pensions in Italy, is a soft form of default. It is a bit unfair to call it a contract though, because if you think of every tax and welfare payment in place as a cast-iron contract that one should never break, then there is no place for change at all. So implicit in the grand social contract is continuous renegotiation of positions. Pensioners simply are the losers of the search for easy savings, but in many ways that has been inevitable for a while because there are too many of them, the capital returns paying for them have been too low, and they live longer than anticipated under their previous contracts :-)

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
9 years ago

Paul,

Thanks for this. I may be flattering myself, but I think I had in a fuzzy kind of way got the rough outline of what you’ve worked out more carefully myself.

It’s a pity they didn’t fix the roof when the sun was shining. Curbing the profligacy of the periphery countries was no bad thing (though much of it – eg in Spain and Ireland – was private profligacy – at least seen not in through the lens of the animal spirits of the times but in hindsight.) But doing it in these circumstances is awful.

Which raises the question of whether one might set up a currency union in a way that doesn’t have such asymmetric rewards for saving, that is in a way that creates symmetrical rewards for excessive saving and excessive spending. That’s what Keynes was about at Bretton Woods and he couldn’t get his ideas up.

Could one try to build the Euro system around such principles and mechanisms?

Secondly I’ve often wondered whether one mightn’t kludge together some kind of internal devaluation more efficiently than just waiting for prices and wages to fall. I wonder if there’s something like the Accord mechanisms we managed in the 1980s. Of course it still wouldn’t be pretty, and there would be artificial aspects to it, but I wonder if it might set things going in the right direction in those countries that must internally devalue.

So what about this kind of mechanism? There’s a political consensus to bear lots of pain, why can’t you lower the internal cost structure by
* Increasing GST
* Reducing input costs on business – like via payroll taxes and/or company taxes.

That would produce something like a nominal devaluation which might set the ball rolling?

Patrick
Patrick
9 years ago

Paul, note that Marks is solely focused on public servant pensions. He is a strong believer in public servants. Of course there are people out there who think that there are special agency problems with public service pensions…

Nick, that sounds rather like what the Germans are trying to do, but with more focus on wages.

The other part of it is that there are lots of ways to lower costs in the Southern European countries through labour and licencing regulatory reform.

Paul Frijters
Paul Frijters
9 years ago

Hi Nick,

thanks. You were certainly right about Mario Monti: he indeed did not tackle the system. 20 billion in reforms is peanuts given their debt levels.

The problem with price deflation (which is indeed something that would help business in Southern Europe if they could deflate whilst the North does not) is that it at the same time makes the debt bigger.

This is why it would actually be helpful to Southern Europe if the whole Eurozone had a few years of relatively high inflation, preferably higher inflation in the North: that way the debt gets reduced in real terms and the competitiveness of Southern Europe improves. However, none of that can happen politically.

Marks
Marks
9 years ago

Hi Paul,

There is an important distinction between the pensions/taxes that you mentioned and employment contracts including common law contracts of employment. That is that in a contractual situation, the employer agrees to pay the employee a given amount for doing the work. Once the work is done, the amount agreed is due and payable. That includes deferred payment in the form of pensions. Not paying someone with whom you have contracted is a default. You can’t say after someone has done work for you that you are going to reduce the payment agreed to – without being in default.

No such contractual arrangement exists with taxes because they are altered parliament after parliament, and are not in any sense a contract.

Patrick, when in the US and elsewhere, large PRIVATE firms with pension plans have gone bankrupt and the pensions reduced/eliminated, nobody has a problem calling it a default or bankruptcy. So why you think it should be any different for the public sector escapes me. In fact, I did say in my original post that there may well be good policy reasons for the pension reductions. You must have missed that bit. My point was that people who should know better are failing to see that pension reductions are defaults – just as in the private sector, such reductions in agreed defined benefit pensions are defaults, so too are they in the public sector. No special pleading (or interest) involved other than to get a reality check.

Marks
Marks
9 years ago

Sure Paul, but Governments can do exactly the same with bonds and other contractual payments if they like. (I am talking generally here – there may be constitutional impediments in some countries obviously).

