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 Grinding Euro Crisis

There are two 'Bill and Ted' movies, and I forget which one contains this scene. For some reason, Bill and Ted are being sent to hell, and they are both falling into endless darkness. At the start of the scene, they are both screaming with fear. However, as they just continue falling and falling, they pause their screaming, start again, then stop.

This scene made me think of the European economic crisis. Bill and Ted (correctly) suspect that they will eventually hit the bottom, but they can only scream for so long. It is becoming like this with the crisis in the EU. In particular, we have the latest stage in the relentless fall of the Greek economy. Perhaps one of the most absurd elements of the Greek default was all of the technical gobbledygook about whether the default was in fact a default. As it is, there is still no end in sight for the problems of the Greek economy:

Greece implemented the biggest debt writedown in history on Monday, swapping the bulk of its privately-held bonds with new ones worth less than half their original value.

Although the exchange will keep Greece solvent and at the receiving end of billions in international rescue loans, markets were underwhelmed amid fears that the country's debt load still remains far too heavy.
A Finance Ministry statement said bonds issued under Greek law with a total face value of €177.2 billion ($232.5 billion) were exchanged. A smaller batch worth €28.5 billion, issued under foreign law or by state enterprises, will be swapped in coming weeks.

The debt exchange opens the way for Greece's second international bailout, expected to be finalized this week by finance ministers from eurozone nations. It will also transfer the majority of the country's debt from private into public ownership — its eurozone partners and the International Monetary Fund.

It is tempting to quote the many other commentaries which assume that this is not even the beginning of the end of the troubles of Greece. However, the real impact of the default is greater than the ongoing problems of Greece. It strains the credibility of the EU as a whole; all of the emergency summits and action plans have simply not worked. Also, the default has established that private bond holders of EU sovereign debt are now relegated to a junior status, meaning that the risks for the private bond holders are now increased. In the meantime, the ongoing bailouts of banks by the European Central Bank marches relentlessly onwards:

The European Central Bank’s balance sheet surged to a record 3.02 trillion euros ($3.96 trillion) last week, 31 percent bigger than the German economy, after a second tranche of three-year loans.

Lending to euro-area banks jumped 310.7 billion euros to 1.13 trillion euros in the week ended March 2, the Frankfurt- based ECB said in a statement today. The balance sheet gained 330.6 billion euros in the week. It is now more than a third bigger than the U.S. Federal Reserve’s $2.9 trillion and eclipses the 2.3 trillion-euro gross domestic product of Germany (EUANDE), the world’s fourth largest economy.

And the assets being pledged to the ECB have been steadily declining in quality. As you would expect, this massive expansion of the balance sheet has not been without criticism.

Jurgen Stark, the ECB's former chief economist and Germany's board member until two months ago, said the blitz of lending had corrupted collateral standards and risked inflation.

"The balance sheet of the euro system isn't just gigantic in size but also shocking in quality," he said.

Unlimited lending to banks for three years has pushed the ECB's balance sheet to over €3 trillion (£2.5 trillion), overtaking the US Federal Reserve to become the world's most activist bank.

The attack come days after Bundesbank chief Jens Weidmann complained that the ECB's payments system known as Target2 had caused the Bundesbank to build up €547bn of claims on the rest of the system, mostly from the central banks of Greece, Ireland, Italy, and France. He demanded measures to protect German interests.

You may want to see an interview with Jurgen Stark (later in the interview), in which he again expresses concern at the ECB's activity, in particular the purchasing of government bonds 'in certain countries' which he argues postponed the reform in the economies. He is clearly against the principal of central banks financing government deficits, and states this very clearly.

The most interesting thing about the current situation in Europe is that the ECB is throwing ever larger amounts of money into the system, but the crisis continues to grind on. It is, in other words, not working. The alternative approach is to reverse austerity. If you look at the Stark interview, the presenter puts the argument more clearly than many. Austerity reduces the size of the tax base.

It is a wonderful Alice in Wonderland logic. If we stop borrowing and spending, people will have less income and will therefore give less tax. Therefore we should borrow x billion Euros to spend on consumption, and this will then generate more tax revenue which will give confidence that we have the income to pay our debts. So what we will do is borrow more money for consumption in order to use the small percentage of that money to us that is returned in taxation to pay for our existing borrowing whilst increasing our overall absolute borrowing.......Makes sense, does it not?

Note: Sorry for the lack of posting. I have been very, very busy, but will try to find a bit more time. There are many developments in the world economy that deserve comment, for example the further steps towards making the RMB a reserve currency, the 'faux' US recovery, and a host of other interesting points.

The Greek Crisis

I don't know about the readers of this blog, but I am now at a stage of simply being overwhelmed by the ongoing and endless rescues of the Euro. Every day the news pours out on the latest initiative, the latest plan, the latest crisis meeting/summit, the latest bad news......In light of this, it was a pleasure to read the latest take on the story from Spiegel Online, which cuts through much of the fluff on Greece. The headline and sub-head offer a great summary:

European Politicians in Denial as Greece Unravels


Europe's politicians are losing touch with reality. Greece is broke, and yet Brussels wants to send the country billions in new loans, to which there is growing opposition within the coalition government in Berlin. Rescue efforts are hopelessly bogged down by bickering over who will ultimately step up.

This was the part that I really liked:

The Greek economy is not productive enough to generate growth. Aside from olive oil, textiles and a few chemicals, there are hardly any Greek products suitable for export. On the contrary, Greece is dependent on food imports to feed its population.

