Angela Calling

Angela Merkel is a Chemist. In her doctoral thesis – entitled “Untersuchung des Mechanismus von Zerfallsreaktionen mit einfachem Bindungsbruch und Berechnung ihrer Geschwindigkeitskonstanten auf der Grundlage quantenchemischer und statistischer Methoden” – she demonstrated herself to be a thoroughgoing expert when it comes to analysing the speed of disintegration of chemical compounds once the bonds which hold them together are weakened. Unfortunately she is now having to apply all this acquired expertise and know-how in a determined attempt to avoid the break up and falling apart, not of a highly complex chemical substance, but of an even more complex economic and political one, and the bonds which are the focus of all her attention right now are not chemical, but financial and social.

The problems we in Europe all now face together (“wir teilen ein gemeinsames schicksal” in M. Trichet’s words) have not arrived just “suddenly one springtime” as it were, indeed they come from afar. Right from the very begining it has been no easy matter for German society to achieve the consensus necessary to accept the idea of participating in a common currency, the Bundesbank has long maintained its by now well-known reservations, while not a few have been the voices expressing the view that having so many diverse countries all sharing the same monetary unit would inevitably create a structure which was too unwieldy to be manageable, and too weak to hold together when the real storm weather came. What was needed, it was argued, was a two, not a one, speed Europe.

Unfortunately, all these simmering issues have once more resurfaced during the last week, over the tricky question of what to do about Greek financing needs, and Germany’s economic and political leadership now seem to be locked in an intense debate about exactly which path to take. Meanwhile Greek bond spreads simply work their way onwards and upwards, while capital flight from Greek bank deposits has forced the banks themselves to go rushing to the government for a further 18.000 million euros in funding just to keep them alive.

The current issue came to a head last Monday afternoon, following a brief report on the Financial Times website stating that progress with the decision on any Greek rescue plan was effectively deadlocked due to the inability of the Germany to agree with her other European partners the precise rate of interest to be charged on any loan to be provided. Ironically it is this single issue which is currently bringing European decision making to a dead halt, and creating a level of uncertainty and debate of such intensity that, if it is not resolved decisively, could bring the very future of the Euro into question. And it is not a trivial matter, since the rate charged will become a precedent, which other, larger, countries can refer to later.

Essentially the problem is this. According to the US economists Carmen Reinhardt a Ken Rogoff (in a widely quoted paper Growth In A Time Of Debt) a potential tipping point exists once government debt breaches the 100% of GDP level in the aftermath of a financial crisis. After this point the impact of additional state spending is, paradoxically, to effectively reduce growth (given the weight of interest repayments, and the additional risk price charged for lending, and the impact of more government debt on investor confidence) and indeed far from helping a country to recover, further borrowing may mean the economy actually shrinks rather than grows.

Let’s take an example. Imagine Greece has debt at the 100% of GDP level (in fact it is somewhat over 115%), and the price investors charge for buying the bonds is around 6% (or more or less 3% more than the German government has to pay to sell equivalemt debt). Now let’s also imagine that Greece has zero inflation and zero growth (they are in the midst of a massive correction which will last some years, so these are reasonable, and indeed possibly even optimistic assumptions). Then Greece will need to produce what is know as a “primary surplus” (or difference between current spending and current income) of around 6% just to stand still, and not see its level of gross indebtedness increase. But Greece, in 2009, had a primary deficit of some 7% of GDP.That is to say, simply to not get more in debt Greece has to withdraw something like 13% of GDP in demand from the economy, and this is massive, which is why all the experts anticipate a sharp contraction in the Greek economy over the next 3 or 4 years, and why rather than looking to domestic demand the Greeks will need to look to exports for support (The US economist Charles Calomiris has an excellent detailed explanation of all this here, while Peter Boone and Simon Johnson dig even deeper here) .

