Thursday, 23 July 2015

When reason departs

In my last post, I pointed out that Greece's current depression is by no means the worst since World War II, as is often stated, and that the US's Great Depression was not the worst depression in history either. For reference, I'm putting up Tony Tassell's chart again.



I'm frankly appalled by the comments on that post. The arguments used to justify the prevailing views amount to the following.

1. The other countries in the list aren't rich Western countries, so they don't count.

Eh???

2. Depression in a time of war isn't really depression.

I doubt if the people of Syria would agree with this.

However, in support of this point (and taking into account point 1), Christos Savva kindly provides this chart:


What this chart shows us is that the two World Wars were bad for the GDP of Western countries, and REALLY bad for the GDP of the countries on the losing side. So if you want to avoid a really bad depression, make sure you always win wars. Unless you are America

So, if we remove non-Western countries (point 1) and countries involved in wars (point 2), we are left with - what? Oh look, Greece and the US. Or, in Chart 1, just Greece (since the depressions in the Baltics and Bulgaria happened before they joined the rich Western European club). How remarkable.

But what is all this about "war doesn't count"? Seriously, Point 3 was actually made in a comment on my last post (though I am paraphrasing, of course):

3. Depressions caused by political decisions are worse than depressions caused by wars. 

Presumably this means "morally worse", not actually worse. GDP falls are clearly far greater when war is involved.

I find this morally inexcusable. War is a political decision. How is a political decision that results in depression worse than a political decision that results in war?

Wars cause depression through killing people and destroying property. "Political decisions" that cause depression also kill people and destroy property, just more slowly and with lots of excuses about "this will be good for you in the long run". And all too often, depression leads to war, just as war causes depression.

So we should rewrite point 3 thus:

 3. Depressions caused by some political decisions are worse than depressions caused by other political decisions. Even when they aren't.

But this is utterly illogical. Reason seems to have departed. 

"Ah well," say some commenters, "the US's Depression was the longest and deepest PEACETIME depression". (Though Greece may overtake it soon.)

But what does "peace" mean, when banks are used as weapons? What is the difference between imposing sanctions on Russia, which restrict financial and trade flows, and forcing closure of Greek banks and imposition of capital controls, which restrict financial and trade flows? Both are a form of siege. Using military force to cut supply lines or seize resources is an outright act of war - though we often turn a blind eye even to this, as we did in Czechoslovakia in 1968 and Weimar in 1923. Sanctions are economic warfare, though we like to pretend we are not actually at war with the countries concerned. But restricting liquidity to Greece's banks is a peacetime activity, apparently. I'm sorry, but I see little difference. The effects are the same.

If Greece's depression is in "peacetime", would someone please define "peace"?


Wednesday, 22 July 2015

Not such a Great Depression

We're used to hearing that the current Greek depression is the longest and deepest since World War II, aren't we? And that the worst depression in history was the US's Great Depression?

Via the FT's Tony Tassell comes this chart:


Looks like the fall of the Iron Curtain, the collapse of the Soviet Union and the first Gulf War did far more damage. Not to mention the numerous wars and crises in Africa. The current Greek depression just about makes it on to the bottom of this chart, and the other recent EU disasters don't even figure. 

I can't imagine what it is like to live through a GDP collapse of nearly 80%. But there are people alive today in Georgia and Iraq who remember that dreadful time all too well. And the appalling collapse suffered by Latvia in 1990-3 made their 2009 recession seem mild by comparison, even though it was the deepest of any country in the EU at that time. 

Nor are these all depressions of the past. Halfway up this chart is Syria, which has suffered a GDP collapse of 50% in the last five years - and we aren't talking about that, though we notice the refugees streaming into Turkey, Egypt and (of all places) Greece, and we don't know what to do about them. 

Now look at this chart:


Yes, that's right. Greece's depression is of a similar depth to the US in the 1930s, and on present trend will last longer. Recent developments may mean it deepens further, too. It may even catch up with Syria.

The next time someone claims the "mother of all depressions" was the US in the 1930s, will someone please show them Tony Tassell's chart?

  


Monday, 20 July 2015

The Great Greek Bank Drama, Act II: The Heist

The banks are re-opening, though just for transactions, so people can pay their bills and their taxes, pay in cheques, that kind of thing. The cash withdrawal limit has been changed to a weekly limit of 420 EUR per card per person, enabling households to manage their cash flow better. But the capital controls remain: money cannot leave the country without the agreement of the Finance Ministry. And the banks remain short of cash: although the ECB has raised the funding limit by 900m EUR, that only amounts to about 80 EUR per Greek so won't go very far. But the tourist season is in full swing, and tourists have been advised to bring cash into the country rather than using ATMs in Greece. On balance, therefore, Greece's monetary conditions should be easing.

