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What is happening on the sovereign debt market must be really incomprehensible to many economists and commentators (professionally) grown up over the last thirty years or so. Indeed, most everything that had become conventional wisdom over the post-Lucas (1974) paper seems to have become irrelevant: distinguished colleagues who have lived their life in terror of inflationary bouts following monetary (or fiscal) expansions are witnessing falling producer prices quarter after quarter; those who believe(-d?) that interest rates have an impact on investment spending are lost in a world in which discount rates are at zero (the intended federal funds rate) or 1% (the refinancing rate), when the President of the Federal Reserve System announces that those values are going to stay for a long time to come while announcing an increase of the discount rate; and those who believe in the thaumaturgic powers of ‘the markets’ to bring equilibrium if and when unencumbered by policy interventions must surely feel like those great politicians who, in the thirties, thought that a good financial crises would ‘cleanse the economy of its excesses’ -whatever that means.
Perhaps the ballooning debate about the likely effects of the Greek Government’s recently uncovered large deficit and debt would be a good starting point to begin understand both the situation on the bond market and the general outlook of the current crisis.
The article is organized as follows. In section 1 I briefly discuss the background of the current situation on the sovereign debt market. One can always expect to learn something interesting from such exercises; Section 2 reviews the basic economic mechanisms leading to the 1992 crisis. Here the question to answer has to do with what economic theory has to say about the current situation as opposed to the 1992 one. Section 3 highlights the differences between then and now; conclusions are reported is Section 4.
1. Recent history -just so one can get a bit of a historical perspective on things
The European Monetary Union was ‘officially’ born on January 1, 1999, when the European Central Bank took over from the European Monetary Institute and the Euro became unit of account and means of payment for official transactions among eleven of the fifteen European Union member countries. Greece joined two years later, having required extra time to fall in line with the basic parameters mandated by the Maastricht Treaty and the Amsterdam Stability Pact. There were rumors that the Greek Government had had serious problems achieving the target, but then there had been similar rumors about a many other member countries which had joined one year earlier: the EMU was a milestone in the process of European integration and enlargement, and if not corner-cutting, some leniency was, as it should have been, adopted in those instances. Those who pretend not to have known deserve no comment.
Skip four years. On March 7, 2004 Mr. Kostas Karamanlis, the nephew of the Karamanlis who engineered the transition of Greece from a military dictatorship to a parliamentary democracy, won general elections and became prime minister. Mr. Karamanlis chose not the let his first mandate expire, and called general elections again on September 16, 2007. Again, he cut the life of his Government short in the Summer on 2009, called the general elections and lost them. Mr. Jorgos Papandreu, the son of Andreas, took over.
Mr. Karamanlis conceded defeat on the 4 October, 2009 elections, just about five and one half years after taking office for the first time. A careful review of the official warnings issued over period by the European Commission to national governments on matters related to their ratio of deficit to Gdp, or that of debt to Gdp, would certainly unveil that such warnings were many and timely -yet, one has difficulties remembering that warnings to the Greek Government were sharp, frequent, and costly (for the Greek Government).
It is even harder to remember warnings of impending ‘downgradings’ by rating agencies over those years. Yet, it is certainly a fact that one of them, Fitch, cut Greek sovereign debt rating to A- from A on October 22, 2009 -that is, seventeen days after the Head of the two consecutive Governments in power for the previous five and one-half years resigned. This is truly amazing: what happened between October 5 and October 22 that has led a rating agency to ‘downgrade’ the Greek Government’s debt? A quick review of the international press over those two weeks or so does not reveal any major shift in the world economy -or the Greek one, for that matter. The only apparently relevant news was the demise of a right-wing government and the taking-over of a left-wing one.
