May 10, 2010, 5:01 pm
Europe’s Debt Crisis: Your Questions Answered
By ECONOMIX EDITORS
Open Market

7:29 p.m. | Updated

On Sunday we invited your questions about the Greek debt crisis and its potential effects on markets and governments in the rest of Europe and beyond. Even as questions were being sent, the European Union moved to provide a huge rescue package intended as a “shock and awe” commitment to prevent the crisis from spreading. Markets reacted favorably, but many questions remain.

To address them, Economix invited three panelists to respond to selected questions. They are Simon Johnson, the former chief economist at the International Monetary Fund, an author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,” and a Daily Economist here at Economix; Carmen M. Reinhart, an economic historian at the University of Maryland whose recent book, “This Time Is Different,” chronicles 800 years’ worth of debt crises and sovereign defaults; and Yves Smith, the financial analyst behind the “Naked Capitalism” blog and “ECONned,” who heads Aurora Advisors, a management consulting firm specializing in corporate finance advisory and financial services.

Initial answers follow, with more responses to be added later today and Tuesday.
Q.

How does a country the size of Greece possess the ability to send shock waves throughout the world? — Paul, Seoul
A.

Carmen M. Reinhart: Thailand has an even smaller gross domestic product (G.D.P.) than Greece. But in 1997, Thai financial problems were the epicenter of an Asian crisis in which currencies and equity prices plummeted in that region. Indonesia ended up defaulting, while Korea and Thailand avoided the same fate only through adjustments and international support. Asian economies posted output losses of 10 to 20 percent.

Companies and markets are interconnected, facilitating cross-border contagion.

First, many governments have common lenders, including big international banks and hedge funds. A large loss in one national market lowers the total amount of capital they can commit. Often they pull back across a broad front.

Second, concerns about debt sustainability in one country acts as a wake-up call to investors, who scour their holdings for risks posed by other economies in similar circumstances. When they look hard enough, they usually find cause for concern, triggering a withdrawal of funds. Citizens of Greece and Japan may speak different languages, but a worried portfolio manager hears only that both countries have ongoing budget deficits and a large outstanding stock of debt. Indeed, those inclined to be nervous about government finances do not have to look beyond the borders of Europe. Ireland, Portugal and Spain are running large budget deficits in proportion to their respective G.D.P.’s.

Third, Greece casts a long shadow on the European continent because 15 other countries share a common currency with it, the euro. Greece’s debt problems have raised a question that European officials thought had been buried with the introduction of the single currency in 1999: Will the euro survive? For an international investor, this means that the price of any European asset should incorporate some compensation for currency risk.

Simon Johnson: The impact of the Greek crisis has to do largely with expectations about what will happen in the rest of the euro zone. If you look at the map of who owes money to whom within the euro zone, you will see that Greece is fairly small in the overall picture — and mostly it owes money to German and French banks, which are backed by their governments (in one form or another).

But Portugal owes a great deal to Spain — and Spain, in turn, owes a great deal to France and Germany. And if you really want to scare yourself (or a European policy maker), look at how much Italy owes to its neighbors — or just add up all these numbers and think about dealing with it all at once.

Financial market confidence in Portugal, Spain, and the other weaker euro zone countries remains fragile. A primary goal of the financial support package put in place this weekend was to slow things down — allowing Portugal, in particular, a chance to differentiate itself from Greece. The potential for uncontrolled contagion needs to be taken off the table.

Yves Smith: If Greece had been truly an isolated actor, it would be unlikely to have had this sort of impact. However, two factors were at work. First, Greek government debt is held, to a significant degree, by French, German and other European banks. A Standard & Poor’s report, issued before the weekend’s measures were announced, suggested that not only might there be a loss or restructuring, which was increasingly expected, but the losses would be larger than most investors anticipated (30 to 50 percent). Since European banks are widely believed to have written off less of their toxic debt from the credit crisis than American banks, they are seen as vulnerable to shocks. Ironically, any lending under new facilities would be senior to the existing debt, which means if they merely delay rather than prevent default, the losses to the current bondholders would actually be greater.

Second is the question of contagion. Recall that Thailand, an even smaller economy, set off a crisis that took down virtually all emerging markets when it devalued the baht in 1997 because it changed investor sentiments. The other so-called PIIGS (Portugal, Italy, Ireland and Spain) face or, in Ireland’s case, are in the midst of European Union-mandated fiscal deficit cuts. All these countries have private debt hangovers, too. Unless a country can engineer a very large increase in exports, which usually happens by depreciating its currency, trying to reduce public- and private-sector debt at the same time results in a big economic contraction. That’s happening now in Ireland, where nominal G.D.P. has fallen over 18 percent. A fall of that magnitude makes it even harder to pay off existing debt.

