Greece, Spain and Germany, and the World

This is the latests on Greek GDP:

ATHENS—The Greek economy shrank further at the beginning of the year, official data showed Tuesday, confirming that the country remains deeply mired in recession even before new austerity plans are due to be implemented in the months ahead.

Greece's gross domestic product contracted by an annual rate of 6.2% in the first quarter of 2012 compared with a year earlier, the country's statistics office said Tuesday. This follows a year-on-year decline in economic output of 7.5% in the previous quarter.
The relatively slower pace of decline reflected, in part, a boost to business and consumer confidence following Greece's recent debt restructuring and promises of new aid from its European partners and the International Monetary Fund.

Still, even if the figures do show some mild improvement and were better than economists' estimates for a first quarter contraction of between 6.7% to 7.9%, many forecasters say the economy shows no signs of recovery with some estimating a decline of 7% or more this year.

The equation was very simple. As long as growth in the rate of borrowing continued unabated, the Greek economy could appear to be in growth mode, activity in the economy continued to grow, and government had the revenue from taxing the growth in activity in the economy to pay for previous borrowing. The apparently virtuous cycle had to stop sometime, as there comes a point at which the debt mounts to such a degree that repayment starts to look increasingly impossible. Then comes the downward spiral as the borrowing slows and activity slows, and then reduces, with commensurate reductions in government revenue, and the inability to meet the terms of previous borrowing. It is not a lesson for Greece, but for all who think that borrow and spend is the way to economic prosperity. Apparently, the Greeks themselves know that the game has now come to an end. This is the news on the Greek banking system:

ATHENS—Greek depositors withdrew EUR700 million from local banks on Monday, the country's president said, and warned that the situation facing Greece's lenders was very difficult.

In a transcript of remarks by President Karolos Papoulias to Greek political leaders that was released Tuesday, Papoulias said that withdrawals plus buy orders received by Greek banks for German bunds totalled some EUR800 million.

Citing a conversation he had with Greek Central Bank Governor George Provopoulos earlier in the day, Papoulias said: "Withdrawals and outflows until 4:00 p.m., when I called him, exceeded EUR600 million, they reached EUR700 million. That doesn't include all those orders that the banks received to convert to German government bonds and other such things. Taking those into account it sums up to about EUR800 million."

Again citing Provopoulos, the president added: "that the strength of banks is very weak right now."

This is not new, but the scale may be. And who can blame those people running for the exit. They compound an already dire situation, but each individual who is looking for a safe haven has good reasons to do so. Of course, the 'safe havens' are actually not so safe, they are just less unsafe. It has not taken much imagination to see the roll-on consequences from the deteriorating situation in Greece, for countries like Spain and Portugal, and for all of the 'at-risk' countries. When (and it now looks like 'when', not if) the Greek economy finally collapses under its own mismanagement, the massive losses to the holders of anything attached to Greek debt will send shudders of fear around the world. The problem is that there are more 'at-risk' countries than currently acknowledged, and this means that the consequences will ripple out into the wider European economy. 

The problem is this; rather than accept that the economic crisis was about something truly fundamental, governments and policy were directed towards saving a system that was unsustainable. The European economy is a micro version of the macro of the world economy. You have the big export creditor countries lending to the import and borrowing countries. To be simplistic, think Germany to Greece, China to the U.S. There are, of course, major differences, with the EU tied together by a dysfunctional currency union. The real difference here is that the union makes the problem more apparent more quickly. The fates of the lender and borrower become tied together, as the failure of the borrower country directly impacts upon the lender. The more money that is lent to the borrower, the greater the potential damage to the lender.

The problem is this; someone, somewhere is providing their savings to lend to the borrowers. This is not the abstraction that is so often reported. Economies are abstractions rooted in the actions of individuals and companies. I will grossly simplify here. When a bank lends the savings of a German worker to a Greek worker, and the Greek worker loses his/her job, that means that the German worker has just lost some money. But its much worse than this. When the German bank lends the savings of a German worker to a Greek worker, some Greek workers then use the borrowed money to buy German goods. This sends a signal to the German company to invest more money in production to meet the demand from Greece, and to hire more workers. These very same newly hired German workers are the ones who then provide further savings that will then be lent to the Greek workers.

