The Lessons of Greece

I have now written several posts on the subject of the Greek crisis, but I thought it might be an appropriate moment to explain why we should all be alarmed at the implications of the Greek crisis. It is not a post about contagion, but about the fundamental problems for all of the countries that are financing huge and growing debts through overseas borrowing.

For regular readers, they will be familiar with the discussion that follows, but I hope they will forgive the repetition for any new readers. The problem that I would like to outline is the problem with the measure so dear to economists, analysts and policymakers; the measure of GDP. The fundamental problem of GDP is that it measures activity within an economy, rather than the underlying size of an economy. As one extreme example of how flawed this measure actually is, if we imagine that a country has an earthquake that destroys a city, the activity that is generated from the rebuilding will possibly see a rise in GDP as the city infrastructure is rebuilt (assuming the loss of productive capacity from the city does not offset the increased activity from the rebuilding). In other words, destruction of assets might give the impression that an economy is growing.

In addition to this problem, there is a more fundamental problem in this rather dangerous measure. This is the inclusion of activity financed through overseas borrowing in the GDP figures. The way this works is simple, and I will give an example to illustrate how it works. Imagine that I go to a restaurant and purchase a meal with a credit card, and the origin of the finance for the card comes from Japan. When I purchase the meal, the activity will be recorded as activity within the economy, and will be reflected in GDP. However, it does not end there. The restaurant will then use that money to pay for a range of expenses, and each payment will also constitute activity in the economy. For example, the restaurant staff will be paid from my borrowed money, and might spend that money in a shop, again creating more activity, then the shop will use that restaurant worker's money and so forth.

What we have is a situation where my borrowed money will not just register as activity in the restaurant, but will also finance considerable subsequent activity. The problem is that this activity is really the result of the output of Japan, as it is Japanese lending that is paying for all of the activity. It is the equivalent of an individual earning £100,000 and borrowing £10,000 and imagining that he actually earns £110,000 per year. Yes, our individual can have a £110,000 lifestyle, but only at a future cost to his diposable income, and only for so long.

In an earlier post, I made a rough and ready calculation of US GDP if overseas funded activity was stripped out of the figures, and came to the following conclusion:

In other words, something like 17% of the US economy is funded by overseas borrowing. You may note that there is a large amount of 'fudge factor' in all of this, and comments and critiques are therefore welcomed (especially from those who are more numerate than myself - which is most people).

There were no critiques, and I would encourage readers to look at the original article, and again encourage critiques. The reason for bring this up in relation to the Greek crisis, and the concern that it should raise for the world economy is relatively simple. If we imagine that Greece does not receive the bailout from the EU/IMF we can see what will happen (I am assuming that there will be no further finance from the markets).

The Greek government will be in a position where it can no longer use the borrowed money to finance activity within the economy, and will have no choice but to enforce extreme austerity measures. As the flow of overseas borrowed money disappears from the economy, the level of activity within the economy will start to fall in an alarming and dramatic way. What will then rapidly follow is that many businesses will find no customers for their goods and services, or a significant reduction, and they will find that they are no longer solvent. Furthermore, many direct employees of the government will be made redundant or have pay-cuts. All of this will lead to less activity within the Greek economy.

The next step will be that a large number of businesses will go bust or start laying off workers, and unemployment will start to rise rapidly. All the while this happening, GDP will be falling off a cliff, and with that falling off, the debt to GDP ratio will be rapidly moving in the wrong direction. Even more worrying is that, as the activity in the economy is falling, the size of the tax base supporting government activity will also be shrinking, causing yet more damage to the fiscal position of the government, which is already in a very poor state. The government will be forced into a further round of cuts.

What we will really see is the actual real output of the Greek economy being laid bare before us. If the ongoing injection of borrowed money is taken out of the economy, many of the jobs accross the economy will simply disappear. In a crude illustration, we might just focus on the amount of activity that is generated by a single civil servant going about their daily life, with their shopping, payment of bills, visits to restaurants and so forth. If the civil servant is made redundant, we can see how the effects of that redundancy will ripple through the economy. Our civil servant will stop their trips to the restaurant, may not be able to pay for their mortgage and put their house on the market, the local shops will lose a customer and so forth. Each of these direct losses of income to businesses will see further downstream losses of income, multiplying the effect of the losses.

It is notable that, within our one rather crude illustration, it is evident that our civil servant will no longer be able to support their mortgage payments. Bearing in mind that unemployment will be rapidly rising over the whole economy, this problem will be replicated over the whole economy. The price of housing will sink, and with it the collateral the banks used for their previous lending. The same will be happening to commercial real estate, as the many businesses that will find that they are in trouble, or going bust, will see a growing flood of commercial properties onto to the market, either for rental or sale. Prices of real estate assets in the country will start to collapse.

