An Experiment in Scotch

"I write to discover what I believe." Michael Lopp on Twitter

Tag: Eurozone

On Exporting Deflation

Return­ing to our char­ac­ters of a few weeks ago, we remem­ber that Bob and his coun­try had increased the sup­ply of waf­fles thus mak­ing the export of Bob’s organic grass-fed but­ter cheaper. This hap­pens because other coun­tries like Nigel’s can now get more waf­fles on the pas­try cur­rency mar­ket and can buy more of Bob’s but­ter. There is a slight (or not so slight in our exam­ple of dou­bling the waf­fle sup­ply just so Bob could sell more but­ter) infla­tion­ary pres­sure in The Land of Guns and Large Bor­der Fences. Another effect of this deci­sion is a slight defla­tion­ary pres­sure in Nigel’s Land of Peo­ple With Below Aver­age Den­tal Hygiene (LOPWBADH).. The rea­son this is so is because of the con­nect­ed­ness of the two coun­tries via the pas­try exchange mar­ket. The Nigel’s clot­ted cream now costs more to export it to Bob’s coun­try. On the sur­face this looks infla­tion­ary because the prices went up. But when think­ing about infla­tion or defla­tion, it’s impor­tant to con­sider both prices and demand. Because Nigel will now sell less clot­ted cream, he may have to lay off Colin, his dairy man­ager. Colin may then have to get a lower pay­ing job which means he has fewer crum­pets to spend. This lack of demand on a broader scale leads to defla­tion­ary pressures.

This lack in aggre­gate demand is a side of the inflation-deflation dis­cuss that you’ll rarely see in finan­cial press because it’s the part of the equa­tion cen­tral banks have almost no con­trol over. We’re cur­rently see­ing this in Euroland where the economies of the mon­e­tary union have been under sig­nif­i­cant down­ward pres­sure for months as unem­ploy­ment remains stub­bornly high in many coun­tries. When you don’t have a job, you don’t buy either clot­ted cream or expen­sive imported grass fed but­ter. The con­tin­ued defla­tion­ary pres­sure can quickly spi­ral down­wards. Once upon a time, defla­tion was a nor­mal part of the eco­nomic cycle and when every major cur­rency in the world was tied to a hard asset, typ­i­cally gold, there was a gen­eral defla­tion­ary pres­sure because you can’t increase the money sup­ply with­out increas­ing the pro­duc­tion of the hard asset. These days, with no coun­try tied to a hard asset, defla­tion is sup­pos­edly a thing of the past (though the time may be return­ing as the Chi­nese gov­ern­ment has been buy­ing gold in large quan­ti­ties, another fact you won’t see men­tioned in the finan­cial press). And in fact, defla­tion is a ter­ri­fy­ing prospect for gov­ern­ments and cit­i­zens that are heav­ily indebted. Dur­ing defla­tion, the cost of debt rises as the cur­rency appreciates.

Imag­ine a sce­nario where 50% of your income goes to ser­vic­ing your credit card debt. What hap­pens if you sud­denly make less money or if the inter­est rates rise? Big trou­ble, that’s what hap­pens. Now your debt to income ratio goes up and you either have to do with­out things or begin to think about default­ing on the debt. Our reliance on debt as a soci­ety both con­sumer and gov­ern­ment means defla­tion is extra­or­di­nar­ily dan­ger­ous. For exam­ple, it takes half the tax rev­enue of the coun­try of Japan to ser­vice their pub­lic debt. What hap­pens if inter­est rates rise in Japan? Sud­denly, they strug­gle to pay their oblig­a­tions. That’s why they (and many other coun­tries) can’t afford to let inter­est rates rise. Their answer is to adopt a pol­icy of zero inter­est rates by manip­u­lat­ing the mar­ket with made up money.

Europe is cur­rently on the precipice of defla­tion. To fight it, the Euro­pean Cen­tral Bank has announced a $1.3 tril­lion (give or take a euro or two) stim­u­lus pro­gram aimed at increas­ing the infla­tion rate and sta­bi­liz­ing the fall in prices. Leav­ing aside whether this will even work, what effect does this have on other coun­tries? This inten­tional devalu­ing of the Euro will lead to stronger cur­ren­cies in the trad­ing part­ners of Europe. Those stronger cur­ren­cies now have to con­tend with the defla­tion­ary aspects which is exactly what is hoped for by the Euro­zone. This beg­gar thy neigh­bour approach even­tu­ally causes other coun­tries to retal­i­ate lead­ing to a cur­rency war which many peo­ple think we are cur­rently in. This is the mean­ing of export­ing deflation.