But there is another tranche of bailout conditions to be agreed by the Greek Parliament by Wednesday 22nd July:
  • the adoption of the Code of Civil Procedure, which is a major overhaul of procedures and arrangements for the civil justice system and can significantly accelerate the judicial process and reduce costs; 
  • the transposition of the BRRD with support from the European Commission.
The first of these is relatively uncontroversial, though a tall order to implement at the speed that the creditors demand. But the second has serious implications for Greek banks and their customers, especially in the light of this part of the bailout agreement:
Given the acute challenges of the Greek financial sector, the total envelope of a possible new ESM programme would have to include the establishment of a buffer of EUR 10 to 25bn for the banking sector in order to address potential bank recapitalisation needs and resolution costs, of which EUR 10bn would be made available immediately in a segregated account at the ESM. 
The Euro Summit is aware that a rapid decision on a new programme is a condition to allow banks to reopen, thus avoiding an increase in the total financing envelope. The ECB/SSM will conduct a comprehensive assessment after the summer. The overall buffer will cater for possible capital shortfalls following the comprehensive assessment after the legal framework is applied.
Back in the autumn of 2014, the ECB & EBA conducted stress tests on European banks, including all four of Greece's large banks (which together make up about 90% of its banking sector). The Greek banks at that time passed the stress tests and were deemed solvent. They are now supervised not by Greek regulatory bodies, but directly by the ECB under the Single Supervisory Mechanism (SSM).

Yet now, eight months later, sufficient damage has apparently been done to Greece's banks to render them collectively insolvent. What on earth has gone wrong?

Greece's banks have suffered a continual deposit drain since the beginning of the year. This is how they became dependent on emergency liquidity assistance (ELA) funding from the Bank of Greece. But liquidity shortfalls do not cause insolvency unless they are covered by means of asset fire sales. In this case, the liquidity drain was until 28th June covered by ELA. Collateral has to be pledged for ELA funding, and Greek banks consequently found their balance sheets becoming more and more encumbered. To make matters worse, the ECB recently increased collateral haircuts for Greek banks. Now the banks are reopening, it is not clear how much collateral they have left for ELA funding. Whether the ECB will relax collateral requirements to allow a wider range of assets to be pledged remains to be seen. It is probably conditional on good behaviour by the Greek sovereign.

But it is not the funding side of Greek banks that is the real problem. It is the asset base.

Greece went into recession in Q4 2014 (yes, BEFORE Syriza came to power). Since then, there has been a considerable fall in output caused mainly by lack of confidence. On top of this, the Greek sovereign has been running substantial primary surpluses all year in order to maintain payments to  creditors in the absence of bailout funding. It has done this not by collecting more taxes but by a considerable squeeze on public spending: this has mainly taken the form of delaying payments to the private sector. Additionally, the private sector itself has cut back spending and investment. The result is that real incomes have tumbled, unemployment has risen and loan defaults have increased. Non-performing loans in the Greek banking sector were already high at the beginning of the year but are now believed to have risen substantially. This is the principal cause of the possible insolvency of Greek banks.

So the bailout plan includes recapitalisation of the banks using a loan from the European Stability Mechanism. This loan would be repaid from sales of sequestered assets in the privatisation fund that also forms part of the bailout agreement (my emphasis):
  • to develop a significantly scaled up privatisation programme with improved governance;  valuable Greek assets will be transferred to an independent fund that will monetize the assets through privatisations and other means. The monetization of the assets will be one source to make the scheduled repayment of the new loan of ESM and generate over the life of the new loan a targeted total of EUR 50bn of which EUR 25bn will be used for the repayment of recapitalization of banks and other assets and 50 % of every remaining euro (i.e. 50% of EUR 25bn) will be used for decreasing the debt to GDP ratio and the remaining 50 % will be used for investments. 
So, let's put this jigsaw puzzle together.

1. Greek banks are currently reopening for transactions only. The cash withdrawal limit is likely to remain in place for the whole of the summer, effectively limiting Greeks' ability to hoard physical cash, and the capital controls that prevent money being moved outside the country will also remain in place.

2. The Greek government is required to fast-track through legislation to implement the European Bank Resolution & Recovery Directive in Greece. Once implemented, bank resolutions will involve bail-in of unsecured creditors.

3. In the autumn, the ECB/SSM will conduct another asset quality review of Greek banks to determine their solvency. Most estimates of the expected capital shortfall seem to be of the order of 15bn EUR without including deferred tax assets (DTAs), a form of capital extensively used in Greek banks that the ECB has already indicated it intends to phase out. If the ECB excludes DTAs from the CET1 definition, the bill would be at least double that.

4. Once the outcome of the asset quality review is known, the Greek banks will be recapitalised by the ESM. This implies use of the ESM's direct recapitalisation facility, which will not be available until January 2016. The banks would be supported by ELA until then, but the cash withdrawal limit and capital controls would remain in place to prevent cash hoarding and capital flight. So Greeks face the prospect of continuing restrictions on access to and use of funds for at least the rest of the year.

There are two significant implications of using the ESM's direct recapitalisation facility.
 
Firstly,  ESM recapitalisation is de facto nationalisation of the banks by Greece's Eurozone creditors, bypassing the Greek sovereign. Once the banks were recapitalised and - presumably - relieved of their non-performing loans, they would be sold back to the private sector. The proceeds of their sale would go to pay back the ESM loans. The asset privatisation fund therefore implicitly includes all the Greek banks. Not many people seem to have understood this.