Which is where the European Union comes in. Basically, if Greece has to pay such a high interest rate differential to support such a large debt there is every likelihood she will not be able to continue to finance herself, and default will become inevitable. You can only demand so much effort from the reformed alchoholic before they are driven back to drinking in frustration. On the other hand the EU could help by making the interest rates charged cheaper, but unfortunately there is a 1993 decision of the German constitutional court which makes it effectively illegal for the German government to participate in such a subsidised loan. The IMF can help, they are reportedly willing to make a loan of up to 10 billion euros at very favourable rates, but there are limits to how far they can go, since they cannot justify favouring comparatively rich Europeans when they deny such funding to poorer countries in the third world.

And the quantity Greece actually needs is massive. Initial reports spoke of a total loan of around 25 billion, but this is surely not enough. At least 50 billion will be needed, and some estimates put the number much higher (see Peter Boone and Simon Johnson again). And remember, we are not talking about fancy theories here, all of this is all simple arithmetic: either Greece gets a large, cheap loan, or she will default. They will have no alternative. So European decision making is gridlocked, while on Thursday Greece’s 10 year bond interest rate differential hit record post-EMU highs of 4,63%, and the ineterest being charged was not 6% but as high as 7.51% at one point.

Naturally, if Greece were to do the “honourable thing”, and leave the Eurozone and default, “all would be light”. But they won’t, and there is no good reason why they should do so. Now, enter Professor Starbatty of Tübingen University. He has another proposal. Not Greece, but Germany should leave the Eurozone, and go back to the Mark. And before you start to laugh, you should bear in mind that he is very serious in his proposal, and many Germans agree with him. Indeed so seriously does Angela Merkel take the possibility that any cheap loan to Germany will encourage supporters of Professor Starbatty to go to the Constitutional Court and ask for a ruling that German participation in the common currency is illegal that she has frozen the whole Greek bailout process.

And it is not clear, at this stage what the view of the Bundesbank is. According to German press reports, accepted by the bank itself, the Bank is currently considering an internal report on the rescue loan proposal which states “This agreement of the heads of government, which according to our knowledge has been reached without any consultations from central banks, implies risks to stability that should not be underestimated,” (my emphasis).

And before anyone complains that the Germans are too dependent on exports to the South of Europe to do anything which makes selling these more difficult, please consider that domestic demand growth in all four Southern European members of the Eurozone is expected to be extremely weak over the next decade, while growth in emerging markets like India, China, Brazil and Indonesia is predicted to be massive. The markets are moving, so why not move with them?

Of course, none of this means that the Eurozone, like one of those chemical compounds Angela used to study, is about to fly apart. But we should not underestimate the stresses the currency union faces at this point. As former IMF chief economist Ken Rogoff pointed out in the Financial Times this week, “if investors gather with enough sustained force, and if the central bank lacks sufficient resilience and resources, they can blow out a fixed exchange rate regime that might otherwise have lasted quite a while longer.” What the countries in the South of Europe need to give the Germans right now are not arguments about how they would be foolish for them to leave, but arguments about what they themselves are prepared to do to make it more attractive for them to stay. The German giving machine is all done, and the Germans themselves are now more than tired of being continually told they need to pay, pay and pay again for events that now took place over half a century ago. Calling, Berlin, calling Berlin, hello, hello, is anybody there?

This entry was posted in Economics and demography by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

15 thoughts on “Angela Calling

  1. So.. care to explain to me why “Greece defaults without either it, or anyone else leaving the eurozone” is not the most likely outcome ? If greece is currently paying 6% of its gdp in interest, and are 7% in the red, defaulting (hell, no need to completely default, even. just announcing that interest on existing debt will not be paid would do) and a one percent increase in tax take, which they could probably get just by improved enforcement of the tax code would leave it in the black, yes?
    I am just not seeing why a sovereign default would imply a need to change currencies.

  2. Greece has very few alternatives. Because there is the very bad all-dreaded example of Latvia: GDP fall of 25% in very short time as a result of deflationary policy.

    At the same time competitiviness gain in Latvia is only 1%. Because dying of firms during deflationary periode has caused enormous monopolisation of markets.

    So Greece will be just sick if they start any deflationary policy.

