News Can the Eurozone Survive the Economic Challenges of Greece and Italy?

[klimatos]

Perhaps, but how do you know this? For all I know Greek bonds are held by the Wisconsin teachers union pension fund, and they, or those like them, are exerting political influence on the IMF level pullers.

I have a daughter who is very high in international banking circles. She predicted every step of the Lehman Brothers fiasco months in advance and warned the Bank of England that they were about to be ripped off. The Bank's response was, "No, No, No. The US wouldn't do that to us!" Now, they know better.

By the way, she predicts that Bank of America will be in Chapter 11 within six months.

 

[MarcoD]

If all of the European governments needed to borrow at 7% then certainly the Dutch interest rate wouldn’t be 2.2%. If the European central banks were trying to not change the money supply they could sell their Dutch debt and buy Italian debt. All central banks influences the money supply by their actions. The only question is how should they do it and how much should they do it.

Yah, that was my point, that with too much inflation all the European governments would need to pay too much interest and in the end the European economy would blow up.

Somehow, given the lack of interest of the ECB and other affiliated central banks, I have the feeling that they are laughing their heads off.

(I checked the assets of the Dutch Central Bank, which is a member on the council of the ECB. I doubt the assets of all the European central banks combined are enough to fill the Italian debt hole, so the ECB can only buy debt with freshly 'printed' money, or European banks chip in. That's the silly thing: I doubt there even would be a debt problem if all the European banks agree to buy the debt. But that's similar like giving a blank cheque to government... seems like a lousy idea to me.)

 

[DoggerDan]

The 1907 panic caused a 50% stock drop which returned to previous highs within eight months.

Precisely. No matter how bad things get, life moves on. Sometimes sooner, sometimes later.

Still, we persist.

 

[John Creighto]

I think the facts are something like this (I need to confirm this with sources). I think the interest rates quoted are for loans with two year terms. For Italy 7% is considered dangerous. 5% is considered stable. Markets valued Greek debt at 50% before the haircut. The actually haircut I think was effectively 20%. That's about a 10% loss per year. If both the risk free rate of return was 2% (which is the target inflation rate) and a 20% haircut was considered likely then one might expect a fair market value for the interest rate on Italian debt to be around 12%.


The fact that interest rates are only 7% could mean the markets think one of the following:
1)the risk of an Itialian debt haircut isn't significant
2)the governments will cover the risk of Italian debt
3)their will be about 5% deflation per year.

For point 1, the Italian economy is considered in much better shape then Greece. For point 2. There has been some precedent of Europe helping to guarantee sovereign debt. Additional the ECB has been buying some sovereign debt to help reduce pressure on the interest rates.

With regards to point three while a 5% deflation rate is not likely to be seen in the CPI, asset prices have fallen significantly since the downturn. Stock market valuations (adjusted for inflation) have not fallen to the lows of the 80s and as the baby-boomers start to draw down their retirement assets there will be further downward pressure on asset valuations.

http://modeledbehavior.com/2011/02/22/the-401k-pyramid/

 

[MarcoD]

I think the facts are something like this.

I think all the facts can be derived from the following table:

The 'red' countries are in problems, Germany and France pretend that they are trying to fix things, which can't be true since their debt cannot run higher. Moreover, Europe can be damned glad with the former eastern bloc countries, who have low debt and a lot of room for growth.

Greece was never a problem (in the sense that I imagine the rest of the EU is more worried about their own debt), Spain cannot possibly be a problem, it is Italy and worst case France and Germany themselves which are the problem.

 

[MarcoD]

The fact that interest rates are only 7% could mean the markets think one of the following:
1)the risk of an Itialian debt haircut isn't significant
2)the governments will cover the risk of Italian debt
3)their will be about 5% deflation per year.

1) It may happen, but it is unlikely, Italy can even sustain 7% several years. 2) Can't really happen, they can take over some of the debt, but not all. 3) I think you mean inflation? My guess is that inflation is probably the worst which can happen; it will deflate the debt burden a bit, but at the cost of increasing the interest rates when rolling over the debt and evaporating Northern European investments.