The problem is this; it all appears as a virtuous circle, right up to the point where it is not. To illustrate this, think of Greece and Germany not in terms of financial flows, but in terms of goods. To illustrate, think in terms of Germany as producing BMW's and Greece producing Ford Fiestas. The value of these two cars are different, but imagine that each is making the same number and exporting the same number cars to each other, on a one for one basis. The Germans do so on the basis that, in the future, their workers will be able to call on Greece to provide more Ford Fiestas than they provide BMWs. When German workers, for example retire, they have a call on a Ford Fiesta which Greece is obliged to produce, in return for a Greek worker being allowed to drive in a BMW now. As long as this situation is one where there is the belief that Greece will provide future Fords, the Germans continue to provide BMWs for now, even expanding their capacity to meet the new demand from Greece.

This is all very well, right up to the point at which the entire capacity of Greece's Ford Focus manufacturing capability is unable to produce enough Ford Focus cars to meet their growing obligations. The German worker is alarmed to hear that, when push comes to shove, Greece is not going to provide the Ford Focus that they promised him in retirement. Even worse, the problem is that, as it becomes apparent that Greece is not going to return the promised Ford cars, workers stop lending money to Greek workers to buy BMWs. The demand for BMWs drops, and some BMW workers start to lose their jobs.

This is a highly simplistic illustration. It omits the aggregated way in which this process has developed, with governments and banks and other countries/economies sitting in the middle of the process. However, it is an illustration of what sits beneath the abstractions we are continually reading about. When an economist suggests that the solution is to lend ever more money to Greece, they mean that they will take the savings of German workers, or income from taxation, and will forward it to Greece so they can continue to buy their BMWs, and this will continue to support German employment of BMW workers. This does not alter the fact that Greece is only returning a Ford Focus for every BMW, and Greece continues to grow its future obligation in provision of the Fords.

I read today about an estimated cost of a Greek Euro exit to Germany, which is around Euros 90 billion. This is a recognition of the imbalance (to continue the illustration) between the consumption of BMWs and Greece's Ford Focus production capacity. For years, Greece has been exchanging a Ford Focus for a BMW, and has promised to provide more Fords than it could ever produce. The capacity in Greece will never grow enough to provide the Fords that it owes. The loss is simple to see. When our German worker goes to the bank at some point in the future, and asks for his 'Ford Focus', he will be told that it does not exist or, if he is fortunate, that he must accept a Ford Fiesta. A German bank received a promise from a Greek bank that the Ford Focus would be there for our German worker, and in turn the German bank promised the German worker the Ford Focus. Along the way, a Greek worker enjoyed driving his BMW.

The loss to the German worker is real, and nothing is ever going to change this. It is the reality of the problem. The losses are real. They cannot be wished away. Extending further credit just extends the losses even further. Lending more of the German worker's savings can only put the problem into the future, and make the problem worse. As for imposition of austerity on Greece, this is an attempt to free more capacity in the Greek economy towards 'Ford Production' for export, and a reduction in the import of BMWs (sorry to stretch the illustration this far, but I hope you get the point). However, even with austerity, the backlog of owed Fords is now so high, that no realistic increase in capacity will ever be enough to clear the backlog.

Lending more money to countries to continue to import goods is just a problem extension, not a solution. It grows the problem. The real solution is to accept the real losses now. It is painful, but miracles do not happen. Greece, Spain, Portugal and all of the rest of the 'at risk' countries are not, as far as I can see, going to have a productivity/competitiveness miracle that will increase their capacity to allow debt repayment. The extend and pretend policies that have been the business of governments have just made the situation worse, and the costs to the creditors are still growing. Whilst my account given here is simplistic, it is exactly how a trade imbalance really works. It is not some magical entity, but rooted in the exchange of value of goods x for value of goods y, with a deficit in the exchange amounting to z. The z is then supported by lending. The lending is expected to be repaid. If the country taking the deficit cannot repay z, the loss must be realised by somebody.

