The End of The Euro For Dummies

Let’s start with a story. You and I are friends. You dis­cover that you’re going to come up a lit­tle bit short on the rent this month and ask to bor­row $100 from me. I agree, loan­ing you $100 at 10% inter­est (we’re just doing that to keep the math sim­ple, I would never loan shark you that bad, you’re my buddy.) So you are going to get $100 this month to pay your rent and pay me back $110 next month when you get paid. That’s a tidy profit for me, rel­a­tively speak­ing, and you don’t get evicted (not that you would get evicted in the US, cur­rent aver­ages are well over a year for a fore­clo­sure to go through but that’s another story.)

I how­ever, think that there is a chance, pos­si­bly small, pos­si­bly large, that you may not be able to pay me back next month and in fact will go into bank­ruptcy over this $100 I have loaned you. I don’t want to lose my entire invest­ment. Luck­ily for me, we have another mutual friend who sells insur­ance on loans, loans he didn’t have any influ­ence over orig­i­nat­ing. He does this because his­tor­i­cally speak­ing, peo­ple like you don’t default on your debts and it’s thought of as an almost risk free way to make some cash.

So I go to this mutual friend and ask to buy insur­ance against you default­ing. I agree to pay $8 to this guy in return for an insur­ance pol­icy that says if you default on your $100 loan to me, our lit­tle friend will pay me the full value of the loan, $110. This way, I am guar­an­teed to make money either way. If you pay me back, I make $2, $10 from you minus the $8 I paid for the insur­ance pol­icy. If you default, I make $10 when our mutual friend pays me my full value, $110. This is a per­fect sit­u­a­tion for me and assum­ing I have deep pock­ets, I’d hap­pily loan all the money I could pos­si­bly afford to you because I’m guar­an­teed to make money. In fact, because of the terms above, I actu­ally make more money if you default. Any­one who believes in the incen­tives of the mar­ket has to see that I’m going to start loan­ing money regard­less of risk because I actu­ally make more money on bad invest­ments. EDIT: As Wes notes in the com­ments, as described, the math is wrong. I added the risk analy­sis part and con­flated how CDS are typ­i­cally done where a long or short posi­tion is estab­lished with my sim­pli­fied story. It should just say that I make $2 either way to keep things sim­ple. It doesn’t mate­ri­ally change the story so I’m leav­ing it in.

Our mutual friend how­ever is on the hook in a bad way, though he doesn’t think that. If you default, he has to pay me $110. Even if the risk is low, the pun­ish­ment for mis­judg­ing the like­li­hood of you default­ing is very, very high. If you lied about your income and in fact have almost no chance of pay­ing, he has badly mis­priced the insur­ance he sold to me. This is not a very good situation.

On the small­est scale, and ignor­ing a ton of highly rel­e­vant but com­pli­cated fac­tors, this is exactly what is hap­pen­ing in Greece right now. Banks, pre­dom­i­nantly French and Ger­man, loaned money to Greece when things were going good. Greece didn’t look like the prof­li­gate wastrel now por­trayed in the media then. But just in case, those banks sold credit default swaps to other enti­ties just in case Greece didn’t make good on her promises. Sud­denly, it’s start­ing to look like Greece can’t pay things back and may very well have to default. In real­ity, the prices on Greek debt are already say­ing Greece WILL have to default. And the kick in the pants is that the enti­ties that sold the insur­ance poli­cies to those banks for the Greek debt are largely unknown. That is to say, we don’t really have a solid clue who will be left hold­ing the bag with the dead bod­ies in it if and when Greece defaults.

Here’s another kick in the pants: the peo­ple of Greece know that even though the media keeps call­ing this a bailout, it’s really a loan. They are being asked to accept dra­con­ian cuts in ser­vices and ben­e­fits now with the promise that they will have to pay all this back at some point in the not so dis­tant future. The aver­age Greek knows that their politi­cians have bent them over in a bad way for decades and that they are now being asked to shoul­der the blame, not only for their rul­ing class’ bad behav­ior but for the behav­ior of the idiot banks who never should have been mak­ing these loans in the first place. This is why they are riot­ing and who can blame them.

The thorni­ness of this sit­u­a­tion grows even more tan­gled when we start to think about what hap­pens if Greek defaults. We really don’t know who is sit­ting there with bil­lions of dol­lars in insur­ance poli­cies against just such an occur­rence. What if the Bank of Britain sold some of those swaps? Hell, what if the US gov­ern­ment decided to get in the game? Remem­ber AIG? Remem­ber Lehman Broth­ers? This could be much worse. We’re talk­ing about an entire country’s debts (not to men­tion Por­tu­gal and Ire­land) and because the risk asso­ci­ated with that debt has been passed up and up the chain, we won’t know who has to pay back what until we get to the last man stand­ing, cur­rently a com­plete unknown. This is how a coun­try like Greece, with a tiny 3% of the entire GDP of the EU, could very well cause a sys­temic cri­sis at least as large as what we saw in 2008.