The entire history of the current financial crisis shows that rating agencies have a way of being good followers, once one of them takes the lead. Below a quick overview of the agencies’ actions taken following Fitch’s strong lead:
October 22: Fitch cuts Greek sovereign debt rating from A to A-
December 8: Fitch lowers the rating further from A- to BBB+
December 16: Standard & Poor’s cuts rating from A to BBB+
December 22: Moody’s cuts rating from A1 to A2
December 24: Parliament approves 2010 budget
January 6: EU and ECB delegations arrive in Athens
January 14: The government approves a three-year stability and growth program
2. What has economic theory to say about this all?
Suppose it were 1992. Assume Greece (here you may read ‘Italy’ or ‘UK’ indifferently) to be a small open economy well integrated in the world economy both on the trade and the capital movements side. Assume now that a rating agency ‘discovered’ that the debt issued by the Greek Government no longer deserves the rating hitherto assigned, and that it went public with the announcement of downgrading: what happens on the basis of elementary, and sound, economic theory?
It simply happens that portfolio holders throughout the world will sell Greek Government bonds in exchange for national currency, go to the foreign exchange market and sell that currency in exchange for a foreign one, and then go on and sell it to purchase foreign bonds1. If the world is running on a system of flexible exchange rates, then the currency issued by the central bank of the country whose government’s debt has lost appeal in the eyes of the rating agency will depreciate vis-à-vis the foreign currencies. This is happening in a very short period of time -it took the Italian lira anywhere between a week and three months, according to what one believes the ‘starting date’ was -the endpoint being, of course, the day in which the lira was let go.
But, one may ask, what if the exchange rate regime is one of fixed rates? Well, the story goes exactly the same way, the only difference being that instead of having the exchange rate bear the burden of adjustment it will be reserves denominated in foreign currencies that will do that: foreign reserves at the Greek Central bank would be spent to absorb excess demand of foreign currency, until they are deemed to be at such a low level that the governing body of the Bank quits using them to buy its own currency and announces devaluation of the domestic currency2.
Thus, whatever the exchange rate system the world is adopting at the time of the downgrading, it is the foreign currency price of the domestic currency that finally bears the brunt of the adjustment. Later, in the longer run, the international price competitiveness gained by domestically produced goods and services through the depreciation/devaluation will make its effects felt on the current account balance, while the same depreciation/devaluation will generate higher costs for the import of raw materials and intermediate inputs, thus generating some degree of inflation which will depend on the extent to which domestic consumers and domestic producers rely on foreign goods and services 3.
3. Differences between then and now
Just as Italy and the UK had to let the exchange rate of their respective currencies govis-à-vis falling demand for their respective national governments’ obligations, so would have Greece. But here we have a problem: Italy’s lira does not exist any longer, as does not the Greek drachma, though the British pound is still there. Given the exchange rate channel does not work as it used to be in 1992, that is, given that a depreciation of the national currency (the drachma) is no longer possible, what other economic variable will absorb the shock? This is THE question we are facing.
New question, new model. Now the Central Bank of Greece does not have a currency of its own -in slightly more accurate terms, it cannot decide what amount of liquidity will be in circulation or, which we may assume to be roughly the same thing, what the level of interest rates will be. We say that monetary authority has moved elsewhere, a place where decisions on matters monetary are taken by a body in which Greece counts, at least nominally, as one out of sixteen. But Greece, just like any other one of the remaining fifteen, retains a national government, whose authority can explicate itself on matters fiscal, that is, level and composition of spending on the one hand and level and allocation of fiscal revenues on the other.
Within the logical framework of the Maastricht Treaty, and given the policy goals shared at the time, this is a potentially dangerous situation for a member of the EMU. Any government of a member country will necessarily find itself compelled to deficit spending for two excellent reasons: first, because all governments like it, votes being conquered through deficit spending; and second, because the monetary stimulus needed at the national level is no longer there, so long as the European Central Bank decides that an expansionary monetary policy is not in order. This is precisely the reason behind the ‘3% rule’, that is, the rule according to which national governments bound themselves to not let deficits run above the level represented by the 3% of Gdp.
The key difference between 1992 and 2010 should now be apparent: while in 1992 a large and growing government deficit (and debt) forced national currencies´ depreciation, in 2010 this is not possible for the very lack of the raw material: if there is no drachma, the drachma cannot depreciate4. What gives, then?