Secondly, the ESM's direct recapitalisation tool requires bail-in of 8% of liabilities. Silvia Merler at Bruegel explains what this would mean for Greek bank bondholders and depositors:
Bail-in would require full haircut of subordinated/other bonds, full haircut of senior non-guaranteed bonds and still a haircut of uninsured deposits ranging between 13% and 39% for three out of four banks. This would already bring all banks above the 4.5% CET1 threshold and two of the banks above 8% CET1. The remaining capital shortfall would be covered by the ESM and Greece together, but the Greek contribution could be suspended. The ESM would effectively play only a very limited role.
Silvia discusses an alternative, ESM direct recapitalisation with bail-in according to amended State Aid guidelines, which would mean bail-in of junior bondholders only:
The amended State aid guidelines require only bail-in of junior debt in the transition to the Bank Recovery and Resolution Directive (BRRD). After a 100% haircut on subordinated/other non-senior debt, the banks’ CET1 would still be below 4.5% in some cases. Under the ESM direct recap’s priority ranking, Greece needs to bring the banks to 4.5% CET1 before the ESM steps in and take them to 8%. With a conservative DTAs assumption, the contribution to reach 4.5% could be substantially bigger than the ESM contribution for those banks that are less capitalised and that do not have much bail-in-able junior debt. However, this contribution could be suspended by mutual agreement in light of the fiscal situation of Greece. If so, the ESM would play a more meaningful role.
 I'm afraid I don't think this second alternative is likely. The creditors are in no mood to cut Greece any slack, and the fact that steps are being taken to ensure that deposits don't leave the banking system in any quantity suggests that the intention is to bail them in. If I am right, then the potential economic outcome is terrible for Greece.

The last time uninsured deposits were haircut was the resolution of Cyprus's two failing banks in 2013. On that occasion, a reasonably large proportion of the cost was borne by foreign depositors, principally Russians, although Cypriot businesses, institutions and households also took a hit. One interesting effect of the Cyprus bail-in was that non-performing loans increased: people whose deposits were frozen were too angry to service their loans. The economic consequence of the Cypriot bank failures, including deposit bail-in, was a fall in GDP of around 6%:



But the situation in Greece is very different. Most large depositors have removed their money already. The remaining uninsured deposits - about 30% of the deposit base - are mainly the working capital of Greek businesses. Bailing these in would be far more destructive for the Greek economy than the bail-in of large depositors was for Cyprus. It is hard to put a figure on exactly what the GDP fall would be, but we should expect it to exceed the Cypriot fall by quite a bit. And this is on top of the 25% fall in GDP Greece experienced 2010-14, and a further projected 2-4% fall in GDP as a direct consequence of the output fall in the first six months of this year, and a planned fiscal tightening of 3% of GDP, and who knows how much of a collapse in the remainder of the year if cash withdrawal limits and capital controls remain in place as I expect.

Silvia argues that the working capital of Greek businesses would be exempt from bail-in because of its systemic consequences:
BRRD foresees some exemptions concerning bail-in, which the ESM direct recap does not have at the moment. Article 43(3) of the BRRD directive provides four exceptions, stating that in those cases the resolution authority may exclude or partially exclude certain liabilities from the application of the write-down or conversion powers. One of these exemption is when “the exclusion is strictly necessary and proportionate to avoid giving rise to widespread contagion, in particular as regards eligible deposits held by natural persons and micro, small and medium sized enterprises, which would severely disrupt the functioning of financial markets, including of financial market infrastructures, in a manner that could cause a serious disturbance to the economy of a Member State or of the Union”. This is evidently happening at the moment in Greece, where a full-fledged bank run is being kept contained only because of capital controls (which should unquestionably qualify as a “severe disruption of the functioning of financial markets”).
I'm afraid I disagree with Silvia. The existence of capital controls eliminates contagion and makes it possible to bail-in deposits that would normally be considered to have systemic consequences. Provided that cash withdrawal limits and capital controls remain in place until bail-in, therefore, there should be no destabilising effects on financial markets or financial market infrastructures. And apparently the microeconomic foundation of the economy can be destroyed with impunity as long as financial stability is not threatened. So therefore I think that bailing-in large deposits and senior unsecured bonds as well as junior debt is exactly what the creditors have in mind.

Bailing-in the deposits of Greek corporations and sole traders would be the clearest indication so far that restoring the Greek economy is on no-one's agenda. It amounts to a massive heist of the Greek private sector's disposable income.

I suspect Alexis Tsipras realised something like this was on the agenda, since he insisted that part of the privatisation receipts must go to new investment. But would this really be sufficient to offset the losses to Greek businesses and households of such a draconian bail-in?

The more I look at it, the less benign this bailout deal appears. Indeed it looks to me as if it was set up to do considerable damage to the Greek economy. Once this becomes apparent, Greeks are surely likely to change their minds about staying in the Euro. And I'm afraid I think this is the point. One way or another, Greece is on its way out of the Eurozone.

Thursday, 16 July 2015

The Great Greek Bank Drama, Act I: Schaeuble's Sin Bin


 Greece's banks have been closed since 29th June. The closure followed the ECB's decision not to increase ELA funding after talks broke down between the Greek government and the Eurogroup.

The closure is doing immense economic damage. The cash withdrawal limit of 60 euros per bank card per day is restricting spending in the Greek economy to a trickle. Media generally focus more on the hardship that the cash limit causes for households: but far worse is the inability of businesses to access working capital and make essential payments. Businesses are failing at a rate of knots. People are losing their jobs. And bank loan defaults are rising rapidly.

