Saturday, November 22, 2014
8

Captured Europe

WASHINGTON, DC – Europe’s policy elite – the people who call the shots at the national and eurozone level – are in serious trouble. They have mismanaged their way into a deep crisis, betraying all of the lofty promises of unity and prosperity issued when the euro was created. The currency union may survive, but, for millions of people, the euro has already failed in its mission of sustaining growth and ensuring stability. How did this happen?

The Greek, Portuguese, Irish, and Italian economies are reeling under fiscal austerity – with budget cuts and higher taxes as far as the eye can see. This policy mix will slow their growth, and that of the rest of Europe.

But that is only part of the problem. The bigger issue is the “debt overhang” that has forced European governments to pursue this course. There are strong parallels to what happened in the United States in the past few years: many families felt crushed by their debts, so household consumption fell and has yet to recover. The adjustment will be even more painful in Europe, because a sovereign-debt crisis has a depressing effect on everyone – consumers, investors, and the public sector alike.

There is a simple way to deal with a debt overhang: reduce payments by restructuring the debt. Many firms are able to renegotiate financing terms with their creditors – typically extending the maturity of their liabilities, which enables them to borrow more to finance new, better projects. If such negotiation cannot be achieved voluntarily, US firms can use Chapter 11 of the bankruptcy code, under which a court supervises and approves the reorganization of liabilities. So you would think the same would be true for US households and embattled European governments. But the restructuring of debt has been too little and has come too late. Why?

In both cases, the main argument for not removing the debt overhang came from bankers, who claimed that it would create havoc in financial markets for two reasons. First, banks were the primary creditors, and the large losses that they would face in any restructuring was bound to trigger a domino effect, with waves of pessimism driving up interest rates and ruining other borrowers’ prospects. Second, banks would also suffer because they had sold insurance against default – in the form of credit-default swaps. When these swaps were activated, the banks would incur potentially further crippling losses.

In the case of Greece, international bankers argued long and hard that debt restructuring would generate contagion far and wide within the eurozone – and perhaps more broadly. And yet, in the end, Greece had little choice but to restructure its debt, cutting the value of private claims by about 75% relative to their face value (although even this is probably not enough to make the country’s debt burden sustainable). This was deemed a “credit event,” so credit-default swaps were exercised: anyone who insured against default had to pay out.

Did all hell break loose? No. Banks have not failed, and there is no sign of tumbling dominoes. But that is not because banks prepared themselves by raising more capital. On the contrary, compared to their likely future losses, European banks have raised relatively little capital recently – and much of this has been creative accounting, rather than truly loss-absorbing shareholder equity.

Perhaps the risk that a Greek debt restructuring would cause a financial meltdown was always minimal, and quiescent markets were to be expected. But, in that case, why all the fuss?

The answer should be clear by now: interest-group politics and policy elites’ worldview. Even if the risk to the financial system was minimal, the impact on banks and bondholders was substantial. They stood to lose billions, and many financial-sector employees stood to lose their jobs. Not surprisingly, leading bankers lobbied against debt restructuring, both behind closed doors and publicly.

For example, the Institute for International Finance, a preeminent Washington, DC-based lobbying group for large banks, consistently argues: bail us out, or else face the consequences. But, just as important as their storyline is their political power, which has risen greatly in recent years – to the point that all major policymakers in the US and Europe cater to banks’ fortunes even when there are no wider implications for the economy.

Even now, many of the losses that bankers should have faced are being shouldered by the public sector, including through various forms of direct support and the extraordinary and risky actions of the European Central Bank. The extent of subsidies in this sector is stunning and, under current policies, will only increase over time – thereby primarily supporting the lifestyles of the top 1% of people in very rich countries.

The Greek default has turned out to be the proverbial dog that didn’t bark. The lesson for Europe – and for the US – is clear: it is time to stop listening to what banks say, and start focusing on what they do. We must re-evaluate the distorted political economy of the financial sector, before the excessive power of the few imposes even larger costs on everyone else.