That collapse of real estate assets will take away the foundations for bank lending. As businesses go bust, and individuals become unemployed in greater numbers, large numbers of what appeared to be sound loans will become delinquent. The banks will start to make large losses on what had appeared to be prime lending. With the values of property falling rapidly, they will not be able to recover their full losses, and they will be on a fast track to insolvency. As they attempt to protect themselves against their losses, they will hold on to cash. They will not only hold on to cash to protect against insolvency, but also out of the fear that they simply do not know where future losses might originate; after all, prime lending is going sour before their eyes.

What we are seeing is that the assets in Greece have been valued not upon the basis of the underlying output of the Greek economy but upon the foundations of unsustainable overseas borrowing.

With bank lending in decline, sources of potential growth in the economy will be closed off. Furthermore, in the case of Greece, capital flight has already been taking place, but it will accelerate rapidly as the crisis progresses from bad to worse. The discovery of the mispricing of assets will create panic. Access to capital will diminish.

What we are seeing is a downward spiral that is resultant of Greece being forced to live within its actual means. To return to the GDP example, it is like the person who has been living on £110,000 having to move to living on £100,000. They find that they can no longer afford their mortgage payments, the trip to the expensive restaurants, and so forth. Moreover, they are now having to pay back their previous borrowing, and they find their disposable income is collapsing. They have no choice but to live a far, far more austere lifestyle.

The essential problem is this. The more a country borrows from overseas, the more it supports GDP growth (or forestalls GDP decline). As time goes on, the more businesses rely on the overseas borrowing in order for their businesses to be solvent, and the more employment is founded in borrowing from overseas. The more businesses and individuals that are reliant on the income from overseas borrowing, the greater the extent of assets being priced on the overseas borrowing. The greater the extent that assets that are priced on the basis of overseas borrowing, the more the banks solvency is reliant on overseas borrowing. In order for an economy to be kept from collapse, it is necessary to keep borrowing, and the more it borrows, the more the economy is adapted to survival on borrowed money.

The only solution is to break the borrowing spiral as soon as possible.

A long, long time ago I proposed reforms for the UK economy. At the time of writing I argued that the UK needed reform now. The reason for the urgency was the absolute necessity to keep creditors on board whilst the reform took place. My argument was that it was necessary to keep them onboard such that the transition to a more sustainable fiscal foundation could be undertaken with the minimum of hardship. I never pretended that it would be easy or painless, but I always had in mind the scenario I have just painted for Greece. Better to reform with the benefit of credit to ease the transition, than face the imposition of reform and change in a state of shock. I think I made the analogy of falling down a hole, or using a ladder to climb down. You arrive at the same place, but in the latter case without broken bones.

So here we are, about two years after I suggested reform, and no reform has been enacted. This applies to the UK, the US, and a host of other 'rich world' countries. Instead of using the access to credit to allow a transition to a sustainable and realistic economic structure, governments have chosen to use massive borrowing to support their faux economies, and frittered away the chances to make the transition to their real size as painless as possible. We have seen the situation get worse, not better. Rich world economies are now increasingly reliant on overseas borrowing, not less so. In doing so, governments have taken a severe crisis, and turned it into a potential catastrophe.

This is the lesson that Greece teaches us.

The Greek Crisis (again)...

Yet again, I have an unfinished post, and again it is due to events that I have changed direction. The Greek crisis has now entered a new phase, with the bailout from the IMF and EU finally enacted:

Greece bowed to market pressure yesterday and formally requested a bailout from the European Union and the International Monetary Fund.

It is the first time a eurozone member has asked for a financial rescue and it is likely to test European political cohesion as well as the stability of the euro itself.

Greece asked for the €45 billion package after being downgraded by the Moody’s credit rating agency on Thursday.

The first problem is that it is just not going to be enough. The problem of the scale of Greek debt is worse than was feared:

Greece' deficit for last year is worse than the cash-strapped country originally reported and could still be revised higher, the European Union said Thursday, news that weighed on the common currency. A sharp upward revision to the 2009 figure, which sent Greek bonds into a tailspin, was surprising because Greek officials just two weeks ago denied reports of a big spike.

And the bailout will only take Greece so far.....

However, there are concerns that despite the unprecedented scale of the loan, it will not be sufficient to do little more than buy the country time, allowing it to finance its state only for another few months. The full details of the loan will not be laid out in the next few weeks, as IMF and euro area officials hammer out an economic plan for the country, which is likely to involve further severe cuts in public spending.