The closure was, of course, the decision of the Greek government, as was the associated decision to impose partial capital controls. But it is hard to see that they had any choice. Deposits have been draining from Greek banks for months, but when talks broke down the outflows increased to a full-blown bank run. The  ECB's decision not to increase liquidity was rather analogous to refusing a blood transfusion when a patient is haemorraghing. Without additional liquidity support, the banks would quickly have bled to death.

Ordinarily, in a bank run the correct action for the central bank is to increase liquidity to accommodate the desire of the private sector to convert bank deposits into physical cash and/or move their money somewhere safer. But this is when the reason for the bank run is concerns about bank solvency. In the Greek case, the bank run was due to concerns about sovereign solvency, and in particular about the growing possibility of redenomination of deposits into a new, devalued currency. Since the reason for the bank run was political, therefore, I find it hard to criticise the ECB. It was in a cleft stick. If it increased liquidity, it was arguably supporting the Greek government. If it reduced it, it was supporting the Eurozone creditors. It therefore did neither. Maintaining ELA at its existing level was a politically neutral decision.

The real mistake was made by the Greek government. It was always obvious that the talks would be difficult, and the Greek government's "strength in weakness" approach meant that it had to allow itself to be pushed dangerously close to Grexit. Bank runs were inevitable. So allowing Greek banks to become totally reliant on a central bank controlled by Greece's Eurozone creditors - and itself a creditor - was a fatal flaw in the Greek government's strategy. It should have imposed capital controls long before. Had it done so, monetary conditions in Greece would still have been very tight but the banks could have remained open.

But the failure to impose capital controls early on was symptomatic of a much larger error. The Greek government allowed itself to drift close to the Grexit cliff edge in the belief that the Eurozone creditors would not dare push it over. On Sunday night, its bluff was called - and it had no response. It had not prepared for the possibility that it might actually have to do the unthinkable and leave the Euro.

The lack of a "plan B" meant that the Greek government was left with no choice but to cave in to its creditors' demands. I have criticised the methods used to break the Greek PM Alexis Tsipras, but the end result was inevitable. He could not accept the "temporary Grexit" plan put forward by Germany's Wolfgang Schaueble. To do so would be catastrophic for the Greek economy. "We do not have the foreign reserves for a Grexit", he explained afterwards. He is right, and those who think that Schaueble's "sin-bin" would have been better for Greece are wrong.

Greece's situation should properly be regarded as a foreign exchange crisis. It is using a foreign currency as its domestic currency, and now that the foreign issuer of that currency has turned off the taps, its only sources of currency are earnings from trade and international borrowing. Greece is of course unable to borrow on the international markets, so earnings from trade are the only possible source of currency. But Greece has a trade deficit, and it imports essentials such as fuel and some foodstuffs. So even with the banks closed and capital controls, there is still a net drain of Euros from the Greek economy.

UPDATE: Kleingut (see comments) points out that it is the current account not the trade balance that matters. This is correct. And for the last two years the current account has been in credit during the tourist season:


It is not clear whether this is sufficient to make Euro earnings positive on an annualised basis. And the wide swings in Euro income need to be buffered by reserves to avoid cash flow problems. But more importantly, it is now a racing certainty that income from tourism will fall significantly in 2015. Bookings are down by 30% despite  operators slashing prices. Even without Grexit, therefore, Greece will have a foreign exchange problem in the autumn if not before unless ELA is restored.
 
So the hope is that with agreement on a new bailout, the ECB will turn the ELA taps back on, easing monetary conditions and allowing discretionary cross-border trade to resume.

Schaueble's scheme would have ended this hope. Here is how it is described in the short paper leaked to the press on Saturday:
In case debt sustainability and a credible implementation perspective cannot be ensured up front, Greece should be offered swift negotiations on a time-out from the Eurozone, with possible debt restructuring, if necessary, in a Paris Club-like format over at least the next 5 years. Only this way forward could allow for sufficient debt restructuring, which would not be in line with the membership in a monetary union (Art. 125 TFEU).
The time-out should be accompanied by supporting Greece as an EU member and the Greek people with growth-enhancing, humanitarian and technical assistance over the next years. 
As always, the devil is in the detail. Greece cannot be prevented from using the Euro, either domestically or internationally. But since it cannot borrow internationally and its Euro earnings are net negative, its access to supplies of the Euro can be completely cut off.  A "time-out" would presumably be implemented by removing ELA from the banks, forcing them to relinquish their Euro reserves, and possibly also by suspending its membership of the Target2 international Euro settlement system, although as Target2 includes among its members four non-Euro users, this would be politically problematic. But removing ELA would be sufficient to exclude Greece from Euro membership.

And it would have terrible consequences. As Silvia Merler explains, ELA is a significant part of the Greek banks' liabilities:
At the aggregate level, central bank liquidity accounted for about 30% of total liabilities the Greek banking system, as of May 2015. At the level of individual institutions, ECB lending was equivalent to 21% of assets in NBG, 37% in both Alpha and Piraeus and 39% in Eurobank. 
Removing ELA would be the equivalent of a simply enormous cash margin call - and as those familiar with the fall of the American insurance giant AIG will no doubt recall, large sudden cash margin calls can break financial institutions. Suddenly removing ELA from Greek banks would undoubtedly break them. Schaueble's "time-out" means the bankruptcy of the entire Greek banking sector.