How is this so difficult, and how do so many suggest that this can fixed by continuing to lend to those who cannot repay, and will never be able to repay? The only question is the size of the losses, when they will be realised, and by who? These are the questions that are being evaded. The evasion of these questions is why we keep growing the problem. It is not just a problem of Europe, but a wider problem in the world.

The Wheels are Falling off....

Oh dear, oh dear. Is the the grand project about to come to a crashing end? The EU and Euro have never looked as fragile as at this moment in time. However, there is a caveat; there is still a strong determination to hold the project together. The question is whether determination is enough in the face of the conflicting interests of very differently positioned EU members and in face of the storm that is now assaulting the EU and Euro.

I will not cite any of the news on the ongoing problems, as just about all the media are talking about the same problems; the fracture between the French and German positions, the IMF's reluctance to provide further bailouts for Greece without banks taking a major 'haircut' on Greek bond holdings, the growing resentment of the 'bailees', the proposals for a true financial union.Then there are the problems of the banks that are exposed to the risks of multiple sovereign defaults.

For all of the determination of politicians to save the grand project, it seems that the prospects for the EU and Euro to crumble are increasing. Of course, the former does not create certainty on the latter. However, if the Euro does crumble, will the political drive survive the recriminations that will follow? It seems unlikely but, again, it would be unwise to underestimate the determination of those who support the grand project. The EU as an institution will fight for survival in the face of any storm, and still has support of many politicians throughout the EU.

You will note here that the questions resolve around politics rather than economics, but now the economics are driving the politics. This is, in some respects, a reversal on the foundations of the EU and Euro in which politics drove the economics.

For the moment, I would like to just speculate on the scenario that there is no final resolution (which seems likely) which satisfies the financial markets. If this is the case, the crisis will hit hard. The reason is very simple - it is not just Greece that is overextended; it is not the only country that is unable to pay back the money that has been borrowed. I have long talked of the fallacy of GDP, that it includes activity that is derived from borrowed money, and in particular includes overseas borrowing. The way that GDP is measured sees increased borrowing from overseas creating activity in the borrower's market, and this gives the illusion of 'economic growth'. At present, for example in Greece, the economy is contracting even with borrowed money creating activity in the economy, and that is a signal for the state of the other 'at risk' economies.

There are some really fundamental points to consider here. The first is to return to a theme of this blog. Countries are unable to borrow money of themselves; they can only borrow and spend money on behalf of the tax base. As such, whether people or businesses, the ultimate borrower is the taxpayer. Some economists delineate public and private debt, as if they were different. However, public debt is in the end private debt as it is taxpayers that must repay the debt, not the government. The government just serves as the legal entity that signs for the debt, and then acts as a conduit for the repayment and distribution of taxpayer debt.

When we consider the position of Greece, or any of the other 'at risk' economies, it is apparent why the crisis is taking place. There are two possible purposes of borrowing and these are 'borrowing for consumption now', and 'borrowing for investment'. For the latter, provided the investment increases productive activity, it is generally a good thing to borrow money. I say generally, as this is not always the case, and this is where it becomes rather tricky to explain the problem. For example, investment in a restaurant will result in productive activities of 'making good food' or 'making convenient food' and so forth. It appears that it is a good investment. The problem arises when the investment is based upon a mistaken assumption about the real number of potential customers and the real underlying spending power of those customers.

If many people are reliant on borrowing for 'consumption now' as a determinant of their ability to spend in the restaurant, then there is a potential problem in the future. It is actually a double-whammy. If the people are reliant on borrowing to increase their spending power to be able to afford the restaurant, there must come a point at which they can no longer borrow, as they must be progressively accumulating debt, and that means that their debt to income ratio will be moving towards a negative. As such, at some point, they must switch from borrowing to repayment. At this point, they no longer have the borrowed money to provide the spending power to go to the restaurant, but also will have less money to spend on other things that they would have been able to buy, if they were not repaying debt. This is the double-whammy.