The point I am trying to get across is that they are defaults, and therefore the defaults are happening a little quicker than people think – because some people don’t recognise them as such means that critical information is being missed.

You should mug up on common law employment contracts and you will see what I mean.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
9 years ago

Patrick said “Nick, that sounds rather like what the Germans are trying to do, but with more focus on wages.”

Well I wasn’t thinking of this for the Germans – rather the opposite for them. The problem is that the periphery countries need to devalue vis a vis Germany and to a lesser extent other countries.

JC
JC
9 years ago

The point I am trying to get across is that they are defaults, and therefore the defaults are happening a little quicker than people think – because some people don’t recognise them as such means that critical information is being missed.

Not really, a default carries a pretty specific meaning and has to be defined as one. If there is no legal opposition to changes changes in public sector pensions then there is no default. Hell the rating agencies may even upgrade te debt.

The current Greek default wasn’t legally defined as such – it was a “voluntary restructuring” and so didn’t trigger CDS’s.

From what I recall certain pension obligations in certain US states actually do carry default risk.

Patrick
Patrick
9 years ago

Nick, sorry, I meant that Germany was trying to do those things to the south; although that is indeed what they have done themselves some time ago.

Marks, I don’t think you are quite there on this one. You typically can sue a government for defaulting on its debt but you typically can’t sue them for breaking a promise.

And pensions are not a debt, there is nothing ‘due and payable'(!), they are just a promise.

Senexx
9 years ago

You don’t see any merit in Iceland or Argentina showing the way forward for the struggling Eurozone countries?

Paul Frijters
Paul Frijters
9 years ago

senexx,

if it were easy to reintroduce your own currency, like it was easy to ditch the gold standard, then several countries should go for it and would go for it. Its the guaranteed recession you will get the moment you start talking about leaving the Euro that makes it hard to see happening. Which politician would go for it, knowing he will be blamed for all the short-run additional misery?

JC
JC
9 years ago

This deserves to…. get the popcorn out, put the feet up and watch the full series.

ECB Lends Banks EU489B for Three Years, Exceeding Forecast

Quite possibly the largest one tender in History.

http://www.bloomberg.com/news/2011-12-21/ecb-will-lend-banks-more-than-forecast-645-billion-to-keep-credit-flowing.html

Marks
Marks
9 years ago

JC I am struggling to remember, but it was now about twenty years ago, so please take this with a truckload of salt – if I can find a reference I will, but not sure if I can.

IIRC (hah), Jeff Kennett tried to reduce the pension liabilities of the Vic Government when he offloaded some of his public servants. The pension scheme was written such that if the public servants were made redundant, then the superannuation was paid as if they had retired. Big cost. Jeff tried to get round that by saying that they were ‘deemed to have resigned’ and resignation benefits were miniscule in comparison. Now here is the bit I am only half sure of, and that is that this was challenged, as the defined benefits were not merely promises to pay, but part of the contract of employment, and therefore like any other contract due and payable if certain conditions under the contract were met.

Patrick, old age and similar pensions are a promise, quite right. Defined benefit pensions which were part of the conditions of employment are contractual obligations in the same sense as payment for building a bridge. You build the bridge, you get the money – it’s in the contract. You work for thirty years, you get the money – it’s in the contract. In both cases, maybe a government could legislate its way out of the obligation (now speaking generally in the case of Europe and without specific constitutional issues in individual countries). The point is, if a government has to legislate its way out of paying for either of these examples, then it is much more than merely a promise it is backing out of. Promises don’t require legislation to back out of, contracts and bonds do.

Paul Frijters
Paul Frijters
9 years ago

yes, these loans to commerical banks (I am presuming without looking carefully that they are done under very loose collateral arrangements, i.e. certainly forms of short-term money creation) are interesting. They can serve several purposes. For one, they might be just what they are billed to me: money injections to try and stimulate growth. If they have to be paid back in 3 years time though, the effect really depends on the interest rates charged. If that interest rate is low, its a form of money printing. If its market rates its just a loan.