That situation meant two things. One was that the economic pressures on these European Union members, as their downturns deepened, would lead them to exit the euro (so they could devalue their economies to spur a recovery). The second was that the shock waves, both to the European banks, and via a euro zone recession, would have an impact on other economies.
Q.

What will it take to contain the debt crisis in Greece (and in the other southern European nations in question) to a sufficient degree to restore confidence in the financial markets? — kenger, Tennessee
A.

Yves Smith: The measures taken thus far are not a remedy and will merely postpone the inevitable. Absent deep structural changes, the euro zone authorities can only placate the market on a short-term basis. Too many diverse economies are bound together, with no fiscal budget mechanism to provide a buffer. To contain the problem, we would need to see an enormous devaluation against the dollar and/or much greater demand from Germany. The fact that all of the euro zone is engaging in budget austerity means that all countries are reducing demand, which in the end is likely to lead to a down spiral, and actually increase deficits as incomes fall.

It’s in theory possible for the euro zone to achieve the needed political integration and become a sort of United States of Europe that its creators envisaged, but unrest in Germany and Greece suggests that this is unlikely. So concerns of the sort we saw over the last two weeks are likely to keep dogging the weaker euro zone economies and the European Union as a whole unless the euro zone members show commitment and progress toward strengthening fiscal arrangements. Incremental responses under extreme market pressure will not do the trick.

Carmen M. Reinhart: The best defense against contagion is not to be vulnerable in the first place. Specifically, not having: a high level of public or private debt, a large current account deficit (borrowing from the rest of the world); and domestic financial institutions that are exposed to toxic assets (in this case Greek government debt). Unfortunately, few European countries meet all three criteria (see also answer to question 1, above).

The large E.U./I.M.F. package put together over the weekend is intended to send a strong signal that the European Union is committed to go to great lengths to avoid a breakdown of the euro experiment. It is intended to provide broad-based coverage beyond Greece, as in the spirit of the TARP legislation in the fall of 2009. As with the United States bailout package, an important feature of the plan of action is to have the European Central Bank continue to treat Greek bonds as if the rating agency downgrades had never taken place. This is the kind of “forbearance” shown to toxic assets when the United States decided to require bank to mark-to-market their asset portfolio. This initiative can buy time for policy makers in other countries that have come under duress (notably Portugal, Spain and Ireland) to implement difficult austerity measures and (hopefully) move toward a broader and deeper restructuring of private debts-notably those of financial institutions. It does not change Greece’s (nor anyone else’s) levels of outstanding debts and their even more worrisome profile in the period ahead.
Q.

Is a restructuring of Greek sovereign debt inevitable? What would restructuring entail? Does the current E.U. plan envision restructuring? Is the current plan more concerned re the health of certain European banks than Greece? — kathaa, West Bloomfield, Mich.

Yves Smith: Yes, it is inevitable. The Greek austerity program is the most daunting in modern times. Argentina defaulted under a much less demanding program. The Greek population also appears to understand intuitively the record of Latin American austerity programs, that they are a transfer from the public to the banks, and they do not appear willing to make the depth of sacrifice demanded of them. Many experts believe the euro zone is wasting valuable firepower and credibility on Greece, when it would have done better to restructure Greece now and use any backstop funds for the other euro zone members under stress.

Simon Johnson: Greece has serious fiscal problems, and it will be hard for it to avoid restructuring its debt. Think about it this way. Under the I.M.F. program completed over the weekend, Greece needs to grow out of its debt problem soon. Greece’s debt/G.D.P. ratio will be a debilitating 145 percent of G.D.P. at the end of 2011. If we put more realistic growth figures into the I.M.F. forecast for Greece’s economy, e.g., with G.D.P. declining 12 percent between now and the end of next year, then the debt/G.D.P. ratio may reach 155 percent. At these levels, with a 5 percent real interest rate and no growth, the country needs a primary surplus (i.e., budget surplus without interest payments) at 8 percent of G.D.P. to keep the debt/G.D.P. ratio stable. This is a huge and painful fiscal adjustment.

The politics of such implied budget surpluses remain brutal. Since most Greek debt is held abroad, roughly 80 percent of the budget savings the Greek government makes goes directly to German, French and other foreign debt holders (mostly banks). If growth turns out poorly, will the Greeks be prepared for ever tougher austerity to pay the Germans? Even if everything goes well, Greek citizens seem unlikely to welcome this version of their “new normal.”

The European Union officially does not want Greece to restructure its debt — the fear is that this would also cause problems for Portugal, Spain and other countries. But if the situation more broadly stabilizes, particularly if Portugal shows progress toward containing its own fiscal dangers, then Greece will most likely move toward restructuring. If this is handled in a cooperative manner, with the help of other European Union countries and the I.M.F., it need not be disruptive to global financial markets.