Now, if we return to so-called government debt, and remember that this is the debt of all taxpayers, then it becomes apparent that, when governments borrow, they are increasing the spending power of each taxpayer, but at the future cost of the double-whammy. If we think of our restaurants, the investment in these appears to be an investment in productive capacity, but in reality it is investment in over-capacity in relation to the underlying size of the market. Borrowing for 'consumption now' by both individuals and government has encouraged the development of capacity with a finite life. Meanwhile, those parts of the economy that, without the borrowing, might have been sustainable, get hit by the double-whammy. Not only can the taxpayers now not afford x, they can also no longer afford y, as they are now paying for the borrowing for 'consumption now'.

If we add in the accumulation of so-called private debt, or debt to which an individual has personally consented and has a personal repayment obligation, then it is possible to see how an economy can become distorted in creating capacity that is, in the long term, unsustainable, and which distorts activity and investment into over-capacity.

Now, we need to think of an individual German worker, for example working in a car factory. Our German worker is productive and helps in creating value in assembling cars. He takes home a wage, spends some of his wages, but also saves some of those wages. There are many ways of saving money but, for simplicity, let's say that he places the money in a pension fund. Included in the portfolio of the pension's investment fund are Greek bonds. Those bonds have gone to the Greek government, which spends the borrowed money in the Greek economy. This input of money from Germany increases activity in the economy, and will allow, for example, more Greek people to have the spending power to buy a German car. This in turn encourages an increase in capacity in the German car factory where our German worker is an assembly worker.

If we think of the way the system is working, it is as follows; in aggregate, lots of German workers are lending lots of money into the Greek economy. This allows the people to consume more German goods and services. In the financial industry, they say that this creates assets for the German worker, but those assets are actually debt obligations from (in the broad) Greece. They are only assets if Greece is willing to return the value of the asset plus interest. The problem is that Greece as a whole has been borrowing for 'consumption now', and even borrowing for investment was in many cases just supporting investment which was supported by borrowed money for 'consumption now'. The financial institutions that claimed they were buying assets with our German workers' savings were in fact primarily providing money for 'consumption now' for the people of Greece. The deal with 'consumption now' borrowing is that it must be matched (and exceeded because of interest) in the future by the double-whammy of less consumption, unless there are increases in productivity.

This is not to say that all of the borrowing in Greece was for 'consumption now', but the parlous state of the Greek economy is suggestive that this was a major proportion of the usage of borrowed money.

Squarely in the middle of this, we have the banks that lent the money. On their books, they have so-called assets. These are of course, obligations for x to pay debt. My intention here is not to go into the complexities of fractional reserve banking which I will leave to one side. However, some of the 'assets' purchased are not funded by inherently speculative use of savings, but by deposits which the banks must return on demand. If a debtor fails to repay debt, then the asset is in fact a liability. If enough debtors refuse or unable to pay, the bank will have greater liabilities than assets. It is bust, and all the depositors lose. In addition, those who gave the banks money for speculation will lose money (e.g. pension funds).

Staying with the Greece and Germany example, the problem is that Greece does not accept the double-whammy, and to do so would see a massive drop in the living standards of people in Greece. They simply do not want to pay back the debt to Germany. In some cases, in the case of 'private debt', there is simply nothing left to pay the debt back with; some of the sectors of the economy supported with borrowing for 'consumption now' are collapsing. The overcapacity supported by 'consumption now' is disappearing and with it 'assets' are disappearing. In the meantime, in Germany, for example where our car assembly worker works, over-capacity starts appearing as demand for German cars in Greece declines. Whilst it is possible that this capacity might be directed to other markets, what happens when other markets (e.g. Spain) see similar declines? How much over-capacity is there in Germany?

The really massive problem boils down to this. Money has been lent into supporting 'consumption now', and this money was lent without ever really considering how the consumption now might be paid back. In part, this was down to the flattery of GDP figures, but also due to banking regulations that pronounced that certain types of debt were safe. The problem is that there is nothing left to recover when debt is used for 'consumption now'. For example, the cars purchased with borrowed money are literally consumed over time (I use a physical entity such as a car for simplicity, but I hope that you can see the same point with services). Unless the Greeks now produce things of equivalent value to repay the Germans, massively reducing their own consumption in the process, the loss must take place. Unless of course, the Greek economy has an overnight miracle of productivity growth....