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    1. CommentedMark Pitts

      In minimizing the seriousness of the Greek situation, the authors demonstrate that they are out of touch with the real world.
      If there were any hint that banks and other private investors would have to take loses in countries other than Greece, private investors would immediately begin dumping sovereign bonds. The ECB and the rescue funds (the “official” investors) would step in and buy to keep yields from surging, This would have the perverse effect of creating even steeper selloffs, since the remaining shrinking pool of non-official investors would be subject to larger and larger haircuts as the official investors are exempt from such losses.
      No the world did not collapse due to the Greek loses, but only because the EU authorities chose not to follow the prescription of the authors.

    2. CommentedMark Pitts

      How can the authors complain that the public sector may have to shoulder some of the losses at the banks, which were caused by mismanagement in the public sector? Surely most readers see the absurdity of this.

    3. CommentedProcyon Mukherjee

      I find it quite apt to reproduce part of Brad DeLong's treatise 'Fiscal Policy in a depressed Economy': Quote-" Fiscal policy in a depressed economy is self-financing as long as:

      r < g +τημ/(1-τμ)

      where r is the real Treasury borrowing rate--take the nominal Treasury borrowing rates and subtract 2%--g is the growth rate, which is 2.5%; τ is the fraction of GDP that shows up as increased tax revenues and reduced social-insurance transfers, which is 1/3; μ is the (debatable) standard Keynesian multiplier when monetary policy is at the zero lower bound; and η is the (largely unknown) hysteresis shadow a long, deep depression casts on future potential output.
      "As we, at least see it, it is possible to be highly confident that the depressed-economy standard Keynesian multiplier when monetary policy is at the zero lower bound μ is greater than 1.0, and substantially confident that the hysteresis shadow η cast by a long, deep depression is greater than 0.05.
      "The arithmetic means that over the past four years fiscal policy has been self-financing, and would be self-financing unless the real Treasury borrowing rate is rapidly going to become greater than 5%--unless the nominal Treasury rate is rapidly going to burst through 7% heading upwards. It has simply never been at such levels seven for a short span of years during and immediately after the Volcker disinflation.
      "Thus even if you think that the United States is on the edge of some kind of fiscal crisis and may be about to transit from a low interest rate "confidence in government" to a high interest rate "panic" equilibrium, increases in debt-service loads relative to GDP from fiscal austerity are more likely to shock the system into the bad equilibrium than are policies of fiscal expansion which over the past four years would--exceptionally and extraordinarily--have, for once, by the arithmetic, paid for themselves." Unquote

      This explains why it is so fundamentally important that interest rates are kept on check as the primary objective function, all the rest are secondary in the current context of the fiscal position of governments, whether EU or U.S.

      Procyon Mukherjee

    4. Commentedandrea naldini

      Banks should come back to make their profession: taking money from housholds and giving it to firms. All the rest has given very little support to the real economy. According to what you say, why not nationalising banks? The economic costs wold be higher than the current ones?

    5. CommentedJonathan Lam

      Gamesmith94134: Good and Bad Deficits 2-20-2012

      Seriously, I think the austerity program is harmful to the health of one’s’ economy if it have affected the basis of the maintenance and development to grow. In term of the recession or under-achievement time, it would deteriorate less availability of revenues from the cut of programs. Some may cause negativity of the social imbalance like unemployment or social unrest. It is understandable in pursuit of the fiscal balance or debt deficits are significant to its future balance of budget; but most the austerity programs are hemorrhagic because of the layoffs to the shrinkage of the economy.

      I often find those deficit hawks wore more ear-marks than local, and the project have been altered its own limits to accommodate the desires to control. Then, commission or operatives adhered to the operation that expanded its linkages to ear-marks. Eventually, the sovereignty projects were exploited through family of linkages and ear-marks on the opposition. Consequently, the cost plus control after environment and financial adjustment, price went into folds to the original planning or disposition of the project that put them to work, nurture their skills, and equip the country with assets.