It also means the denial of cash to Greek households and the loss of household and business deposits in the inevitable bank insolvencies. So it is not just the banks who would be suddenly insolvent. It would be the whole of Greek society.

The solution to this is of course for the Greek government to seize the Greek central bank (which is currently part of the Eurosystem) and force it to replace the lost ELA with a new Greek currency. Realistically this would be a Greek Euro, not drachma. The banks could then be recapitalised by the Greek state (i.e. nationalised) using money created by the now-captive central bank, rather than international borrowing. And since the new currency would be Euro not drachma, household and business deposits would not need to be redenominated. This sounds like a plan, doesn't it?

The domestic monetary squeeze could indeed be solved by creating Greek euros. But these would not be accepted internationally, since the ECB would regard them as counterfeit money. So Greece would still have to find "proper" euros, or perhaps US dollars or sterling, to pay for its imports - and although such a tight monetary squeeze would cause a sharp fall in imports, having to curtail essential imports because of lack of foreign exchange would do the sort of damage to the economy that cutting supply lines does in a war. Countries can be broken through lack of foreign exchange. Just ask India.

There is a further problem with Schaeuble's scheme. It envisages debt restructuring in a Paris Club-type arrangement. But all of Greece's debt is Euro-denominated. Grexit, even on a supposedly temporary basis, would leave Greece with no means whatsoever of obtaining the Euros to service that debt. Here, courtesy of RBC Capital Markets, is a graphic showing Greece's repayment schedule over the next few years:

The chart shows that if Greece were completely cut off from Euro supplies, default on its debts to the ECB, the IMF and the private sector would be certain, although the Eurozone might decide to swap out the ECB's holdings with the ESM - a ruse suggested originally by the Greek government's erstwhile finance minister Yanis Varoufakis. Interestingly, though, payments to other Eurozone official creditors would not be affected provided that Greece returned to Euro membership by 2020. Schaueble's choice of 5 years is not accidental. Temporary exit would force losses on to the IMF and the private sector ahead of Eurozone official creditors. Nice.

Defaulting on payment to the IMF prevents the IMF or its partner Bretton Woods organisation, the World Bank, offering further aid. All humanitarian relief would therefore have to come through bilateral assistance from friendly countries. And this is where the geopolitics gets nasty. Russia has already offered to maintain gas supplies, and I'm sure further "humanitarian assistance" would be offered if Greece were forced into a Grexit, whether permanent or temporary. That would go down REALLY well with the USA.

But what about this Paris Club lark? If I were the Club de Paris, I wouldn't touch this with a barge pole. Greece is already in IMF arrears. It is by Club de Paris standards a rich country, so would not qualify for exceptional assistance. And its official creditors have so far shown complete intransigence as far as debt relief is concerned - yes, even the IMF, which wants everyone except itself to restructure Greece's debt. Admittedly, Schaueble suggests that Eurozone creditors might be more willing to consider debt restructuring including NPV haircut if Greece were not in the Eurozone, but as Greece would still be an EU member it's really not clear why the Club de Paris should be involved. It would risk being drawn into the Eurozone's political quagmire for no purpose.

The fact is that Schaueble's "sin bin" would be the worst possible outcome for Greece. Even a permanent Grexit including leaving the EU would be preferable, since at least then it could default on Euro-denominated debts. But it would still face a foreign exchange crunch due to its import dependence. Grexit is toxic while Greece's export sector is so weak.

Alexis Tsipras and Euclid Tsakalotos made the best decision possible in a dreadful situation. They should be commended for that. But the drama is not over yet. This show begins and ends with banks - and Greek banks are now terribly damaged. The bailout includes proposals for restructuring them which will inflict further severe damage on the Greek economy and almost certainly lead to the failure of the new program. I shall discuss this in my next post.




Friday, 10 July 2015

There are controls, and then there are controls....

