Thursday, October 27, 2011

Dealing with the Basic problem of Euro Debt vs Financial Engineering

Many imaginative, perhaps, even innovative approaches are being proposed for dealing with Euro crises. They contain a wealth of interesting ideas and mechanisms that can be useful in designing solutions.  There is a danger however, of getting lost in the minutiae of solutions and forgetting the basic fundamental economic problem that has to be addressed.     One of the most important lessons of the financial bubble and the subsequent financial crisis in the USA was that the slicing, dicing and recombining risk through levels and layers does not necessarily help risk diversification; it can as likely help to hide risk from innocent buyers of these products and make it easier to fool them into thinking that the risk has somehow dis-appeared.  In other words, the finest financial engineering cannot make the existing risk magically vanish, it can only hide it and confuse the na├»ve for a while.  Even the latter will be short lived as long as the memory of the financial crisis remains in the public mind! It is therefore useful to go back to the source(s) of the Euro crises and reiterate the essential economic measures that are required to diffuse the crisis!
There are five elements of any viable solution.  These are presented in their simplest form without bells and whistles, perhaps even in over simplified form in the light of the previous point.
(1)   Countries with unsustainable debt (GIIPS?) must put it on a sustainable path through a combination of fundamental reform of the expenditure, tax, transfer and growth policies.  The objective is to meet the sovereign debt sustainability condition [g-r+Pb > 0, where g = GDP growth rate, r = real interest rate on sovereign debt, Pb = Primary balance]. In this context it is important to remember that a fiscal squeeze by previously extravagant countries is not a morality play but an attempt to meet the debt sustainability condition!  Thus, beyond some point (the optimal) an immediate and sharp fiscal squeeze will reduce growth more than it increases the primary balance or reduces the real interest rate and thus make the fiscal situation less (not more) viable.
(2)   Greece (+Portugal?) is in a situation in which even the optimal policy mix outlined in (1) cannot put it in a sustainable path without debt restructuring.  In other words, Greece has been structurally insolvent for the past year or so.  The ‘grant’ funds needed to convert this problem from one of insolvency to one of liquidity must come from somewhere outside Greece - no amount of financial engineering can make this fact disappear.  Rough calculations suggest that a 60% haircut on Greek government debt would be sufficient to make Greece solvent.  It seems logical and fair that those who took the risk (or deliberately overlooked it) to earn higher returns (profits, bonuses) from Greece should pay when the risk materializes.
(3)   A Greek debt restructuring will have consequences for Euro area banks who have lent to Greece.  These consequences should have been anticipated and dealt with at least a year ago, by recapitalizing the banks.  The European Banking Authority now (reportedly) estimates these cost to be of the order of Euro 80 -100 bi (FT  Oct. 20, 2011).  To the extent that private investors are unwilling to raise the equity in these banks, the home country of these banks will have to provide the capital.  The 60% haircut on Greek debt presumably accounts for the indirect cost to the Greek Govt. of the effect of this default on Greek banks.  Other affected countries would also have to do the needful.  To the extent that the home country is not in a position to recapitalize, support is needed from outside the home country- the EFSF can be used to provide this additional support, either for direct financing or to underwrite repayments.  If the above estimate is correct, there will be money left over in the EFSF to strengthen the provisioning of bank loans to governments of countries that are on the border line of solvency, so as to remove doubts about potential contagion to these countries.
(4)   Once the direct and indirect effects of solvency problem are addressed, the borderline Euro area countries, such as Spain and Italy (along with Greece and Portugal), would be left with a liquidity problem.  If the ECB acted like a normal country central bank, such as the US FED, it could provide as much liquidity as needed to solve the liquidity problems of Spain and Italy.  As there is no explicit medium-long term grant element (once steps 1-3 are undertaken), there is no logical reason for not doing so in a period of low demand and low inflation (only ideology or primordial fear).  To the extent that mark to market accounting will impose temporary balance sheet losses on the ECB, the EFSF could be used to provide fiscal support till the markets stabilize and return to normal (at which point the ‘mark to market’ profits of ECB would revert to the EFSF).

A simple example illustrates.  Assume that the long term interest rate for a solvent Italy is the German rate +0.5%.  Because of all the problems outlined above, the premium above Germany has gone up to 2.5% (say).  Thus the ECB will be effectively picking up the risk equivalent to 2% points for debt coming due in the next 6 -12 months and will therefore constitute ‘mark to market losses’ in its balance sheet of this amount.  This fiscal cost has to be borne by the EFCF till the markets realize that the problems at 1-3 have been addressed (after which Italian interest rate will go back to the German rate +0.5%).  Thus the fiscal cost is borne by the EFCF not the ECB – with Euro 300 billion of Italian debt coming due in the next 12 months (in this example) the temporary fiscal cost to be borne by the EFSF will be Euro 6 bi).  The ECB provides the liquidity, whether directly or through Banks.

(5)  Finally for other non-Euro area countries that may be affected in the days/weeks/months following a Greek debt restructuring, the IMF must stand ready to provide liquidity support to “innocent bystanders”.  The IMF still has sufficient funds for this purpose, and these could easily be augmented to the needed extent, if prior action has been taken on points 1 to 4 above.

The longer the basic problems outlined above remain unaddressed, the more difficult they become to address, as private creditors gradually reduce their exposure to insolvent countries at the cost of official and multilateral lenders and borderline solvent countries are pushed over the line by rising interest rates.

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