      Or does these boondoggle turn into tit- for-tat can ease on the tension family of linkages and settle on the ear-marks among the developers after they rally politics on its social issues like employment and education? Many believe these are unfazed by the corruption and waste that turns into the ‘Irrational Exuberance’ as shown in the past, like the toll turn out to be the contribution to remodeling of the mayor’s luxurious office.

      However, the governments often choose to the build-up or maintenance on the infrastructure projects over social programs like education; but the rationale on the material and human resources over cost and revenue, I favor lower cost in hiring people to work with revenue returned over the larger infrastructures with higher cost. I made jokes on the eight workers watering the pots of plants at the center of the road during the exhibit in China, but what if the water truck costs over half a million and a $50/hr drive to operate. Strategically, the low cost of eight workers over years and timely disposal of the plant sounds more efficient than the fancy water truck and its great driver.
      Based on What Adam Smith wrote in The Wealth of The Nation, it gave a clear distinction of the sovereignty debts and duties; that the profit could never repay the expense to any individual, or small number of individuals; and which it, therefore, cannot be expected that any individual, or small number of individuals, should erect or maintain. .” And my vision of the financing sovereignty must put localization to innovate in the processing of the projects, after the decentralized of the public institutions through the political process.

      The government should establish a National Infrastructure Bank to provide the finance by borrowing directly, attracting private-sector funds, or a mixture of the two. Then, the supervision and monitory can be developed its oversights in bi-level environment and balance itself through the private and public levels. Perhaps, I am talking of the Sovereignty bonds should be trade through the State Banking system or National Infrastructure Bank to the central banks or World Bank, then, the transfers to the Development Bank. Then, the equitable can be purchased through Insurance companies or equitable entity to ensure supervision and monitory system function properly; and the public institutions are yield to the scrutiny of the public monitories. Eventually, I am certain that the insurance companies can do a better inspection of the progress over time and ensure the necessity of alternation and adjustments. Perhaps, such process can avoid further interruptions and succeed in completion of the projects with proper appropriation and timely financing. In due time, the process of the transitory and monitory system can establish certain trust, then, the private investment can participate its secondary after the proposals; if only the system allows the genuine bi-level supervision and monitory are put in effects.

      At least, education can be greater deposit to the assets of the national wealth and social complacency; and employment can generate tax form revenues and students can have a better position in seek a better future. I am sure there are good and bad deficit, if there is an applicable and reliable system to service in the sovereignty level.

      May the Buddha bless you?

    6. CommentedZsolt Hermann

      The last paragraph of the article is encouraging:
      "...The Greek default has turned out to be the proverbial dog that
      didn’t bark. The lesson for Europe – and for the US – is clear: it is
      time to stop listening to what banks say, and start focusing on what
      they do. We must re-evaluate the distorted political economy of the
      financial sector, before the excessive power of the few imposes even
      larger costs on everyone else..."
      But it is still only the tip of the iceberg.
      At the moment the financial institutions have become the overhead
      controlling decisions, every stimulus, bailout starts with the banks
      with little care for the "little people" who have to shoulder the real
      burdens, just look at Greece, the tope layer is celebrating at how
      they "saved the country" while it is still unclear how the public will
      cope with austerity, and the same question will be raised in other
      countries as well.
      But pointing fingers at the banks is not helpful because it is missing
      the points. The financial institutions have not become the "bad guys"
      by themselves. After all they are only serving the system, which in
      order to be capable of the excessive production/consumption profit
      accumulating machinery needed the credit and some more credit, thus
      banks become the linchpins in the system.
      We cannot regulate the banks while leaving the system untouched.
      The only true remedy that can really solve our problems is the return
      to necessity and resource based economy and a governing and financial
      system that assists such structure.
      It is not like we have much choice. The present system is leaking all
      around and it is only a matter of time when even the most die hard
      fanatics will stop calling our situation crisis, recession and accept
      that we reached a system failure.
      It is always easier to start building a new structure while the old
      has not fully collapsed, when we still do not have to make panic
      reactions simply to survive.
      Finally we have to accept we moved on in our evolution, we live in a
      different reality today, and thus we have to adapt.
      If we do everything optimally we will understand that what today we
      call "unemployment", "crisis" is actually a liberation process where
      we free ourselves from slavery from the constant growth, profit
      chasing "Matrix" that has been poisoning our lives for decades.