Carmen M. Reinhart: It may not be inevitable, but it certainly seems probable. The need for fiscal austerity in Greece is not an artificial imposition by the I.M.F. and big governments of the European Union. It is an arithmetic reality once investors have woken up to the dubious prospects for repayment by a government living well beyond its means. This lesson might be news to governments in advanced economies since World War II, but it has been a fact of life for emerging market countries.

But fiscal austerity does not often have an immediate payoff. Such restraint, especially when significant in size and sudden in its enactment, almost surely contracts economic activity. This trims tax collection and increases unemployment and welfare benefits, working to scale back any progress in reducing the deficit. Even if new borrowing is reduced or eliminated, it takes time to whittle down a large outstanding stock of debt relative to income. Investors do not always have the patience to look past the immediate to that brighter future.

The problem for Greece is compounded by the common currency. From Greece’s perspective, its goods and services are uncompetitive on world markets. But many of its most important trading partners share the euro, so there is no scope for a change in an exchange rate’s value to improve competitiveness with them. Moreover, the value of the euro, which matters for the rest of Greece’s trading partners, is set on continental considerations, not for one country alone. Thus, the only way Greece can improve its competitiveness is through a compression in domestic prices and costs.

Cutting government wages can restore competitiveness only gradually. Similarly, improvements in productivity take time. Most importantly, deflation (or a general decline in prices might help competitiveness, but it also lowers nominal G.D.P., making the burden of debt higher and less sustainable. If the goal is to reduce the ratio of debt to G.D.P., it will take price increases, not declines, and higher economic growth, not lower.

Of course, the ratio of debt to income could be trimmed by cutting the amount of debt, but that is an option that officials dare not mention. After all, restructuring of outstanding obligations is nothing less than a partial default.

It is also no panacea. Argentina’s economy contracted 20 percent in 2001 after its default, as it was shut out of international markets for a time. But when debt dynamics turn as adverse as they currently appear in Greece, authorities do not have any good options. History suggests that as other alternatives are exhausted, governments come to recognize that restructuring may be the lesser of the remaining multiple evils.

Fiscal adjustment is not impossible. The list of countries that opted for austerity in the face of market pressures and succeeded includes Mexico in 1995, Korea in 1998, Turkey in 2001, and Brazil in 2002. They paid a price in terms of lost output, but by communicating a credible commitment to a sustainable budget path, market access was restored relatively quickly and growth rebounded. But those countries all started with debt loads significantly below Greece’s and relied on significant exchange rate depreciation to gain an edge on international competitiveness.

The current E.U. plan does not envision restructuring; restructuring remains a taboo subject in official circles. Restructuring can be extremely disorderly, or it can be made less so (an under-the-rug restructuring) — if, for instance, French, German and other banks holding Greek debts are offered support from their governments if the interest rates on Greek debts are trimmed and maturities lengthened. Officials, of course, deny such a scenario to be possible — which, of course, means nothing.

The current plan is about saving the E.U., not about saving Greece per se. This includes reducing speculation about the demise of the euro as well as concerns about what a Greek default could do to financial institutions in France and elsewhere. This is understandable. The sharp easing in monetary policy in the summer of 1982 in the United States, for example, was not about helping Mexico and other emerging markets cope with default but about softening the blow for American banks that had high exposure to the newly (or nearly) defaulted sovereign loans.
Q.

What is the future of the euro? It seems plain that the current structure, with a common currency, common regulatory regime, but separate sovereign governments, cannot continue as it currently exists. … Should the nations of Europe go their separate ways? — stevieray, New Jersey
A.

Simon Johnson: The euro zone does not look viable in its current form. The basic premise was to unify monetary policy (i.e., one currency, under the European Central Bank) while keeping fiscal policy completely separate — and constrained only by broad and vague promises. This arrangement has completely broken down.

Either the Europeans now go their own ways or — more likely — a core group moves toward greater integration, including integration of fiscal policy. But it seems unlikely that this new core will include Greece, and the thinking in financial markets is that Portugal and some others (Spain? Ireland?) will also be excluded. The “out” countries would presumably leave the euro or, if they refuse, the “in” countries could leave to set up their own bloc.

Either way, it will be messy — but more about the need for convergence in economic policy than any issues of more general culture. The need for a more integrated or complete political union remains more open; this seems less likely, even for countries that essentially share the same fiscal policy going forward.
Q.

How is the state of California any different than Greece? — CraigA, Los Angeles
A.

Simon Johnson: Greece has been able to issue a great deal of debt — and run a big budget deficit — because European banks did not think it was dangerous to lend to a euro zone member country. This expectation has now been validated in large part by the bailout measures put in place over the weekend.

In contrast, the federal government does not stand behind California — at least, that is what most people think. This puts more of a limit on what California can borrow. California can still have a fiscal crisis, but this will have different consequences from what is happening in Greece — and (hopefully) will not, even in a very negative scenario, contribute to financial contagion.