On top of all that, we have the issue of the euro as a com­mon cur­rency across nation states that don’t share finan­cial pol­icy. What that means is that when some­thing bad hap­pens in a coun­try in the EU mon­e­tar­ily speak­ing (say, a coun­try is in ter­ri­ble debt, has 16% unem­ploy­ment and an angry pop­u­lace), indi­vid­ual coun­tries don’t con­trol their own money and thus can’t solve prob­lems in ways a coun­try like the US can (by print­ing up a bunch of money to pay back the debt.) So all coun­tries in the EU are on the hook for each other, a fact that doesn’t sit to well in Ger­many who may now have to “bailout” the Greeks (the Ger­mans are not at all blame­less in this fiasco but again, a post for another day.) What this means is that if Greece defaults, the risk for a con­ta­gion spread­ing through­out the EU is sud­denly very high. If Greece defaults, sud­denly the mar­ket will won­der if Por­tu­gal or Ire­land can afford to repay their debts. The price of these bailouts/loans for the Greeks and the Irish are above 5%. Those are ter­ri­ble terms given the fact that cur­rent inter­est rates in the US hover around 1%. If Greece goes under, no one is going to believe Por­tu­gal and Ire­land can repay. If those coun­tries go under, sud­denly Spain is in line and Spain is a huge chunk of the GDP of the EU. There will be no bailouts for Spain. We’ll just have to kiss the EU good­bye at that point.

When you read the head­lines about protests and riots in Greece over the aus­ter­ity mea­sures and think “Those dumb Greeks, they can’t have their cake and eat it too”, remem­ber this. They are not receiv­ing bailouts. A bailout is what we gave to AIG and GM here in the US. Tax-payer funded cash infu­sions are bailouts. What the EU is giv­ing to Greece are loans, loans with hor­ri­bly unfa­vor­able terms. The aver­age per­son in Greece knows this. That same per­son also knows that for decades, cor­rup­tion and crony­ism in Greece has been ram­pant. Rich peo­ple in Greece have never paid taxes and they have no plans to start now. This entire bur­den is being foisted on the lower and mid­dle class Greek. He is being asked to take a pay cut, pay more in taxes and work real hard for the fore­see­able future so that Ger­man and French banks can get their money back, money he never really saw in the first place because the rul­ing class of his coun­try absorbed most of it. You can see how he might think that is an excep­tion­ally shitty deal for him.

The only way the euro can con­tinue to sur­vive as a cur­rency is if the Ger­man peo­ple con­tinue to accept the neces­sity of the “bailouts” and agree to keep fund­ing them. Ger­many has a large enough econ­omy that they can do this with­out too much pain. The Ger­mans ben­e­fit greatly from the cur­rent arrange­ment for a vari­ety of rea­sons and ratio­nally, it’s in their inter­est to keep the sta­tus quo. But elec­torates are rarely ratio­nal. If they stop fund­ing the bailouts, and there is cer­tainly plenty of evi­dence that they are tired of doing so, the euro is doomed. If Ger­many refuses to loan money to Greece, Greece defaults fol­lowed shortly there­after by Por­tu­gal and Ire­land. Then the big hairy ele­phant of Spain shows up in the mid­dle of the liv­ing room and takes a dump on the cof­fee table. The euro will be gone because no one will be able to afford to keep the debts going.

These are excep­tion­ally tricky times for the EU. What is going on is unprece­dented and prob­a­bly largely unplanned for. Oh sure, there were prob­a­bly some the­o­ret­i­cal games played about “What hap­pens if some coun­try defaults?” but based on how this is being han­dled, they weren’t very seri­ous about them. The chance of the euro as a cur­rency con­tin­u­ing to exist is falling on a daily basis. This will have huge effects, effects we can’t pos­si­bly begin to under­stand right now. The world econ­omy is going to suf­fer regard­less of what hap­pens until some of the details start to shake out. This would all be a lot of fun to watch if we weren’t all so intri­cately involved in the result.

2 Comments

  • Wesley wrote:

    Quote: “I agree to pay $8 to this guy in return for an insur­ance pol­icy that says if you default on your $100 loan to me, our lit­tle friend will pay me the full value of the loan, $110. This way, I am guar­an­teed to make money either way. If you pay me back, I make $2, $10 from you minus the $8 I paid for the insur­ance pol­icy. If you default, I make $10 when our mutual friend pays me my full value, $110.”

    This is com­pletely flawed: you’ve already paid out the $8 for the insur­ance pol­icy. Unless your insur­ance pol­icy is going to return $118 to you, you’re not going to make $10. You make $2 either way: there is no increase in prof­its if your friend defaults.

  • Scotch Drinker wrote:

    It was a sim­pli­fied ver­sion, some­thing I should have noted in the post. Typ­i­cally under CDS terms, the pay­ments are made quar­terly for the length of the bond. CDS can be set up to be either short or long posi­tions so if I wanted to hedge, I could essen­tially short my loan to my friend in such a way that I’d make more money if he defaulted.

    You’re right though, in my ver­sion, I should have left it as just a $2 profit either way for simplicity’s sake.

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