The euro (non) solution

 by michael roberts

So after much tortuous negotiation and mind-bending attempts to come up with clever and obtuse financial structures, the 17 leaders of the Eurozone states have announced a package of measures that they hope will convince the banks, pension funds and insurance companies and stock markets of Europe and the governments of Asia to maintain their holdings of Italian and Spanish government bonds – and indeed buy lots more.

What is the ‘comprehensive’ package that Angela Merkel, Nicolas Sarkozy and the other leaders have agreed to?  First, they have agreed to provide more funding to the Greek government so that they do not have to find private buyers for their debt issuance over the next three years.  But what is different this time is that the European leaders recognise that the Greek government cannot stop its debt mountain from growing ever higher for the rest of this decade (and beyond), whatever cuts in spending, rises in taxes, closures of public services and selling off of national assets that the Greeks have been forced to commit to by the Eurozone states.

The IMF in its latest review of Greek public finances and economy admitted that it had got it wrong in the past.  As the dreaded Troika put it in  their debt sustainability analysis for Greece (leaked to the press): “Since the fourth review, the situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity.  The authorities have also struggled to meet their policy commitments against these headwinds, and due to administrative capacity limitations in the Greek government. The growth and fiscal policy adjustments assumed under the program individually have precedent in other countries’ experience, but experience to date under the program suggests that Greece will not be able to set a new precedent by realizing at the same time and from very weak initial conditions a large internal devaluation, fiscal adjustment, and privatization program”.  In other words, the huge cuts in government spending, public services and tax hikes imposed by the Troika were not achieving the aims of the European leaders and the IMF in controlling Greece’s public debt.

The IMF and the EU had thought that if the Greeks imposed enough fiscal austerity measures that the public debt ratio to GDP could be brought under control within a few years.  But now they admit won’t be able to do that – mainly because the Greek economy has slipped into an even deeper recession than the IMF expected and partly because the Greek government just cannot cut spending, raise taxes and sell off assets fast enough.  The IMF reckons that Greek government debt will rise to 186% of GDP by 2013 and would still be higher in 2030 than it was in 2009!  What better proof is there that fiscal austerity will fail even to deleverage debt, let alone restore economic growth.

The Troika finally admitted that the Greeks must default on the government debt held by the private sector.  The  default option is something advocated by this blog and by many heterodox economists over the last few months (see my post, Greece heading for default, 13 June 2011).  This was the right policy for the Greek people, but never admitted or supported by the so-called socialist government, the banks or the Euro leaders until now.  But reality sometimes spits in the face of greed and lies.   Of course, this default has not been negotiated by a socialist government to make sure it benefits the 99% most rather than the 1%.  This default was negotiated on the Greeks’ behalf by the Euro leaders.  Socialist prime minister Papandreou was kept in a separate room at the Euro summit while Merkel and Sarkozy thrashed out a deal with the banks in another room.

The deal involves the banks and other private sector bond holders (pension funds, insurance companies, hedge funds) taking a 50% loss in swapping their bond holdings for new 30-year Greek government bonds, but getting a cash payment up front plus guarantees on their new holdings from the Eurozone’s emergency financial facility (EFSF).  Even after the default, the Greek government will still have the largest debt ratio in Europe of at least 120% of GDP.  And that assumes that all the private sector debt holders participate in the 50% swap – after all, it’s supposed to be voluntary.  A forced default would invoke a credit downgrading from the international agencies and also the payment of credit insurance by financial institutions (something that caused the global financial meltdown back in 2008).  But if not all bondholders joined the scheme, then Greek public sector debt could still be above 140% of GDP by the end of this decade.  That’s because the money Greece owes to the IMF, the ECB and its eurozone partners is not up for renegotiation and that’s one-third of all the debt.

Even worse, the Greek state pension scheme and the Greek banks hold €80bn of this debt.  So they stand to be gutted just at a time when Greeks need unemployment benefit (heading towards 20% of the workforce) and banks to help with credit for small businesses.   So Greece’s pensioners will pay the most in this form of default.  Also under the new package of financing, the Greeks are being asked to sell off even more state assets to the private sector and foreign investors.  They were already committed to selling €50bn; now another €15bn has to be raised.   Indeed, over time, this ‘voluntary default’ deal may well turn out to be lucrative to the banks and insurance companies even if it is damaging to their balance sheets in the short term.  The holders of new Greek debt will receive a fat annual interest payment along with guarantees against losses.

The irony is that the Irish and Portuguese will not be allowed for opt for default as well – this is a special deal for Greece.  The other ‘bailed out’ states must continue to service their mountains of public debt.  Above all, the Italians must carry through huge reductions in public services, pension entitlement and privatisations with no debt relief.  This austerity demand was brusquely put before the Italian government at the Euro summit.  It pushed to breaking point the right-wing coalition government of Silvio Berlusconi, when his right-wing coalition Northern League opposed raising the state retirement age from 65 years to 67 years 9whatever the length of work service) among other austerity measures.