  3. Thomas,
    the 7% deficit is primary, that is what Greece would have to come up with on its own, not just 1%. This number also makes sense compared to the stated borrowing needs of Greece for 2010-2012, which are 15-20 billion euros more than what is needed to cover maturing debt and interest.

    do you have a sense of the absolute size of the Greek debt? The analysis in the Economist of two weeks ago was using a 2009 debt of 269 billion euros amounting to 113% of GDP — similar to your number.
    But in the end of 2009, the Greek government was saying the debt was 300 billion euros, and in February 2010 a Ministry of Finance Committee uncovered an additional “hidden” debt of 40 billion euros. This would make a total debt of at least 340 billion euros. What’s going on?


  4. Well basically Thomas, the economic dynamics you are much more complex than those you are assuming, but:

    “I am just not seeing why a sovereign default would imply a need to change currencies.”

    It doesn’t, and I am not saying it does. But Greece is just the first, and Germany has to decide just how many sovereign restructurings she is willing to pay towards. That is the issue I am raising. Either we move forwards towards the political union that we will make this work, or the danger of falling apart rises and rises.

    They don’t just need to have a small hike in tax income they need a huge restoration of competitiveness to the whole economy.

  5. Yannis:

    “do you have a sense of the absolute size of the Greek debt?”

    Not really. No better than anyone else. I am just starting to appreciate the extent of “underwater” debt we have in Spain, but basically all these needs better accounting skills than I have (and some Greek I guess). On the other hand there is obviously a lot more debt to come out in things like health receivables (money suppliers are still waiting to receive). The number I mentioned of last years deficit being actually 14.5% – which comes from the official report I received a copy of in January – and health receiveables seem to be the main item extra.

    At this point neither the IMF nor the EU Commission would want too much bad news to come out while they are trying to calm markets. My guess is that when the new loan agreement is in place we will see it all come out and on the table. But of course, at the preent time, debt numbers are going up and up, while nominal GDP is going down and down.

  6. Pingback: Angela Calling Update | afoe | A Fistful of Euros | European Opinion

  7. Pingback: Angela Calling Update - Credit Writedowns

  8. Thomas,

    The problem for Greece is that if it defaults, but stays in the Eurozone, it is very difficult to see how it could ever get out of default and gain access to capital markets again. The normal route in such a case is massive devaluation (a la Argentina) to get the export sector moving again. Down the road this would then lead to improved real economic performance, drawing investors back to provide credit. This way is foreclosed to Greece due to Eurozone membership.

    In the event of a threatening Greek default, to save Greece as a functioning economy, the Eurozone would have to step in and bail Greece out. This, however, would be in direct violation of the EU treaties. If there is a bail-out, it would be challenged in Germany’s Constitutional Court, a process that could well lead to a break-up of the EU itself (and no, that is not a joke).

    The current situation is extremely serious and the Eurozone’s recently announced ‘measures’ are no more than a band-aid, leaving the wound that is Greece to fester and deteriorate…

  9. But restoring primary surplus and telling the creditors to take a hike would still be much easier and less politically painful than the likely consequences of a eurozone exit. Or to put it in another way – Greece has, for a very long time run deficits at all times, both boom and bust. This obviously cannot continue, so regardless of which course of action their government pursues, primary surplus must be restored, correct? And that done, access to capital markets is no longer a must, so if the interest payments are at that point considered onerous, haircuts will happen.
    And there are fairly obvious things that can be done to improve the budget position of the greek government other than “Print money”.

  10. Edward, I left this comment on W. Munchau’s column as a possible way out of this mess without a default. Please tell me what you think :

    Step 1 : Germany introduces the “German Indexation Factor” (let’s call it GIF, but I am sure Germans can find a deliciously long word for it) , managed solely by the Bundesbank, after consultation with the ECB. The Index has a value of one today, and is set arbitrarily by the Buba Board, with the explicit objective that German inflation, using (prices in Euro) divided by the GIF is low and stable (you know, the German thing…) .
    By law, all German salaries must be indexed by GIF, national accounts are expressed in indexed fashion, and future issuance of Bunds would be mostly indexed by GIF. The existing stock of Bunds would stay denominated in Euros, but German residents would be allowed to exchange a certain amount of Bunds into same maturity and rate GIM indexed Bunds at par. The Buba would refinance in GIF indexed loans, using a rate determined by the Buba board (again after consulting with the ECB).

