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MIT professor Simon Johnson critical of EU leadership on Greece

by Upstate NY Thu Mar 11th, 2010 at 01:46:00 PM EST

http://economix.blogs.nytimes.com/2010/03/11/greece-the-latest-and-greatest-bubble/

The French and Germans are apparently actually encouraging banks, pension funds and individuals to buy these Greek bonds -- despite the fact senior politicians must surely know this is a Ponzi scheme (i.e., people can get out of Greek bonds only to the extent that new investors come in).

At best, this does nothing more than postpone the crisis. In the business, it is known as "kicking the can down the road."  At worst, it encourages less informed people (including perhaps pension funds) to buy bonds as smarter people (and big banks, surely) take the opportunity to exit.


I don't have much more to add. He raises some sobering questions, but he doesn't really analyze the flip side of "kicking the can down the road" which is, "buying time."

He doesn't ask, what does time afford you? Either bigger debts, or maybe Greece turns things around. Also, do bank balances improve over time? So that they can absorb the shock of a Greek default.

On a country-specific level, he does leave out a few important points. Maybe it's because he's looking at Greece as a case study and not as a country. If you're only looking at the ledger, you may miss something. One, Greece is a poor country with an undiversified economy that should always run surpluses except in times of recession. Its two main sectors are shipping and tourism, which are awful in recessions. The good thing about them is that if the world economy moves, they bring external funds quite apart from the internal business climate. Two, the country's bureaucracy is dysfunctional. Quite apart from the fact the country is poor, it has an internal problem that it needs to solve, and many statements uttered by EU politicians are meant to apply precisely this pressure. Europe does not need a drachma-denominated but still dysfunctional Greece at its southeastern tip. Whether it defaults or not, Greece needs to change course. Three, the country's tax system needs to modernize.

So, my point is: Greece has an external capacity for bringing funds to the economy, and this may cut into the debt when/if the world economy starts growing again. Also, a modern tax system and a justice system with bite would raise revenues as well. I know Johnson mentions that the rich are fleeing Greece, but the fact is, tax evasion in Greece is at 25%, and 19% in the Eurozone, and 14% in the USA. Yes, even 6% in additional revenues will help Greece, but the rich know how to beat taxes all over the world. Greece isn't going to solve that. But they can force doctors and lawyers to abide by tax laws.

Johnson's model needs to account for potential sources of revenue that aren't apparent in his model. Cutting the bureaucracy isn't really one of them since Greek bureaucrats pay is tiny and the payments are roughly akin to a social safety net. In other words, the Greek public sector is really just a form of workfare. If you slash the bureaucracy, you end up paying anyway. Only when the economy starts growing will the slashing of the bureaucracy pay off, as hopefully a more equitable environment will be in place for all Greek citizens, and this will lead to expansion of business.

Still, one needs to account for how much of Greek debt accounted for a 4 to 5% expansion of GDP over the last 10 years. If one subtracts the stimulative effects, what are we left with? Will EU growth and world trade contribute enough to Greece's GDP to prevent a default, or is this not very likely?

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European Tribune - MIT professor Simon Johnson critical of EU leadership on Greece
The French and Germans are apparently actually encouraging banks, pension funds and individuals to buy these Greek bonds -- despite the fact senior politicians must surely know this is a Ponzi scheme (i.e., people can get out of Greek bonds only to the extent that new investors come in).

Really? Look, there's plenty to say about the way the EU is handling this, but what source does Simon Johnson cite to back up the assertion the "the French and the Germans" (who's that? Governments, banks, brokers, pundits..?) are "encouraging" right down to "individuals" to buy "these Greek bonds"? There's something I must have missed, I'd be glad to be proved wrong.

by afew (afew(a in a circle)eurotrib_dot_com) on Thu Mar 11th, 2010 at 04:03:45 PM EST
He's probably thinking of Prodi and Strauss-Kahn. Prodi declared the Greek debt crisis over and Strauss-Kahn said Greece can pare down debt on its own.
by Upstate NY on Thu Mar 11th, 2010 at 04:19:50 PM EST
[ Parent ]
That's a long way from what he says. Prodi's neither French nor German, Strauss-Kahn speaks as an international functionary more than as "French", and neither of them are "apparently actually encouraging" anyone to enter a Ponzi scheme.
by afew (afew(a in a circle)eurotrib_dot_com) on Thu Mar 11th, 2010 at 04:30:37 PM EST
[ Parent ]
The Coming Greek Debt Bubble  By Peter Boone and Simon Johnson  Baseline Scenario

I think Johnson's arguments need to be considered in full, so I will quote him at length below.