So how is the prob­lem actu­ally solved? A decreas­ing reliance on debt is the first start. In nor­mal times (like the 1800s) defla­tion was part of the busi­ness cycle. As defla­tion would occur, peo­ple, busi­nesses and coun­tries would delever­age, reduc­ing their debt. Even­tu­ally, the economies would cycle back to infla­tion. In today’s world, defla­tion can’t even be allowed to occur because of the debt lev­els of coun­tries. The goal is per­ma­nent growth because with­out it, we can’t pay our debts. But per­ma­nent growth funded by increas­ing debts is a fan­tasy world that doesn’t have a happy end­ing. A coun­try like Japan has no choice but to try and print money (the Bank of Japan cur­rently buys almost all of the country’s pub­lic debt) to ser­vice their debt and increase infla­tion. This is a grand exper­i­ment of our cen­tral banks unseen before in his­tory. In the short term, it means the Japan­ese yen will con­tinue to lose value to the dol­lar and the Euro­pean stock mar­kets are likely to increase just like the US stock mar­ket went up over the past sev­eral years dur­ing our own quan­ti­ta­tive eas­ing. In the long term, it’s anyone’s guess. What hap­pens if Japan defaults? What hap­pens if the ECB’s tril­lion euro pack­age doesn’t work? At some point, the lev­els of debt have to be reduced either by the dif­fi­cult process of delever­ag­ing or by default. Nei­ther will be pleas­ing and the far­ther down the road we kick the can, the harder it will get. Even­tu­ally, the road will end on a cliff and we may all just tum­ble over it.

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.

Can Civilization’s Birthplace Become Its Funeral Pyre?

Over­reach­ing head­lines aside, the Euro­zone is a bit of trou­ble. Greece has been bailed out in an attempt to avoid a sov­er­eign default. Those in the know think the Greeks are unlikely to be the last coun­try in the Euro­zone to require a bailout and the con­di­tions the IMF are expect­ing Greece to con­form with are likely to have unin­tended far-reaching con­se­quences that we can’t pos­si­bly under­stand at this point. A lot of peo­ple I talk to seem to be of the opin­ion that the Greeks got them­selves into this mess and that bail­ing them out serves lit­tle pur­pose. This is prob­a­bly true though for rea­sons far more com­pli­cated than that.

A guest post over at Naked Cap­i­tal­ism out­lines 11 points sup­port­ing the idea that the Euro­zone will likely break down over the Greece bailout. One of the key points revolves around a basic account­ing prin­ci­ple: if one entity has a deficit, some other entity must have a sur­plus. Fis­cal account­ing is essen­tially a zero sum game and this is very impor­tant in the Greek case. When think­ing about this, it’s impor­tant to real­ize that Greece, being a mem­ber of the EU, does not con­trol its own sov­er­eign cur­rency. Thus, for Greece to run a deficit, there had to have been com­plic­ity from within the EU, specif­i­cally from Ger­many. It’s the fis­cally con­ser­v­a­tive Ger­mans ben­e­fit­ing from their strong export dri­ven econ­omy who pro­vide the oppor­tu­nity for the Greek gov­ern­ment to run a deficit.

This part about sov­er­eign cur­rency is impor­tant. His­tor­i­cally, coun­tries that con­trol their own cur­rency have been able to inflate their way out of debt, at least to some degree. In Greece’s case, the coun­try is unable to do this because their cur­rency is the euro and is out­side their con­trol. There­fore, they essen­tially have two options: default or bailout and accept the dra­con­ian retrench­ment terms the IMF is demand­ing. As the arti­cle above men­tions, it is unlikely that these terms are cre­ated with the con­sid­er­a­tions nec­es­sary regard­ing the sim­ple account­ing fact above, e.g. if Greece suc­cess­fully imposes finan­cial aus­ter­ity mea­sures on its peo­ple (a HUGE if at this point, one that isn’t get­ting enough atten­tion), this nec­es­sar­ily means that the export soci­eties of Ger­many and other Euro­zone coun­tries will retract due to the cut­backs in spend­ing in Greece and others.

On top of that, these aus­ter­ity mea­sures will likely have a defla­tion­ary effect on the Euro­zone. The bailout of Greece is aimed at gov­ern­ment debt and the aus­ter­ity mea­sures are aimed in the same direc­tion. Based on the same sim­ple account­ing con­cept I talked about above, if Greek gov­ern­ment debt oblig­a­tions are reduced through aus­ter­ity mea­sures, the Greek pri­vate sec­tor will see their debt oblig­a­tions grow lead­ing to more pri­vate defaults and less growth in the Greek econ­omy. Short­sight­edly demand­ing to lower gov­ern­ment debt with no con­sid­er­a­tion of the inter­con­nect­ed­ness of the gov­ern­ment and pri­vate sec­tor spend­ing will lead to fur­ther pull­backs and lack of growth in Greece.

In the end, the issues that we are see­ing with Greece and the like illus­trates sev­eral prob­lems with the Euro­zone as it is cur­rently exist­ing. If the Euro­zone col­lapses, as the arti­cle seems to think pos­si­ble, the ram­i­fi­ca­tions will spread out over a much big­ger area than just Europe. My crys­tal ball is cloudy when it comes to the results of a Euro­zone col­lapse but I can’t help but think it will be highly detri­men­tal to our coun­try as well. We should watch care­fully how things play out in Europe since it’s quite pos­si­ble we may have to deal with sim­i­lar cir­cum­stances in the near future here at home as prof­li­gate states like Cal­i­for­nia begin to encounter the same issues the Greeks are run­ning into.