If you look at the European figures of the previous post, the problem just isn't that big at the moment to start the money printing presses - and some of the Northern European countries will be very upset if the ECB starts doing that; I doubt it will happen. It is mostly sentiment which says that Europe is in a bad shape which, unfortunately, is also a hard economic fact.

The problem is the Italian government. They have been unable, under Berlusconi, to implement market reforms and austerity measures to get the Italian debt lower. In fact, they have seemed to have done the opposite the last decade. Now they have to, but it may be too little, too late, for market sentiment.

 

[AlephZero]

1) It may happen, but it is unlikely, Italy can even sustain 7% several years.

That is very unlikely under any set of assumptions. The only way to sustain debt in the long term is for the economy to grow faster than the debt interest rate, (and allowing for inflation). The Eurozone strategy on inflation is to keep it low (say less than 3%). The long term growth rate of the Italian economy has been less than 1%. So the debt is sustainable if 3+1 > 7. Financial engineers spend their working lives redefining the rules of arithmetic, but that's a tough one even for them to justify.

 

[MarcoD]

That is very unlikely under any set of assumptions. The only way to sustain debt in the long term is for the economy to grow faster than the debt interest rate, (and allowing for inflation). The Eurozone strategy on inflation is to keep it low (say less than 3%). The long term growth rate of the Italian economy has been less than 1%. So the debt is sustainable if 3+1 > 7. Financial engineers spend their working lives redefining the rules of arithmetic, but that's a tough one even for them to justify.

I agree with that, the debt would grow under these circumstances. But it can grow to, say, a 140% GDP before the government would go bankrupt. It ain't nice, but they could do that for a few years, if they would find a way out meantime.

[ The thing with Italy is that they have the money, they just don't tax enough. ]

[ Of course, I am Dutch. My best guess is that a combination of austerity in Italy and not starting the money presses is the best for the Netherlands, and probably most of the Scandinavian countries. The French, Germans, and Brits may disagree, though, not sure. ]

 

[John Creighto]

I think all the facts can be derived from the following table:

The 'red' countries are in problems,

Maybe but who decided that above 90% debt to GDP was a dangerous situation. I read somewhere else that 120% debt to GDP was sustainable. Japan was even able to sustain a higher debt to GDP then Greece but Japan has control over it's currency. What debt levels are sustainable is partly driven by Germany's fear of inflation
http://www.americanfuture.net/2011/11/10/germany-the-weimar-hyperinflation/

That is very unlikely under any set of assumptions. The only way to sustain debt in the long term is for the economy to grow faster than the debt interest rate, (and allowing for inflation). The Eurozone strategy on inflation is to keep it low (say less than 3%). The long term growth rate of the Italian economy has been less than 1%. So the debt is sustainable if 3+1 > 7. Financial engineers spend their working lives redefining the rules of arithmetic, but that's a tough one even for them to justify.

Interesting math but while 3+1 doesn't equal 7 part of the interest on the debt is paid of course from tax revenue. As to weather the debt is sustainable I have no opinion on this yet but here is what the German presendent of the Bundesbank Juegan Stark has to say:
"JW: You are rushing to conclusions in saying that the interest rate levels are unsustainable. Of course this level may not be sustainable in the long run if there is a lack of fiscal discipline and economic growth remains low. But in the short run I do not think it is such a big an issue. What we are facing in Italy is an acute confidence crisis, and only the Italian government can resolve that crisis by implementing what has been announced. Italy is very different from Greece in a lot of respects. I’m confident that Italy will be able to deliver."

http://www.americanfuture.net/2011/11/13/germany-bundesbank-president-opposes-ecb-as-lender-of-last-resort/

 

[MarcoD]

Japan was even able to sustain a higher debt to GDP then Greece but Japan has control over it's currency.

I always find the currency argument a bit silly. When it comes to government debt, there is no difference between a haircut, and devaluation of sovereign issued money. There is also no difference between lowering (government) wages and deflation of a currency. All in all, it doesn't matter. Most of the news about breaking up the Euro therefor is completely nonsensical. It'll only blow up a southern economy since they then need to invest in new IT, don't have access to the European market, and don't have access to European development funds.