"Greece has been living beyond its means for years," an unpublished study by the German Institute for Economic Research (DIW) concludes. "The consumption of goods has exceeded economic output by far."

Especially devastating is the assessment that the DIW experts make about the condition of an industry that is generally seen as a potential engine for growth: tourism. According to the DIW study, the Greek tourism industry concentrates on the summer months, with almost nothing happening throughout the rest of the year. There is almost no tourism in the cities, which translates into low overall capacity utilization and high costs for hotel operators. By contrast, capacity utilization in the hotel sector is much more uniform in other Mediterranean countries.

I have long argued that this is one of the fundamental problems that sits beneath the economic crisis. It is the fantasy that a country can just continue to endlessly consume more than it produces. Whilst Greece may be an extreme case, it is very apparent that Greece is not alone. I am going to quote at length from the first post of this blog, which is from an essay I wrote in 2007:

I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’

The Greeks are the Wilsons. Yes, they have lived a good life. But the bills have simply grown to the point where they do not have enough income to repay them. This aspect of economics has never been complicated. If you are continually borrowing to pay for consumption, you will indeed have a high standard of living - for a while. Unless your income growth is outstripping the rate of debt accumulation, it is only a question of time before the credit becomes too much to service. It is not a case of 'if', but 'when'.

It is very curious how much effort and time goes into denying this simple formulation. The answer to the problems of too much debt is apparently to just borrow more....We see it endlessly from economists, politicians and commentators. Austerity is self-defeating. The answer is to borrow more. 'Yes', when borrowing more, the economy will appear to grow. Just like the Wilsons, there will be an illusion of wealth for a little longer. However, like the Wilsons, it can not change their actual real income; it cannot change the ability to create real wealth.

The Spiegel article gets to exactly this point with Greece. Greece simply does not have the ability to continue to have the high standard of living that it has previously enjoyed. That standard of living was supported by unsustainable debt accumulation. They just do not create enough wealth to either continue to live as they have done, or pay back the debts accumulated in giving them an illusion of wealth.

I just do not understand how it is that this simple and evident reality can be ignored by so many. In the case of Greece, it is plain to see. And just as it is plain to see in the case of Greece, it is also plain to see in the cases of other economies. They may not be as dramatic as Greece, but the same principle applies.It really is very simple.

Austerity in the UK

I know I bang on about Krugman, but his pronouncements become ever more silly, and I would like to relate his latest silliness to the post above. This is his commentary on austerity in the UK:

Britain, in particular, was supposed to be a showcase for “expansionary austerity,” the notion that instead of increasing government spending to fight recessions, you should slash spending instead — and that this would lead to faster economic growth. “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” declared David Cameron, Britain’s prime minister. “You cannot put off the first in order to promote the second.”

[and later]

And we may get tipped in the wrong direction by Continental Europe, where austerity policies are having the same effect as in Britain, with many signs pointing to recession this year. 

The infuriating thing about this tragedy is that it was completely unnecessary. Half a century ago, any economist — or for that matter any undergraduate who had read Paul Samuelson’s textbook “Economics” — could have told you that austerity in the face of depression was a very bad idea. But policy makers, pundits and, I’m sorry to say, many economists decided, largely for political reasons, to forget what they used to know. And millions of workers are paying the price for their willful amnesia.

There is one very fundamental problem with his use of the exemplar of the UK for the evils of austerity; there is no 'austerity' in the UK, just talk of it. It is a point made very well in a post in the Money Illusion:

But I am seeing article after article claiming that the coming recession is due to fiscal tightening.  I was curious to see just how tight British fiscal policy actually is, so I checked the “Economic and Financial indicators” section at the back of a recent issue of The Economist. They list indicators for 44 countries, including virtually all of the important economies in the world.  Here are the three biggest budget deficits of 2011:
1.  Egypt  10% of GDP
2.  Greece:  9.5% of GDP
3.  Britain:   8.8% of GDP
Egypt was thrown into turmoil by a revolution in early 2011.  Greece is, well, we all know about Greece.  And then there’s Great Britain, third biggest deficit in the world.

There is absolutely nothing that can be described as 'austere' about the rate of borrowing in the UK. Quite the opposite - it is shockingly profligate. In reality, the UK is doing exactly what Krugman has long argued for, and has now been doing it for a long time. The UK is borrowing and spending with abandon. The really shocking thing about the UK economy is that, despite following this reckless path, it is still seeing shrinkage of the economy.

What Krugman means is that the UK government should increase the rate of debt accumulation to even higher levels. It is his solution to all ills. Just borrow more, or print more money. He cannot even see that the UK is already doing exactly what he recommends, that it has been doing so for a long time, and that it has not worked. Quite the opposite. For all the debt accumulation, the UK economy is still shrinking.

As regular readers know, I do not argue the case of expansionary austerity. I can at least agree with Krugman on this point. Real austerity will be a hard and painful path. If the UK were to balance the government budget tomorrow, the UK economy will nosedive. However, as I argue above, in the end, there is no real choice but to see the economy nosedive at some point. It is not 'if', it is 'when'. Again, as argued above, Krugman's solution will keep the illusion going for a while, assuming that bond markets play ball, but it will only prolong an illusion.

In the post above, I talked of the way that modern economists might see the two families. At the time of writing I was not familiar with Krugman. However, he is exactly the kind of economist who would propose that the Wilsons are the wealthier of the two families. He seems to really believe this......it is shocking. It is why his pronouncements are so very, very wrong.