Bubbles are back as a topic of serious discussion, as they were before the financial crisis.  The questions are: (1) can you spot bubbles, (2) can policymakers do anything to deflate them gently, and (3) can anyone make money when bubbles get out of control?

Our answers are: Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit.  But policymakers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse.  A few investors can do well by betting against such bubbles, but it's harder than you might think because you have to get the timing right - and that's much more about luck than skill.

Bubbles are usually associated with runaway real estate prices (think Japan in the 1980s and the US more recently) or emerging market booms (parts of Asia in the 1990s and, some begin to argue, China today) or just the stock market gone mad (remember pets.com?)  But they are a much more general phenomenon - any time the actual market value for any asset diverges from a reasonable estimate of its "fundamental" value.


Perhaps Simon has seen a few bubbles while at the IMF. There certainly has been no recent shortage of cheap money, with "the world's reserve currency" being on offer at close to zero percent interest rates.

Bubbles are usually associated with runaway real estate prices (think Japan in the 1980s and the US more recently) or emerging market booms (parts of Asia in the 1990s and, some begin to argue, China today) or just the stock market gone mad (remember pets.com?)  But they are a much more general phenomenon - any time the actual market value for any asset diverges from a reasonable estimate of its "fundamental" value.

To think about this more specifically, consider the case of Greece today.  It might seem odd to suggest there is a bubble in a country so evidently under financial pressure - and working hard to stave off collapse with the help of its neighbors - but the important thing about bubbles is: Don't listen to the "market color" (otherwise known as ex post rationalization), just look at the numbers.

By the end of 2011 Greece's debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time - for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently).  About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany.  Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders.

What if Greek interest rates rise to, say, 10% - a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called "austerity" program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe?  Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years).

This is simply impossible and unheard of for any long period of history.  German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings).  Neither of these were good experiences.

We are not dealing with questions of definitive proof here. The issue is the risks and duties of public officials dealing with financial problems.  The meat of Johnson's argument is below.  

On top of all this Greece's debt, even under the IMF's mild assumptions, is on a non-convergent path even with the perceived "austerity" measures.  Bubble math is easy.  Hide all the names and just look at the numbers.  If debt looks like it will explode as a percent of GDP, then a spectacular collapse is in the cards.

Seen in this comparative perspective, Greece is bankrupt today without a great deal more European assistance or without a much more drastic austerity program. Probably they need both.

Given there's a definite bubble in Greek debt, should we expect European politicians to help deflate this gradually?  Definitely not - in fact, it is their misleading statements, supported in recent days (astonishingly) by the head of the International Monetary Fund, that keep the debt bubble going and set us all up for a greater crash later.

The French and Germans are apparently actually encouraging banks, pension funds, and individuals to buy these bonds - despite the fact senior politicians must surely know this is a Ponzi scheme, i.e., people can get out of Greek bonds only to the extent that new investors come in.  At best, this does nothing more than postpone the crisis - in the business, it is known as "kicking the can down the road."  At worst, it encourages less informed people (including perhaps pension funds) to buy bonds as smarter people (and big banks, surely) take the opportunity to exit.

While the French and German leadership makes a great spectacle of wanting to end speculation, in fact they are instead encouraging it.  The hypocrisy is horrifying - Mr. Sarkozy and Ms. Merkel are helping realistic speculators make money on the backs of those who take seriously misleading statements by European politicians.  This is irresponsible.

While Mr. Sarkozy, Ms. Merkel and Dominique Strass-Kahn may be possessed of iron resolve that Greece will not be allowed to default, the specifics as to what will be done have been scant. The article does say, rather vaguely, that "the French and Germans are apparently actually encouraging banks, pension funds, and individuals to buy these bonds..." and elsewhere refers to Sarkozy and Merkel by name and Dominique Strauss-Kahn by his position. (My italics.)