A secondary role of these loans could be a means of printing way more money should a country misbehave. For instance, should Italy default the ECB could announce that it will forego the pay-back of these loans to banks as means to limiting the impact of the defaulting italian state to the same banks, i.e. the loans become a way to be able to have specific money creation depending on the actions of states. Its a means of generating a versatile policy instrument.

Now, I dnot know what the internal ECB deliberations are, but if I were in charge of the bank, I do would be looking for ways of reducing the potential fall-out of a default of the most at risk Southern European countries on banks and other countries, whilst I would not offer much help to the banks inside these countries at risk since I would want to keep risk to default as much bottled up inside the countries at risk in order to maximise the concessions one can get out of them.

JC
JC
9 years ago

Paul,

At the last meeting, either last week or the one before, Draghi was pretty explicit that the unlimited 36 months tender would be offered on very easy collateral terms and the rate, being a tender, would be pretty decent too.

However the problem that I see here is that while it may alleviate some of the liquidity problems and banks may actually begin to use the funds to buy PIIG bonds (which is what I alluded to earlier up the thread) it doesn’t add new money to the system as its not a QE. As far as I understand it the ECB will sterilize the outflow.

Lastly it doesn’t remove the risk of default for an insolvent bank or country such as Greece. As I said this may induce banks to arb the PIIG bonds vs the long term repo, however if a bank is solvent it does nothing to the capital, as that’s where the problem lies.

In any case this is a pretty important event and it may actually open the credit markets and thereby reduce the illiquidity that was constipating the markets. We’ll see. Perhaps this could reduce the crisis in a way where it clarifies the insolvent from the illiquid.

——-

Marks

You could be right. I dunno. It could be a case where the government is unable to walk from certain obligations because there are legal constraints. However, I wouldn’t be relying on a mere promise if there wasn’t, as a hard up government will walk away.

Recall that Argentina raided their pension system (like our super) at the beginning of the decade when they ran into difficulties. So anything is possible with a cash strapped government I guess.

In the last couple of weeks I have been wondering what happens to a prescribed pension I have with a French bank if it goes belly up, which I vested in after 5 years of working for them.

I guess I will lose it before even been able to draw of the first payment. LOl

Paul Frijters
Paul Frijters
9 years ago

dont be fooled by the ECB’s talk of sterilisation. The reality is that the ECB balance sheet has been expanding rapidly, doubling during the crisis to about 2.5 trillion Euro (http://www.euroeconomics.eu.com/money.htm#ECB) and that cash-for-trash (easy collateral) is simply a roundabout form of money-creation. Also, on December 10 the ECB doubled its own capital to meet contingencies. However you turn it therefore, the ECB is printing money. At a fairly steady rate.

To see this at its most basic: suppose a bank borrows 10 billion off the ECB at 1% interest rate, giving the ECB as collateral 10 billion in old PIIG bonds it is holding, and then gets 10 billion dollars more PIIG bonds that yield 6%. What has then effectively changed? The ECB has effectively bought 10 billion worth of new PIIG bonds, leaving the PIIG governments with more money, whilst the banks doing the actual purchasing are getting the difference between the 6% and the 1%. I dont call it sterilised because the ECB is holding the old PIIG bonds as collateral, I call it money printing and direct handouts to banks.

Patrick
Patrick
9 years ago

Promises don’t require legislation to back out of, contracts and bonds do.

Actually… Are you sure that Greece can legislate its way out of bonds? Aren’t most of them subject to UK law? Investors realise that risk and have worked around it by contracting for non-local-state remedies such as international arbitration (most bonds) or foreign-state law (Greece is both).

Whereas governments can break promises in an infinite variety of ways, including legislation. Pensions are legislated in some countries but not others. It just depends on that country’s constitutional structure.

If it helps, think of defined-benefit plan civil servants as equity holders in the country.

Marks
Marks
9 years ago

JC,

Responding to a couple of your earlier points, I can see that if a country is seen to be cutting down on some expenditures (like ps pensions), then if there is sufficient money elsewise, that should increase the likelihood of being able to pay other obligations, and hence your point about credit rating improvement kicks in.