Guest post by Sigrún Davídsdóttir


Now that Greece has controls on outtake from banks, capital controls, many commentators are comparing Greece to Iceland. There is little to compare regarding the nature of capital controls in these two countries. The controls are different in every respect except in the name. Iceland had, what I would call, real capital controls – Greece has control on outtake from banks. With the names changed, the difference is clear.
Iceland – capital controls
The controls in Iceland stem from the fact that with its own currency and a huge inflow of foreign funds seeking the high interest rates in Iceland in the years up to the collapse in October 2008, Iceland enjoyed – and then suffered – the consequences, as had emerging markets in Asia in the 1980s and 1990s.
Enjoyed, because these inflows kept the value of the króna, ISK, very high and the whole of the 300.000 inhabitants lived for a few years with a very high-valued króna, creating the illusion that the country was better off then it really was. After all, this was a sort of windfall, not a sustainable gain or growth in anything except these fickle inflows.
Suffered, because when uncertainty hit the flows predictably flowed out and Iceland’s foreign currency reserve suffered. As did the whole of the country, very dependent on imports, as the rate of the ISK fell rapidly.
During the boom, Icelandic regulators were unable and to some degree unwilling to rein in the insane foreign expansion of the Icelandic banks. On the whole, there was little understanding of the danger and challenge to financial stability that was gathering. It was as if the Asia crisis had never happened.
As the banks fell October 6-9 2008, these inflows amounted to ISK625bn, now $4.6bn, or 44% of GDP – these were the circumstances when the controls were put on in Iceland due to lack of foreign currency for all these foreign-owned ISK. The controls were put on November 29 2008, after Iceland had entered an IMF programme, supported by an IMF loan of $2.1bn. (Ironically, Poul Thomsen who successfully oversaw the Icelandic programme is now much maligned for overseeing the Greek IMF programme – but then, Iceland is not Greece and vice versa.)
With time, these foreign-owned ISK has dwindled, is now at 15% of GDP but another pool of foreign-owned ISK has come into being in the estates of the failed bank, amounting to ca. ISK500bn, $3.7bn, or 25% of GDP.
In early June this year, the government announced a plan to lift capital controls – it will take some years, partly depending on how well this plan will be executed (see more here, toungue-in-cheek and, more seriously, here).
Greece – bank-outtake controls
The European Central Bank, ECB, has kept Greek banks liquid over the past many months with its Emergency Liquid Assistance, ELA. With the Greek government’s decision to buy time with a referendum on the Troika programme and the ensuing uncertainty this assistance is now severely tested. The logical (and long-expected) step to stem the outflows from banks is limit funds taken out of the banks.
This means that the Greek controls are only on outtake from banks. The Greek controls, as the Cypriot, earlier, have nothing to do with the value or convertibility of the euro in Greece. The value of the Greek euro is the same as the euro in all other countries. All speculation to the contrary seems to be entirely based on either wishful thinking or misunderstanding of the controls.
However, it seems that ELA is hovering close to its limits. If correct that Greek ELA-suitable collaterals are €95bn and the ELA is already hovering around €90bn the situation, also in respect, is precarious.
How quickly to lift – depends on type of controls
The Icelandic type of capital controls is typically difficult to lift because either the country has to make an exorbitant amount of foreign currency, not likely, a write-down on the foreign-owned ISK or binding outflows over a certain time. The Icelandic plan makes use of the two latter options.
Lifting controls on outtake from banks takes less time, as shown in Cyprus, because the lifting then depends on stabilising the banks and to a certain degree the trust in the banks.
This certainly is a severe problem in Greece where the banks are only kept alive with ELA – funding coming from a source outside of Greece. This source, ECB, is clearly unwilling to play a political role; it will want to focus on its role of maintaining financial stability in the Eurozone. (I very much understand the June 26 press release from the ECB as a declaration that it will stick with the Greek banks as long as it possibly can; ECB is not only a fair-weather friend…)
Without the IMF it would have been difficult for Iceland to gather trust abroad in its crisis actions – but Greece is not only dependent on the Eurozone for trust but on the ECB for liquidity. Without ELA there are no functioning Greek banks. If the measures to stabilise the banks are to be successful then controls are only the first step.
_________________________________________________________________________________
Sigrún Davídsdóttir is an Icelandic journalist, broadcaster and writer. Her coverage of Iceland's financial crisis and subsequent recovery can be found at her Icelog, where this post first appeared. 
Together with Professor Þórólfur Matthíasson she has earlier written at A Fistful of Euros on what Icelandic lessons could be used to deal with the Greek banks. 

Image from WSJ. 

Thursday, 9 July 2015

Tsipras in the crucible



The atmosphere in the Greek standoff is turning ugly. On Tuesday, after new Greek finance minister Euclid Tsakalotos turned up to Eurogroup talks with nothing but hastily-drafted notes written on hotel paper, Eurozone leaders told the Greek government in no uncertain terms that if it did not produce credible proposals by Sunday 12th July Greece would be thrown out of the Eurozone. "We have a Grexit scenario prepared in detail", said European Commission president Jean-Claude Juncker.

The President of the European Council, Donald Tusk - one of the very few consistently sane and reasonable voices in this drama - said that inability to find agreement may lead to the bankruptcy of Greece and the insolvency of its banking system. And he warned that there would be serious - possibly irreparable - geopolitical repercussions for the European Union. "If someone has any illusion that it will not be so," he said, "they are naive".

Others have also warned about the geopolitical risks and the threat to the Euro project that a Grexit would create. In an interview on BBC Radio 4, the former head of the ECB, Jean-Claude Trichet, warned that Grexit would cause a "loss of credibility for Europe" and increase instability in a geopolitically sensitive region. The US has also expressed concern: on Tuesday evening President Obama telephoned both Angela Merkel and Alexis Tsipras, and today the Treasury Secretary Jack Lew warned that a deal was essential for the economic and geopolitical stability of Europe. In his Budget speech, the UK's Chancellor George Osborne described Grexit as the biggest risk facing the UK economy. And France's Prime Minister Manuel Valls, warning of geopolitical risks from Grexit, insisted that Grexit would be an indication of "impotence". "France refuses this", he said adamantly.

But despite all these warnings, Grexit now appears to be the default position of most European leaders. Eastern European leaders, particularly, are strongly opposed to any more help for Greece, while Germany would apparently consider money for humanitarian relief after a Grexit but not for debt restructuring to avoid it. France and Cyprus appear to be Greece's only friends.