Imagine what the difference could be between the town of, say, Milano, and Italy in 1992. The City of Milano running a large deficit would induce a depreciation of the Italian lira only insofar as the municipal deficit were accounted as an item in the general government deficit. Suppose it were (which is the most adverse scenario for the point we are making here): then what? We may legitimately imagine that a large and growing deficit by the City of Milano would generate a depreciation of the lira in some sense proportional to its share in the total deficit of all Italian governments, central and peripheral.
It follows that, beginning in October 2009 and thanks to ever-watchful rating agencies, we would have to expect a depreciation of the Euro somewhat proportional to the share of outstanding Greek sovereign debt to total sovereign debt outstanding in Europe. Indeed, such depreciation has taken place vis-à-vis the Us Dollar (and therefore the Ren Min Bi, which exchanges against the Dollar at a fixed rate) 5. So, why should anything else happen at all? Why such a tremendous amount of press? Why do we read about ‘bailing out Greece’? Why the very existence of the EMU is being questioned? And why do we read that “America is nowhere near a Greek-style crisis” (the Financial Times, 12 February 2010, letter by Mr. George Magnus, Senior Economic Advisor at UBS Investment Bank), when the projected 2010 deficit/Gdp ratio is not at all dissimilar from that of the Greek Government?
4. Have we learned anything at all by reading this piece?
To make a long story short, we have learned that:
1. Social-Democratic Greek Governments are the object of very intensive scrutiny by rating agencies;
2. There is nothing about the Greek Government’s debt that needs ‘bailing out.’ All it needs is buying. There is little doubt that buying requires rates of return higher than those paid by the previous Government. Whether the buying requires that international bondholders be reassured by fifteen EMU Governments is a call for politicians to make, but it appears rather obvious to us. But buying by one very special economic agent would still be problematic: given its current ‘grading’, much Greek Government’s debt fails to qualify as collateral for cash borrowing from the Central Bank. The FED has been accepting all sorts of private debt in the desperate attempt to keep the Us economy liquid: what, exactly, would be wrong, if the ECB acted along similar lines?
3. Under international capital mobility and flexible exchange rates it is the domestic currency price of foreign exchange that bears the weight of adjustment. Thus, we can expect a depreciation of the Euro roughly proportional to the weight of the Greek Government debt on total outstanding EMU sovereign debt. Anything more than that would be the result of speculation;
4. To be sure, there is nothing wrong with speculation. But, it would be nice to remember, speculators are betting on the weakening of the Euro. Is the 2010 EMU as weak as the 1992 EMS was?
5. Of course, different is the UK position. Pound sterling freely floats against all major currencies, and it will suffer from the growing debt of its Government just as economic theory predicts.
Having said all that, what is the future going to look like for Greek residents/taxpayers?The answer is straightforward: bleak. Cutting the deficit will imply a mix of tax increases (such as the 1% increase in VAT suggested/required by some EMU governments) and spending cuts. The deflationary-recessionary effects of such measures are guaranteed: in the short run production, employment and prices will fall way more than the EMU average. Certainly, in the longer run tourist and construction industries will benefit greatly from such developments, as the Country will attract foreign tourists and buyers of residential property. But for two-to-three years at the very least economic conditions in Greece will be very, very hard -as hard as fifteen EMU governments and one Central Bank will desire it to be.
1 For the sake of simplicity we are assuming here that sovereign debts are the only bonds in the market. Conclusions do not change is one were to allow for the existence of private bonds as well.
2 Needless to say, if the exchange rate system is a mix of the two regimes, just as it were in 1992 for Italy and the UK, similar results would obtain.
3 These observations will be useful later on, when we will be looking at the likely developments of Greek employment and Gdp.
4 This point is so obvious that Martin Feldstein has suggested temporary reintroduction of the drachma as a way for Greece to ‘take a holiday’ from the EMU and re-enter it once a sufficient degree of depreciation of the drachma vis-à-vis the euro will have been validated by the markets. This suggestion is not discussed here further, but the reader can certainly perceive the tremendously disruptive power such procedure would have on the process of European integration.
5 It goes without saying that we do not believe for a second that the cause of the Euro’s depreciation vis-à-vis the Dollar – Ren Min Bi couple is due to the ‘Greek events,’ but that is beside the point.