However, if there is not sufficient money elsewhere (your other earlier point), then the fact that a government is prepared to not pay amounts due in one particular type of contract – because it can – then I would suggest that it means that that government is prepared to not pay amounts due in other types of contract – because it can. While you point out that maybe contracts for Greek bonds are written in London, that does not stop the Greek govt from saying ‘nup, not paying’.

In this case, since cutting ps conditions is hardly a vote loser, those cuts are a logical political first step. My betting is that the political next step is demonisation of bankers (not that it hasn’t started, so I am not going for the Nostradamus award) and then cutting or modifying bond conditions. Politically, not too many friends of bankers out there, and the ps people whose conditions have been cut will get a warm inner glow out of it. (Not to mention the history of rulers and bankers in the past – think of the Lombards for example). The third step of cuts if there is still not enough money is cutting payment to contractors such as infrastructure providers, ie not just limiting the number of contracts (which happens all the time), but actually re-pricing the contracts. I think this is a third step since the consequences could hit pretty close and personal to the politicians themselves.

As an aside, one of the reasons I left the ps years ago is that on looking at the unfunded liability of the fund I was in, and making a judgement of the trustworthiness of government if push came to shove, I thought it wiser to jump ship from the ps, take a higher immediate salary and invest in my own retirement in ways that did not rely on trusting too much in one source of income.

JC
JC
9 years ago

Actually… Are you sure that Greece can legislate its way out of bonds? Aren’t most of them subject to UK law?

Dunno, but this is sure going to be interesting, as it could trigger a default event according to the bearshitter at zerohedge.( I despise that site, as it reminds me of what hell looks like)

(I trade for a living. I never thought I’d ever see the day when my trading decisions would be based on what happens to 10 year Italian bonds, but there you go.)

Madrid-based Vega Asset Management, an original member of a steering committee for bondholder negotiators, wrote to fellow investors this month to say that it would consider suing if Greece insisted on writedowns of more than half the net present value of the debt.

“Vega believes that, given the current position of the official sector, a voluntary exchange that implies a NPV loss of 50 per cent or less is not now a likely outcome,” Jesús Sáa Requejo, a senior Vega executive, wrote in the letter on December 7. “Vega needs to start considering all available legal options to refuse and challenge any exchange that implies a NPV loss of more than 50 per cent.”

Vega, which has resigned from the steering committee, declined to comment.

The Greek bond deal is the centrepiece of a €130bn second Greek bail-out negotiated at an October summit in Brussels. Bondholders agreed to take a 50 per cent “haircut” on the face value of their bonds, which officials estimated would knock about €100bn off Greece’s €350bn debt pile.

Vega is thought to have been upset by the negotiating approach of Greece and international lenders, including the EU and International Monetary Fund. According to one participant, at meetings Vega complained about the refusal of the European Central Bank to take any losses on its holdings or for Greek banks – in effect wards of the state – to accept write downs.

——–
Marks

Sure, most of what you say is true, however there’s the ironic point that Greece is not calling a default, or least trying to avoid such an action under the definition carried in loan/bond agreements. They are calling it a “voluntary restructuring”, which has various important implications, such as allowing the ECB to hold onto bonds at face value and not triggering a CDS event. Judging by the comment I lifted from that eternal bear at Zerohedge, that could be a more difficult now.

I

thought it wiser to jump ship from the ps, take a higher immediate salary and invest in my own retirement in ways that did not rely on trusting too much in one source of income.

Good thinking. You obviously got the point about sovereign risk much earlier than anyone else. :-)

JC
JC
9 years ago

To see this at its most basic: suppose a bank borrows 10 billion off the ECB at 1% interest rate, giving the ECB as collateral 10 billion in old PIIG bonds it is holding, and then gets 10 billion dollars more PIIG bonds that yield 6%.

Or to make it even easier the bank goes and buys these bonds and then lobs them as collateral with the ECB.