    7. CommentedZsolt Hermann

      The last paragraph of the article is encouraging:
      "...The Greek default has turned out to be the proverbial dog that didn’t bark. The lesson for Europe – and for the US – is clear: it is time to stop listening to what banks say, and start focusing on what they do. We must re-evaluate the distorted political economy of the financial sector, before the excessive power of the few imposes even larger costs on everyone else..."
      But it is still only the tip of the iceberg.
      At the moment the financial institutions have become the overhead controlling decisions, every stimulus, bailout starts with the banks with little care for the "little people" who have to shoulder the real burdens, just look at Greece, the tope layer is celebrating at how they "saved the country" while it is still unclear how the public will cope with austerity, and the same question will be raised in other countries as well.
      But pointing fingers at the banks is not helpful because it is missing the points. The financial institutions have not become the "bad guys" by themselves. After all they are only serving the system, which in order to be capable of the excessive production/consumption profit accumulating machinery needed the credit and some more credit, thus banks become the linchpins in the system.
      We cannot regulate the banks while leaving the system untouched.
      The only true remedy that can really solve our problems is the return to necessity and resource based economy and a governing and financial system that assists such structure.
      It is not like we have much choice. The present system is leaking all around and it is only a matter of time when even the most die hard fanatics will stop calling our situation crisis, recession and accept that we reached a system failure.
      It is always easier to start building a new structure while the old has not fully collapsed, when we still do not have to make panic reactions simply to survive.
      Finally we have to accept we moved on in our evolution, we live in a different reality today, and thus we have to adapt.
      If we do everything optimally we will understand that what today we call "unemployment", "crisis" is actually a liberation process where we free ourselves from slavery from the constant growth, profit chasing "Matrix" that has been poisoning our lives for decades.

    8. CommentedPaul A. Myers

      If it were simply a question of no longer listening to what big banks say, then fixing the current mismanagement in both Europe and the US would be straightforward. But there is a symbiosis between the two elites that is difficult to disentangle that is intrinsic to the politics of most advanced democratic governments.

      What is the dynamic behind the power duopoly exercised by the financial and political elites? Finance deals with intermediation. The political sphere has adopted the technique to make promises to voters to provide current and future benefits out of the future stream of income of a country: the benefits are intermediated over time. Pensions are a prime example. If an economy does not grow at a sufficiently high enough rate in the future, funding these promises becomes quite difficult. Other politically important choices get crowded out.

      Banking provides through credit creation additional "no cost" money--from a politician's point of view--that fuels additional prosperity. And the less stringent the bank capital rules, the more credit creation, and more prosperity. What elected legislator could be against that!

      But there are two costs to credit, particularly incremental credit. One is the interest expense, which the central bank can conveniently minimize, and the other is bad loan write-offs. As those final incremental loans are made, the implicit credit losses rise disproportionately. But notice that the political process now intervenes to "administratively" minimize these costs by avoiding mark-to-market rules and other measures. The reckoning gets put off. But it eventually comes home.

      But the other trick that goes with front-loading profits and pushing out losses, is that current bank profits are high, and the bankers' bonuses high.

      The banking system has immense flows of money with which to pamper and buyoff the political elites, in both Washington and Paris and London and other capitals.

      The politicians go along with this--it is always the ball the night before Waterloo in these capital cities--because the hope is that some continuance of the status quo will keep the game going past the next election and some other group of politicians someday will have to deal with the escalating costs of promises too expensive to pay.

      The duopoly in essence is an arbitrage game. And the bankers understand the politicians' price. And the people may or may not be catching on. That is what the 2012 election is really about.

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