    Step 2 : The market understands exactly what it means : EUR*GIF = DEM ! The euro drops like a stone, as everybody understands that Germany has no more any interest in a strong euro. Thanks to this drop and the indexation mechanism described above, the PIGS become more competitive outside the eurozone and inside (relative cost of labor is automatically adjusted). 10y GIF indexed Bunds are issued with “Japanese-like” fixed rates. The ECB let this happen, knowing perfectly what the next steps are going to be.

    Step 3 : The French Government understands what it means and implements exactly the same mechanism, claiming it was their idea in the first place. How hawkish or dovish the French indexation stance would be is anyone’s guess. Soon, every single country in the EMU follows.

    Step 4 : An amendment to the Lisbon Treaty is passed, that removes the inflation targeting mandate of the ECB and the stability Pact, that nobody believes any more, only giving a fuzzy “optimal economic development” target to the ECB. Of course, it will include some language as “endeavoring to converge towards harmonized monetary conditions”, but this time the cart will not be put before the horse : it will happen only if economies converge.

    Step 5 : All “out” countries like the UK or the Scandinavians get into the eurozone, as the euro simply becomes a useful way to buy a coffee in Valencia, Athens, London or Stockholm with the same bank note (with some frequent price update, at least for the next decade). Every EU country enjoys the maximization of seignorage income. Luca Papademos or Mervyn King becomes ECB new Boss.

    End Result : no default for Greece, no Debt Deflation for Europe, a robust mechanism to deal with Europe’s internal imbalances, Surplus countries learn the translation of ” Our currency, your problem” in the 23 EU languages.

  11. Edward,

    great post! For what it’s worth, while I agree with your estimation in the last paragraph with respect to the general emotional attitude in Germany with respect to the EU, I would say that the Greek issue is really more about being disappointed in the Greek ability to use the credibility that was transferred before and *with* the EURO in a way that would not lead to a situation such as this (disregarding the lying factor for a moment). And as I said on your facebook note about Munchau’s article –

    Well, I still say this was *never* really about Greece in the first place. This was about Spain and how to discourage the markets from betting against Spain. So, being quick to bail out Greece would likely have been interpreted as an invitation to the game. Now it’s still not so clear what would happen then. In a situation like this, having a generalised crisis regulation system, it seems to me, is pretty much a recipe to *create* a speculation crisis, since everyone knows the rules that will be applied. No no, I think the slightly erratic German reaction was actually the smart thing to do to. I don’t know the Greek trade structure by heart, but my intuition is that the relative positive effects of devalution are vastly overestimated by commentators. That’s probably because this is the Mundell variable that was at the center of the Euro debate. The Greek problem isn’t the impossibility to devaluate as much as it is the failure of the political class to use the windfall in credibility that *was* transferred with the Euro regime producively. Now, of course, if *this* crisis will not prompt the Greek political class to do something, then I don’t know. But I can’t really see how the possibility to devalue their currency would *help* them with the political process. For all I’ve seen, positive extrinsic motivation doesn’t work, now we’ll have to see how negative extrinsic motivation fares.

  12. Edward is comedian. There is absolutely no doubt about this.

    He now says that: ” I am just starting to appreciate the extent of “underwater” debt we have in Spain”. A country that has less debt than Germany and that will not get to have as much debt as Germany in the worst predictions of deficit in the coming 10 years. A country that uses less than 2% of its GDP in servicing its debt.

    Please Edward check now your predictions for economic growth for this last three months: Germany contracted, contrary to your prediction and Spain grew, opposing your ‘appreciations’. And tell us another of your jokes.

  13. Charles, I think you are talking about decentralizing the monetary policy to some degree while mantaining the common currency. But I think you don´t need to use indexation for that.

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