Then there is the problem of the potential challenge in Germany as to whether the Greek bailout is unconstitutional:

The German constitutional lawyer seeking to derail Berlin's contribution to a Greek rescue plan said he likes his chance better this time than in 1998, when he tried unsuccessfully to block Germany's adoption of the euro.

Karl Albrecht Schachtschneider, a retired University of Nuremberg law professor and expert on the constitutional court, said he believes that the Greek aid package is in clear violation of European treaties and the German constitution and sees a chance of convincing the court this time.

What may seem a contrarian quest has attracted attention in financial markets, where investors fret over any sign that Germany would withhold or even delay providing its share to the EUR30 billion rescue plan if Greece requests it.

Schachtschneider is drafting the legal complaint with three other established euro skeptics, all of whom are into retirement age.

Working with him are economics professors Wilhelm Hankel, Wilhelm Noelling and Joachim Starbatty. Noelling is a one-time governor of the Bundesbank, Germany's central bank. The same foursome were behind the ill-fated legal challenge 12 years ago.

I would like to give some perspective on whether the challenge might be realistic, but must confess that I have no particular insight on the issue. Some time ago, when first reading about this (sorry, no references), I did see some fairly persuasive cases for the challenge, but still remain on the fence with regards to whether the challenge might gain traction.

As I have posted before, the real issue of interest is the wider consequences of the Greek crisis. When first starting this blog, I contemplated the possibility that the Euro might not survive the crisis, and others are now seriously contemplating this possibility. This is Edmund Conway of the Telegraph writing from the G20:

Though they don’t admit it, they also privately suspect that this crisis will be the biggest challenge yet for the euro project. And for many it is no longer anathema to suggest that the euro may not survive this crisis – at least not in its current form.

I would agree that, at the very least, that there will be strong pressure to reform the structure, with Germany leading the way. Of course, the only kind of reform that might work is closer regulation of Euro-wide fiscal policy, which implies a significant loss of sovereignty of Euro member countries. Somehow, I suspect that, even for those who support the European project, this might just be too much.

Then there are the next contenders for debt crisis. Spain and Portugal are looking increasingly vulnerable:

Iberian stocks fell sharply Thursday amid concern the escalating Greek debt crisis could spread to other southern European countries with troubled finances.

Madrid's IBEX-35 index ended 2.19% lower at 10,821.9 points, while Portugal's PSI-20 index closed 2.57% down at 7,751.95 points.

"There's confusion and a great insecurity in the market," said Karsten Sommer, a trader at BCP in Lisbon, adding that rising government sovereign yields are bad news for stocks.

As Moody's Investor Service Inc. downgraded Greek sovereign debt, the cost of taking out insurance of Greek government bonds through credit default swaps surged about 10% to 620 basis points earlier Thursday. Spanish CDS spreads were also pushed higher to 171.5 basis points from 158.5 earlier in the day, while Portuguese CDS spreads moved to 260 basis points from 232.

Banking stocks were hit hard, with Banco Santander SA (STD) down 3.1% to EUR9.91, and Banco Bilbao Vizcaya Argentaria SA (BBVA) plunging 3.1% to EUR10.55. Portugal's Banco Espirito Santo SA (BES.LB) shed 4.1% to EUR3.569 after a Nomura downgrade.

....then there are the banks that hold Greek bonds, with the largest holders in France and Germany. A Greek default will put new stresses on an already stressed banking system. Unlike commercial loans going sour, it will be hard for the banks suffering such losses to have the news buried or obscured:

Private investors are already seeking ways to decrease their exposure to Greek debt although European banks appear to own some 58% of Greece’s 270 bln euro debt. Greece’s indebtedness to European banks appears to have been one of the key facts that convinced Brussels to take the lead and seek a mainly European solution.

It is worth reminding readers that the Basel rules gave OECD debt a zero risk rating in the calculation of capital adequacy ratios..... These are the same regulators who will now, apparently, be able to foresee future risk and prevent it. The new regulation will, of course, learn the lessons of the past, implement a new and more secure structure, and so forth. Just as they do after each crisis and problem.....and remember, this is not new obscure financial instruments, this is sovereign debt. This has been around for centuries.

With regards to the next phase of the crisis, it is tempting to use emotive expressions such as 'now that the markets have tasted blood...' and all of the cliches that we see in so many articles. However, it is not a question of 'tasting blood', but rather the facing up to the reality of the terrible fiscal position of so many 'rich world' nations. The markets, the holders of 'safe' sovereign debt, are just waking up to the fact that it is not, after all, safe.