Germany's position is the same as ever: no debt relief, no bridge finance, reforms must be delivered before any money is released, and the IMF must continue to be involved. If it sticks to these, Grexit is a certainty, since the IMF's involvement is incompatible with lack of debt relief. Christine Lagarde, speaking in Washington DC, reiterated the IMF's position that debt relief is required in addition to further cost cutting by Greece:
The other leg is debt restructuring, which we believe is needed in the particular case of Greece for it to have debt sustainability. That analysis has not changed. It well may be that numbers may have to be revisited but our analysis has not changed.
Lagarde's repetition of "our analysis has not changed" is clearly aimed at Angela Merkel. Continued involvement of the IMF is impossible unless the creditors agree to debt relief. Unless Merkel agrees to debt relief, she may go down in history as the German leader whose intransigence destroyed the Euro project. It is perhaps not surprising that this week there have been pieces in the German magazines Der Spiegel and Handelsblatt that are highly critical of Angela Merkel's handling of the Greek crisis. For now, she is popular - but would she remain so after a disorderly Grexit?

I fear we may soon find out. Watching Alexis Tsipras's address to the European Parliament this afternoon, I was filled with a terrible sense of foreboding. The tension in the room, the antagonistic attitude of a sizeable proportion of the audience and the angry interventions by several MEPs reminded me of the courtroom scene in Arthur Miller's The Crucible. There was little sense in evidence: fear and anger ruled the roost. One MEP even suggested that Greece needed a "General Pinochet" to take over and sort the place out. A military coup, for a country whose people remember the "colonels" with fear and loathing. What kind of union is this?

Nor is the sense that the lunatics have taken over the asylum limited to the European Parliament. Lagarde's comment a few weeks ago that there needed to be adults in the room in any negotiations was not aimed only at Greece. The Eurozone leadership is beginning to resemble the feral boys in William Golding's Lord of the Flies. Gone is any idea of working together to achieve the best outcome for everyone. The "no bailout" faction led by Germany's Schaueble is so intent on hunting down and killing the PIIG that the warnings from outsiders pass unnoticed.  It is a completely unedifying spectacle.

It cannot be stated too strongly that Grexit is NOT the best outcome. Not for anyone. It would be terrible for Greece, of course: the Greek government is very aware of that. But it would also be terrible for Europe, possibly spelling the end of the Euro and even of the European Union. What sort of message does the sight of a group of countries ganging up on a weaker one to force it out of their club send to the world? And with the current turmoil in the Chinese stock market, and the instability and conflicts along the EU's eastern border and in the Middle East, the consequences for the whole world of an economic and political disaster in the Balkans could be severe.

The Greek negotiations have become a classic "prisoner's dilemma". The best outcome FOR EVERYONE - even for those currently in favour of Grexit - is a negotiated restructuring of debt coupled with sensible and achievable reforms. But that means that everyone involved must put aside their anger, their fear and their pride so that they can cooperate. I don't see any signs of this at the moment, and I fear for Greece, for Europe and for the world.

Greece has now formally requested a third bailout, and will present its proposals to the Eurogroup tomorrow (Thursday). The letter from Euclid Tsakalotos is more conciliatory than previous letters from his predecessor Yanis Varoufakis, and offers to commence reform of tax and pensions immediately. Greece, therefore, has made the first move. It is blurring its "red lines" in an effort to seek a negotiated solution. It is now up to the creditors to respond in kind.

Donald Tusk has called a European summit for Sunday July 12th. This summit will involve the leaders of all 28 European Union nations, not just the Eurozone leaders. Given how bad relationships between the Eurozone leaders and the Greek government appear to be at the moment, this is a wise decision. I sincerely hope that there will be sufficient adults at this meeting for an agreement to be reached.

This insanity must end.



Tuesday, 7 July 2015

Who would win and who would lose from Grexit?


Guest post by Tom Streithorst


Vladimir Illych Lenin may well be the most destructive political theorist of the 20th century.  His glorification of a conspiratorial party as agent of a glorious future legitimised mass murder from Bolshevik Russia to Nazi Germany to Cambodia's Khmer Rouge.  Nonetheless, he did invent an analytical tool political scientists and economists should use more often: “Kto Kovo”, or “who beats whom”.  In examining any policy, Lenin suggests the first question to ask is who gains and who suffers.

Neoclassical economics pretends that we search for an optimum solution that serves the economy as a whole. In truth, all change creates winners and losers. 

The most obvious example is currency appreciation.  If the dollar is strong and its value rises against the euro, then American tourists enjoy nicer vacations, able to eat and drink more luxuriously for less money, but American exporters pay the price.  The cost of their goods in euro rises, so unless they cut their margins they will sell less product.  The public generally favours a strong currency, thinking it demonstrates the vigour and vitality of the economy; but economists know a weaker currency can create jobs by increasing sales overseas, reducing imports relative to exports.

Inflation has a terrible reputation amongst the general public but for most it is relatively painless. If you hold your wealth in cash, inflation is your enemy.  If you own real assets, it doesn’t have to be a problem. For those of us who are net borrowers (and most of us are), inflation is beneficial in that it reduces the real value of our debts. That is why creditors despise it: inflation allows debtors to pay them back in depreciated currency. 

Keynes, in Essays in Persuasion, tells us inflation is beneficial to entrepreneurs, who must make their product before they can sell it.  Since their costs are in period 1 and their sales are in period 2, inflation increases their profits.  Net lenders, like banks and bondholders, are the most damaged by inflation. It is a sign of their dominion over economic debate that the public fear it as much as they do.
 