Then there are the savings of the Germans. If Greece does not meet its obligations, then the savings that have been poured into so-called Greek 'assets' will disappear. Even if governments borrow (from where?) to support the banks/other countries, the problem is that they are borrowing on behalf of tax-payers in order to protect those same tax-payers from losing money on their own savings. They do not lose their savings now, but they still have to effectively repurchase the same savings through the tax system. It comes back to the idea that governments can borrow on their own account. They cannot.

At this stage, I would like you to take a pause for thought. I would like you to think this through for yourself, as it puts a whole new context around the pantomime taking place amongst the governments of Europe. The tax-payers of Europe are borrowing money to bail out the losses on their own savings? Every Euro used by government to fill the hole of losses creates an exact equivalent of a Euro + interest obligation from tax payers on the borrowing. It is, of course, an absurdity. As there is nothing but tax-payers to repay the debt, it can only be a redistribution of the losses. And whoever lends the money to fill the hole from the bad debt, will want interest for their lending. Tax-payers bailing out themselves?  Or, here is a thought, is it that the taxpayer money is being used to save the banks?



I am, of course, simplifying overall. I have just focused on Greece and Germany, and excluded all the other actors throughout much of the discussion. However, when considering the big picture, we can see similar networks of relationships between individuals, economies, banks, governments etc. In the end, it is all about borrowing for 'consumption now', without the ability of the over-consumers to repay their borrowing. Meanwhile governments claim that they can save the day, but they have absolutely no resources of their own to use to save the day. They only have their tax-base to fall back upon, so that they are using tax-payer money to save the same tax-payers (or banks) from financial loss. The interesting part of all of this is that, if you listen to the news, you would think that it is governments, not tax-payers who are borrowing the money to 'save the EU' or 'save the Euro', or save the 'at risk' countries. In summary, the whole pantomime is simply madness.

Predicting the Economic Future

In my essay 'A Funny View of Wealth', I made some predictions for the UK economy - most of which have been (as near as possible) exactly right. I thought it may therefore be time to mention the things that I did not manage to predict and the events I failed to mention.

The first thing I failed to see was that consumer price inflation would be accelerating. It could be argued that, in missing this, I missed a vital part of the current crisis. However, as I have pointed out elsewhere, inflation measures are not actually measuring real inflation. As such, at present, despite the headlines, real inflation is negative. This is not to say that some goods and services are not increasing in price in a dramatic fashion, but rather that the overall cost of living is falling.

One of the disturbing things about the current state of consumer price inflation is that I did not predict this, and it will have a downwards leverage on the UK economy. As such, I think that the economic collapse in the UK will be faster and more severe than I had assumed.

The reason for this inflation is a combination of the madness of biofuels taking land away from food production, and increasing demand for food amongst emerging economies. These problems will not go away in hurry, and I had no idea that they would impact upon the economy in the way that they have. Several years ago, for rather odd reasons, I studied meat consumption in Taiwan, and noted that there was a massive increase in meat consumption over the period of Taiwan's economic development. I should have noted this trend and seen that the growth in the emerging economies would eventually impact food prices. As for biofuels, I am not sure that anyone could predict that such silliness would occur, though the consequences for food prices should have been obvious.

As for oil (and other commodity) prices, I have discussed this elsewhere, and this is a matter of capacity not keeping up with demand as the world economy expanded. As economic growth turns to contraction, this situation will resolve itself and oil prices would fall back. However, I did not manage to predict this problem, as it now stands. The reason for this is that I had assumed that high oil prices were a factor of instability in the Gulf states, rather than reaching capacity constraints. In short, I got it wrong. For other commodity prices, I just wasn't paying enough attention.

My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.

As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.

Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.

India I will leave alone, as I know very little about the economy there. I have read some reports that are suggesting that the economy is very frothy, but have little else to say.

This is a very brief summary, but it is all pointing in one direction. The world economy, not just the UK, is teetering on the edge. The big question is; Why? At a later date I hope to start to unravel just how this situation has arisen. The theme of the essay will be the imbalances in the world economy. I made a start on this with my post on the 'Cigarette Lighter Problem', but this is only a tiny element in the overall picture. The essay will explain why the economies of the West are in such deep trouble, and why the problems will not go away in a hurry.