The big questions, aside from the crisis in Greece is who is next, and where the bailout money might come from? Will the EU also be prepared to bailout the next country in line, or the next....? How about the IMF? Can it fund a series of EU country bailouts? As has been discussed in the case of Greece, this bailout is likely to just be the first tranche....Greece will need further finance later. Then there will be the steep fall in Greek GDP as the austerity bites, and the picture will be one of a GDP to debt ratio moving in the wrong direction....it will not be pretty. This will cause even more alarm, as the markets see what happens to an economy that is mired in debt and where GDP has been sustained/obscured with debt.

And then...if the crisis gathers pace, will the markets start to look at economies such as the US, the UK and Japan. For example, Japan has now had a rating downgrade:

Fitch Ratings said Thursday that Japan's credit ratings face downward pressure in the medium term due to the ballooning debt, increasing the urgency that the government come up with a plan to get it public finances under control.

"In the absence of sustained economic recovery and fiscal consolidation, government debt will continue to rise, placing downward pressure on sovereign credit and ratings over the medium term," the credit-rating agency said in a report.

"The Japanese government is one of the most indebted in the world," Fitch said in the report titled, "Just How Indebted Is The Japanese Government?"

Fitch estimates Japan's headline gross government debt reached 201% of gross domestic product at the end of the last year, the highest ratio of any country the agency rates.

Any downgrade would elevate market concerns about Japan's creditworthiness and could prompt investors to unload their government bond holdings.

"It's important to show that the government is managing fiscal policy in an appropriate manner," Cabinet Office Senior Vice Minister Motohisa Furukawa said at a press conference following the release of the report.

Just for the sake of interest, I undertook a Google new search for 'sovereign debt' and found an article that is illustrative of the growing concerns in the media:

So here’s a brief look at some aspects of the UK’s debt vulnerability compared with that of France, using a useful table in an IMF report issued this week. (The link is below).

It shows the rating agencies agree with the continental finger-pointers. France’s top triple-A rating is stable; while the UK’s has a negative outlook. That’s even though the UK’s deficit at the end of this year will be below France’s, at 78% of GDP compared with 84%.

By some measures, France is more vulnerable. Foreigners tend to be more skittish than domestic bond holders and foreigners hold only 22% of British debt, compared with 58% of France’s. On top of that, a fifth of France’s debt is maturing in the next year, compared with 8.4% of UK government debt.

The article is not of particular interest of itself, but for the way that it is framed. The article is about relative vulnerability. The framing of the article speaks volumes. The IMF now sees sovereign debt crisis as a real possibility, and they are a long way from the (sometimes) radical musings of a blogger - they are the embodiment of the mainstream:

Greece's upheaval could mark the starting point of a "new phase" in the global crisis if countries don't get their fiscal houses in order, despite the low risk of contagion, the International Monetary Fund said Tuesday.

While the IMF slashed its projections for bank losses from the crisis to an amount deemed manageable, the rapid buildup of sovereign debt among advanced countries to levels not seen since the end of World War II has emerged as the biggest threat to global financial stability.

"In spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured," said Jose Vinals, director of the IMF's monetary and capital markets department, at a press conference to discuss the semi-annual Global Financial Stability Report.

"If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the real risk of undermining the recovery and extending the financial crisis to a new phase," he said.

All of this leads to a question. When, and under what circumstances are the policymakers, the politicians and economists cheerleading for fiscal profligacy going to wake up to what is taking place. When I first started writing this blog, the situation was different. Reality was obscured, theory was not being tested in the real world, and there was some kind of excuse (albeit a poor excuse) for the lunatic policy that was being enacted. As we now see the consequences, there is simply no excuse for the continuation of the madness, but still it continues.

Notes:

The UK election has taken some unusual twists and turns of late, with the Liberal Democrats making a big splash. However, I am not convinced that they, any more than the Conservatives or Labour, are serious about the dire fiscal crisis. Interestingly, some commentators and analysts seem to think a hung parliament is not a problem. I am agnostic on this, as it is always possible that the right leader, and the right coalition might work, but do recognise that this represents big uncertainty. What will finally matter is not who does it, but what they do.

Yet again, some very interesting comments on the last post, and it good to see some further challenges to Lord Keynes. Interestingly, his view of economics is now starting to face the real test. I would like him to be right, as I do not want what is coming, but alas I think this unlikely.

My original post was on housing / real estate, and I will try to finish in the week.