For the banks, default by Greece means that a hole is driven into their balance sheets.  They will need more capital.  The Euro summit agreement is to raise around another €100bn in capital for Europe’s banks. Most analysts reckon that this is way too little, as the figure is reached by just measuring the value of Greek and other government at current prices (Greek bonds are currently worth only 30% of their original price in bond markets).  The bank recap figure does not take into account potential losses if a new economic recession should break out in Europe.  Then bank profits would be lower and bond prices would fall even more.  Probably, the banks need another €300bn, not €100bn.  And yet the Euro leaders hope that the banks can raise this extra capital themselves without asking for more money from the state.  That’s a last resort.  And even if the taxpayers have to bail out the banks again, their governments will do so without taking state control.  Nationalisation, even of the Greek banks, is anathema.

The key issue for financial markets is how the Euro leaders are going to ensure that Italy and Spain continue to service their debts and do not default.  The cost of financing government debt in those countries has risen nearly to levels where repayments will not keep up with the rise in the debt level.  New issuance of these government bonds is now costing 5-6% a year in interest, more double the rate the German government pays.  Moreover, Italy already has a huge debt mountain (120% of GDP) which up to now it has financed through its own banks and pension funds buying bonds.  With those bonds losing value every day, Italy’s banks are looking in trouble.

But Germany does not want to stump up more taxpayers money to fund Italy and Spain for the next three years.  The German parliament and constitutional court has already objected to any further bailouts and the electorate will vote against any German government that agrees to it.  So there can be no extra cash or even guarantees for cash above what has already been provided in the EFSF.  So the Euro leaders have wrestled with some instruments of financial hocus pocus that will create extra funds without involving more cash.   The ‘solution’ agreed is to set up ‘special purpose investment vehicles’  (SPVs), which are funds that issue bonds guaranteed by the EFSF and can be bought by the likes of the IMF or the governments of rich oil sheikhs or the so-called BRICs, (Brazil India, China and Russia) which are flush with cash reserves.  The SPVs will then buy Italian or Spanish bonds and keep their prices up.  The EFSF will also offer to insure any buyer of Italian bonds for any potential losses from a default by up to 20%.  All this is supposed to attract sufficient funds to keep the governments of Italy and Spain from defaulting while they apply their fiscal austerity packages on their people.  This could be a great deal for the banks and foreign governments as they are partially guaranteed against any loss from default and yet get high grade EFSF bonds backed by European government with good interest rates. No wonder the stock markets have been booming on the news.

But none of these cunning schemes will work without a return to economic growth in those countries with debt mountains.  While nominal growth rates of annual output stay below the cost of servicing debt, the debt will continue to rise despite all the sacrifices the people make. But what hope is there of that when most of Europe is being asked to pay down public debt and cut their living standards? The ‘austerian’ wing of mainstream economics argue that it is possible to cut living standards and public services (i.e. an ‘internal devaluation’ of wealth and income) without the economy nose-diving or the people revolting.  They cite the examples of Latvia and Ireland.   Despite an 18% GDP decline in 2009 and a massive jump in unemployment from 6% in 2007 to 19% in 2010, Latvia cut its budget deficit from 8% of GDP in 2009-2010 to an estimated 4.5% this year.  But this tiny ex-Soviet state is not a good example.  While Latvian per capita GDP fell sharply, it had risen hugely before from a base index of 100 in 2000 to 324 by 2007.  It has now fallen back, but only to 304.  Latvians (with jobs) remain vastly better off than they did in 1990.  That does not apply to the Greeks.

As for Ireland, from the 1990s, the great Celtic Tiger saw a massive boom driven by huge inward foreign investment by American corporations taking advantage of low wages, a highly skilled English-speaking workforce and low corporate taxes.  These multi-nationals were able to export their goods from inside the EU to the rest of Europe.  Ireland’s per capita in 2007 was over 40% higher than Germany’s as a result.  But this is misleading, because that higher income does not end up in Irish pockets but in those of the multinationals.  Indeed, if you exclude the income that these multinationals receive from Ireland’s national income, Ireland’s national output would be 20% lower.  And you should do so, to get a better gauge of domestic prosperity.  Ireland’s real GDP has fallen 13% since 2007 and the unemployment rate is up to 14%.  But it has one advantage that the Greek capitalists do not – an export sector that is worth 100% of GDP.  As long as Europe does not go into another slump, Irish capitalism can recover quicker, even with severe fiscal austerity.

But the outlook for growth in general is not bright.  I still don’t think Europe or the US is heading directly into another slump.  But they are in a depression or very weak recovery.  That does not allow sufficient growth to overcome the debt problem.  This poses a straight question for the Euro leaders.  They can face the increasing possibility that the euro project will break up or they can opt for letting the ECB print money to ‘inflate’ their way out of the crisis, Keynesian-style.  So far, they are hoping to avoid both.

Those are the options for the capitalist leaders.  There are other alternatives for the people of Europe (see my post, An alternative programme for Europe,  11 September 2011).   The Greek government could organise its own default, one which reduces the pain for its pensioners and unemployed, namely default on all its creditors.  It could take over its banks and use them to provide credit for investment and growth and jobs.  There is money available from euro funds for this.  A Greek government should negotiate for the release of these funds.  Greece has untapped Euro funds worth around 7% of GDP.  A campaign by socialist governments for a different policy aimed at investment and job creation based on a euro-wide plan backed by state-owned banks could revive Europe’s economy and so make the issue of state debt levels redundant.  Unfortunately, such governments and such campaigns are nowhere to be seen.