Inflation need not hurt workers.  The inflationary 1970s saw real wages grow more than they have in any decade since.  In the 1970s, wage inflation exceeded goods inflation, so most people were better off.  Today, with unions eviscerated and worker power a joke, goods inflation would probably not spark wage inflation.  That tells us that an inflationary spiral is almost impossible, but it also means that inflation today might not be as benign to workers as it was in the 1970s.

The economics blogosphere hates austerity as much as the average citizen hates inflation. Everybody but the ECB, George Osborne and the general public recognises that tax hikes and public service cuts reduce demand, slow the economy and increase unemployment.  Austerity in a stagnant economy is as sensible as bleeding a sick patient in the hope of extracting evil humours.  Austerity hurts workers and entrepreneurs. It slows the economy today and reduces investment for tomorrow. Why then is it still so popular? Partly it is because austerity, although wrong headed, does make intuitive sense. “When times are hard and families are tightening their belts, government must as well” is a snappy sound bite, even if contradicted by 80 years of macroeconomic knowledge.

Austerity, as historians of the IMF knowwell, is the creditors’ preferred policy in the aftermath of every financial crisis.  Creditors naturally want debtors to reduce their expenses so as to free up cash flow for debt service.  If you have borrowed money from your brother-in-law, he doesn’t want you to take a lavish vacation or aspire to an early retirement. Likewise, if a German bank is lending to the Greek government, it does not care if pensioners starve and civil servants lose their jobs as long as cash is made available to service the debt.

Bondholders are generally rich.  Rich people make most of their money from their investments, not from their labour, so rising unemployment has little effect on them.  Thus they are insulated from the costs of austerity. What bondholders fear is inflation, in being repaid in depreciated currency.  Increased government spending could be inflationary, and it could also damage the government’s credit rating, which would affect the value of existing bonds.

This may explain the popularity of austerity, even though it has been disproved both in theory and practice. Michael Kalecki remindsus that “Obstinate ignorance is usually a manifestation of underlying political motives.” The passion for austerity is not merely misguided. It persists because it serves the interests of the rentier class.

So far so simple.  Let’s try a trickier one. “Grexit” is terrifying. If it sparks contagion, it could plunge Europe and the world back into recession. Most pundits assume it would be an unmitigated disaster. But remembering Kto Kovo, it is worth contemplating who would suffer and who would gain from Grexit.

The most obvious loser is anyone with euros in a Greek bank. If Greece exits the common currency and replaces euro deposits with drachma, and the drachma inevitably falls in value, then the value of those cash deposits would plunge as well. No wonder the Greek middle class fears leaving the euro. Their savings, sitting in their bank accounts, would be devastated.

Of course, most rich Greeks have already shifted their euro deposits out of Greek banks into institutions in Switzerland or Germany. After Grexit, their euro holdings would remain constant while their drachma costs would fall. As Greek banks collapsed and Greek businesses struggled to access capital, some would inevitably need to sell assets to raise cash.  As a flood of middle-class assets hit the market, their price would collapse and rich Greeks sitting on euros would sweep in and buy them for a song. The rich who liquidated their Greek bank accounts in time could end up the big winners from Grexit.

Foreign tourists and investors would also gain from a weak drachma. Vacations in Greece would be cheaper, as would buying property and businesses. Increased tourism and more competitive exports would create jobs, lowering the 27% adult unemployment and 50% youth unemployment created by five years of austerity.

Greek pensioners and civil servants, hammered by austerity, would get a break. With Greece once again in control of its own currency, the Greek government would finally be able to enact a simulative monetary policy, and that should provide a boost to workers and entrepreneurs.

German workers, on the other hand, wouldn’t do well from Grexit, especially if other periphery countries followed suit. The value of the euro has been held down because of stagnation in the southern periphery. The weak euro has been enormously stimulative for Germany’s export sector. As the Eurozone shrank down to a German core and the euro rose in value, becoming more like a renascent Deutschmark, German exports would shrink and German jobs would disappear. 

German taxpayers would also lose. The money they lent Greece, or more accurately the money used to buy Greek debt previously owned by German and French banks, will probably never be paid back.  Which reminds us of perhaps the biggest winner of all.

Every financial crisis ultimately is caused by creditors lending more than borrowers can repay. Both borrowers and lenders hope to make the other shoulder the cost of that imprudent lending. Had Greece defaulted and left the euro in 2010, the German and French banks holding their debt would have failed. The austerity of the past five years was the price of shifting debt from private sector banks on to the balance sheets of public institutions. German taxpayers have taken the hit - but German banks have not. Perhaps that helps explain the last five years.

In 1931, speculative pressures drove Britain off the gold standard. Losing the time-honoured link between sterling and gold was seen as unthinkable and terrifying. But historians now tell us that leaving gold, allowing Britain to run an independent and stimulative monetary policy, was the key to Britain’s recovery from the Great Depression. All over Europe, unemployment reduced and growth started in countries that left the gold standard and regained control of monetary policy. Perhaps Grexit would do the same for Greece today.
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Tom Streithorst is an American in London who has been writing for magazines on both sides of the pond since 2008. He is currently working on a book on post scarcity economics.

Image is courtesy of Jean-Pisani Ferry.