I can see two sides to this issue. With most of the bonds held by French and German citizens or institutions neither Sarkozy nor Merkel want to precipitate a default and must take care not to do so.  But if they give the impression that a default will not be allowed to happen without having in place the means to prevent default and if any in their governments encourage institutions or individuals to purchase these bonds, their position in the event of a default will be questionable.

I have read of non-specific plans to provide French and German support for Greek debt and Greece has just issued new bonds--after the question of possible default has arisen. And I recall that the sale of these bonds to Europeans has been favorably characterized in press reports. Unfortunately, I had not seen the arguments put forth by Johnson and Boone when I saw these reports, so I did not bookmark them. But if Johnson and Boone are correct in their analysis and Greece is caught in a debt trap there will be plenty of time and reporters to sift through public statements by all involved. Meanwhile Johnson and Boone are apparently being circumspect by implying more than they can demonstrate. Time will tell who is better serving potential purchasers of Greek debt.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 12th, 2010 at 12:12:52 AM EST
[ Parent ]
Still don't see any backing for the assertion that unspecified but definite-article "the" French and Germans are encouraging right down to individuals to put their money in what "the" French and Germans know is a Ponzi scheme.

Sure time will tell what will happen for Greece. I'm not arguing about that.

by afew (afew(a in a circle)eurotrib_dot_com) on Fri Mar 12th, 2010 at 02:10:26 AM EST
[ Parent ]
to be fair, there has been talk of getting CDC and KfW to support the bond auction if needed. These are however not commercial or investment bank, even less pension funds or individuals. And as you know the auction was oversubscribed anyway.
by jayjay (jeremy [at] will-hier-weg.de) on Fri Mar 12th, 2010 at 05:51:44 AM EST
[ Parent ]
the auction was oversubscribed anyway

Which means Greek debt wasn't as much of a problem as the business press would have had us believe?

Or that the romour-mongers had successfully lowered the price of Greek bonds while at the same time coercing the politicians to more or less commit to helping Greece, so that speculators could take part in the auction at a substantial discount, hence the oversubscription?

En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma

by Migeru (migeru at eurotrib dot com) on Fri Mar 12th, 2010 at 06:03:04 AM EST
[ Parent ]
Oversubscribed three times. But who was buying?
by afew (afew(a in a circle)eurotrib_dot_com) on Fri Mar 12th, 2010 at 09:38:03 AM EST
[ Parent ]
It was oversubscribed but I would point out two things.

One, lots of American banks and hedge funds were trying to get in on the action so we can't assume that it was German or French banks/gov't institutions that were buying (although if they were they would be making a handsome profit on the interest payments).

Two, the interest is exorbitantly high and that's why Johnson thinks it is unsustainable for Greece, so the real key is, who buys when the interest rates drop--as they must?

by Upstate NY on Fri Mar 12th, 2010 at 10:04:30 AM EST
[ Parent ]
I quite agree, there's certainly been talk of those two institutions -- as you say, they are not pension funds or private individuals. The talk seems to get stronger today, as an article in the Austrian paper Kurier claims to have leaks on a plan steered by Merkel and Sarkozy to be able to back Greece with €55bn, €20bn from Germany, half guarantee, half KfW, and €10bn from France, with other EZ countries that are able making up the rest.

Also see this from a couple of weeks ago, where it's suggested that Euro system central banks hold the major part of Greek bonds.

 

by afew (afew(a in a circle)eurotrib_dot_com) on Fri Mar 12th, 2010 at 09:33:11 AM EST
[ Parent ]
€55bn or approx. what Greece needs to raise this year, so it could make sense. The recent auction of €8 Bn at 6% just buys them time really.
by jayjay (jeremy [at] will-hier-weg.de) on Fri Mar 12th, 2010 at 10:50:29 AM EST
[ Parent ]
One other thing to add is that Greece actually barred a number of hedge funds from the bond auction last week, and those funds wanted in.

So, it takes some of the edge off the statements of public officials, when the very bonds that made a killing by selling their CDS contracts at a premium to panicked investors then decide to become investors themselves. These hedge funds and banks in particular know where the bodies are buried.

by Upstate NY on Fri Mar 12th, 2010 at 10:01:30 AM EST
[ Parent ]


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