The difference between northern and southern Europe is production and wealth; some of the southern European countries gambled on that they could grow their economies to compete with the north. Government debt isn't everything, I think if you look at private ownership of investments and banks, the truth -I expect- is that some of these economies (Portugal/Greece) just found out that they can't compete [at least not in the timeframe they thought they could], and now the north simply owns them. That's the real problem since there is no way out of that except for reforming the economies to make them competitive.

Maybe the only way out for Europe is to just implement a federal European army which mostly hires from the poor parts of the south. That manner the rich parts can send loads of money without anybody feeling bad about it.

(Then again, after the army we would need to start a war with, say, Iran, to defend the federal defense budget. And who would want that? )

(Anyway, I estimate that Japan, like Germany, still has a trade surplus, so they are hoarding cash and buying up the rest of the world. Likewise, the US can run a large deficit since, as the world's reserve currency, more money doesn't drive government bond interest up, but down. What do the Greeks have?)

 

[John Creighto]

"3)their will be about 5% deflation per year."

3) I think you mean inflation? My guess is that inflation is probably the worst which can happen;

I did mean deflation. But I meant asset deflation through deleveraging not CPI deflation. The money has to to go somewhere, and if all assets are losing value than cash may be a safe place to keep ones savings. However, after rethinking it why not just stock pile cash if deflation is a fear? So perhaps the nominal risk free rate of return can't fall below zero percent. However, hording currency is illegal and one could still be robbed so perhaps even hording currency isn't risk free.

So even though deflation can help favor currency valued assets like low risk debt it is also true that inflation can reduce real debt. However, unless people have a way of making more than inflation on their investments, assets which yield less then inflation will not be attractive. Banks find government debt attractive at low yields only because they are able to borrow at cheaper then inflation and able to borrow at many multiples of their net worth. They are able to do this because of both governments insures depositors and central banks providing liquidity when needed. This is effectively a subsidy of the banking system.

 

[John Creighto]

I always find the currency argument a bit silly. When it comes to government debt, there is no difference between a haircut, and devaluation of sovereign issued money. There is also no difference between lowering (government) wages and deflation of a currency.

This is true in some sense but one approach is much more gradual and politically palatable. There are also some technical differences which I'll discuss elsewhere.

All in all, it doesn't matter. Most of the news about breaking up the Euro therefor is completely nonsensical. It'll only blow up a southern economy since they then need to invest in new IT, don't have access to the European market, and don't have access to European development funds.

Is there sort of a prisoners dilemma going on here. Everyone knows they can benefit from the European Union but everyone is looking for the most advantageous terms.

 

[MarcoD]

Is there sort of a prisoners dilemma going on here. Everyone knows they can benefit from the European Union but everyone is looking for the most advantageous terms.

I think it's the growing pains of a union. Personally, I am not even that opposed to the current debacle, it forces the weak economies to restructure, and the debt position overall of Europe certainly doesn't seem worse in comparison to the US's.

I don't even like the idea of European bonds. I mean, to do what with them? Raise the overall government debt to 100%? A system in which debt is locally held, and in check with market forces, seems more robust in the long term.

The risk, of course, is that the whole of Europe may blow up... But I am gambling on the fact that there still is loads of money going round in most of northern Europe.

 

[MarcoD]

I did mean deflation.

Hmm, this is the difference between historical financial fears of the US and Germany right? The US fear deflation, and the Germans fear inflation. The current rate of inflation in Europe was, last I heard, still in the 2%-3% range. I doubt deflation will be a problem anytime soon, but I may be mistaken.

(Anyway, wouldn't people buy government debt -certainly if it goes at 7%- if deflation is a problem?

To be honest, I am not an economist, and not from the US. I don't even understand the problems of deflation that well, seems it just isn't in my historical genes. Weird uh?)

 

[MarcoD]

What about the Italian government debt credit default swaps?

Numbers are by http://www.bloomberg.com/news/2011-11-16/jpmorgan-joins-goldman-keeping-investors-in-dark-on-italy-derivatives-risk.html" , well, kind off.

 

[Vanadium 50]

I always find the currency argument a bit silly. When it comes to government debt, there is no difference between a haircut, and devaluation of sovereign issued money.

Of course there is. A default affects those people who are holding bonds. A devaluation affects those people who are holding (or will be holding) cash.