What has then effectively changed? The ECB has effectively bought 10 billion worth of new PIIG bonds, leaving the PIIG governments with more money, whilst the banks doing the actual purchasing are getting the difference between the 6% and the 1%. I dont call it sterilised because the ECB is holding the old PIIG bonds as collateral, I call it money printing and direct handouts to banks.

That’s true in of itself. This process is clearly money printing or at its most basic, an addition to the money supply, as there’s money leaving the central and paper leaving the banking system.

That’s quite clear.

However my understanding is that the ECB sterilizes this addition through other actions in the repo market. Perhaps I’m wrong, but that has been my understanding.

We have to see what develops out of this 36 month tender, Paul as I’m not totally convinced it will be used by the banks to arb the PIIG bond markets. The reason is that the banks are in a serious de-leveraging track at the moment, so this would be at odds against that objective, as they may not have enough capacity on their balance sheets to make much difference. They may simply use this as a way of reducing their liquidity needs and 1/2 trillion in one freaking tender suggests the level of illiqidity is damned frightening over there. In fact the asset markets were spooked by the sheer size of the sum involved and back up again.

My guess is that very little of this tender will be used to buy PIIG bonds. That may come later at other tenders in subsequent weeks. Something like 520 European banks participated!

The next few weeks will be important.

Patrick
Patrick
9 years ago

JC, it’s called financial repression and I am quite certain that at the very least local country banks are going to buy all available issues (which should be exactly all issued) at new auctions.

Financial repression is how you describe governments forcing banks bidding for new debt at 5-7% when the YTM on similar maturities is vastly greater (in Greek’s case YTM can be 300% I believe). France the difference is far less but still enough.

IIRC (which is unlikely) the ECB tender primarily enables ‘repressed’ banks to avoid insolvency by not having to mark the debt to market since it is ‘worth’ the same as eg German debt at ECB.

It will also create an incentive for hedge fund buyers at 50%+ yields to sell to banks at massive profits since the banks can then make a massive profit from ECB.

In three years minus about three months we can safely predict that there will be another panic unless something dramatic happens since Greece, at least, won’t be able to issue bonds without this program for 10+ years.

Ultimately this is a radical chapter 11 for countries with the ECB, i.e. Germany, as debtor-in-possession lender (through the banks) but without rules.

I am not sure how long Germany can bear this happening though, I expect that the price paid by the bankrupt countries will be very high indeed (in terms of giving up nearly every little quirk of labour/licensing/local investment regulation they ever held dear).

JC
JC
9 years ago

Fair dinkum Partick…I honestly don’t know how anyone wants to buy another government bond ever again. They change the rules to suit the government at any time there is a problem and they play favourites.

The only “risk-free” asset these days are top name equities that have pricing power and raise their divs each year, as a result of good management. Everything else is crap or being turned into crap. Perhaps the real gold standard going forward are world’s top companies that fall within that parameter.

Patrick
Patrick
9 years ago

I’m with you there JC. The only remaining question is what currency do they denominate their debt in?

Paul Frijters
Paul Frijters
9 years ago

JC,

on sterilisation and repo-markets, there is all kinds of tricks being played to pull the wool over our eyes. See for instance here: http://www.zerohedge.com/news/ecb-succeeds-latest-weekly-sterilization-%E2%82%AC207-billion-piigs-bond-purchases

that piece argues that the early december ‘sterilisation’ of the bond buy-up was a sham. At its most basic, the ECB bought bonds off Southern European governments, bringing money into the system. It then wanted to sell bonds of its own to banks generally so that there were less Euros in the banking system after it had printed more of them and given them to Southern European governments. It turned out that there were not enough takers amongst the banks. So, in order to meet its own promise at ‘full sterilisation’, the ECB did a swifty. It lend banks around 250 billion euro (liquidity help) who then in turn lend the ECB 200 billion back to meet the ‘sterilisation promise’. Promise kept and promise broken at the same time.

The bottom line is hence that the money printing press has been on for a while, and that German members of the ECB have resigned partially in frustration with this, eg. see here: http://www.zerohedge.com/news/actually-ecb-has-already-handed-out-%E2%82%AC1-trillion-and-why-germany-equates-ecb-printing-hyperinfla