 

[MarcoD]

Of course there is. A default affects those people who are holding bonds. A devaluation affects those people who are holding (or will be holding) cash.

Yeah, that's true, which is why I said: "When it comes to government debt, ...".

(Anyway, let's say Greece or Italy step out of the Euro. There is little to no chance that their external debt will be redefined it lires or drachmes - all creditors will want it in Euros. So leaving the Euro is hardly an option for them: they'll have external debt which will grow if they devalue their currency, their own assets evaporate, and the only good thing is that devaluing would help their export position but they'll have less export to Europe since their currency will be deemed unstable. There really doesn't seem any benefit to either the creditor or the debtor.)

 

[AlephZero]

To be honest, I am not an economist, and not from the US. I don't even understand the problems of deflation that well, seems it just isn't in my historical genes. Weird uh?)

I'm still not quite sure what John Creighto means by "deflation", but the standard defintion is usually a good way to start a depression, because when prices are falling there is no incentive for anybody to buy stuff they don't actually need right now. Why buy something today for $100, if you know can buy it tomorrow for $99 or next year for $90?

 

[AlephZero]

Interesting math but while 3+1 doesn't equal 7 part of the interest on the debt is paid of course from tax revenue.

And in the long term, increased tax revenue comes from increased economic activity. QED.

Of course you can try to "screw the 1%" as a short term measure, but the likely result will be they just move themselves and their wealth to some place else.

 

[MarcoD]

I'm still not quite sure what John Creighto means by "deflation", but the standard defintion is usually a good way to start a depression, because when prices are falling there is no incentive for anybody to buy stuff they don't actually need right now. Why buy something today for $100, if you know can buy it tomorrow for $99 or next year for $90?

Yeah, I think I got it, and I think I understand the liquidity trap now. There doesn't seem to be a real danger for that, at the moment.

Back to that Bloomberg report. Anybody else got the feeling that this is a great time to be a banker, and -provided banks don't blow up- (inter-)national banks are soon swimming in GIIPS cash?

 

[AlephZero]

A summary of "who owes what to whom": http://www.bbc.co.uk/news/business-15748696

 

[MarcoD]

A summary of "who owes what to whom": http://www.bbc.co.uk/news/business-15748696

Either I am an idiot, or financial markets are. I mean seriously, Spain has an ok-ish public, and a large private debt, which is owned by the UK. That's probably mostly housing, which is worth exactly nada since their housing bubble collapsed. Who has the problem? If anyone is bankrupt, it's the UK's financial sector. But the Spanish are paying an enormous interest?

But I guess I am the idiot.

 

[DoggerDan]

Maybe but who decided that above 90% debt to GDP was a dangerous situation.

The 95% of countries who don't share in the miseries of the 5%?

 

[AlephZero]

If anyone is bankrupt, it's the UK's financial sector. But the Spanish are paying an enormous interest?

Spain not only has an economic depression caused by the property bubble collapse, but also some insanely protectionist employment laws. Employers are requred to give up to 5 years notice of redundancies, or keep paying people their full salary for doing nothing for that length of time.

The consequence is that no Spanish company has much interest in hiring new employees (hence youth unemployment is about 50%, and rising) and certainly no new startup company is going to base itself in Spain if there is an alternative option.

Financial markets work on the basis of predicting the future, not just on the current situation.

 

[MarcoD]

Financial markets work on the basis of predicting the future, not just on the current situation.

Yeah, I know that. Housing bubble, expensive healthcare, lots of workers protection rights, large (youth) unemployment.

But that doesn't change the fact that the public debt is low, and that the (bad) private debt is probably owned by the UK. The country itself shouldn't have a fiscal, liquidity or solvency problem but only a structural problem, and the way to deal with that is mostly a political issue.

I mean, this is a scenario where some small Spanish banks will topple, private debt will be restructured, both at the expense of the UK, and Spain will be left with low public debt and a slow economy. That's not a bad position to end up with.

I don't know the cost of bailing out (the clients of) bad banks though.

(I really have the feeling that in this case, high Spanish interest rates are the by product of bad financial news from the UK which wants its investments to pay off, moreover, also dominate the international financial media. I can understand that a US firm went bust on this one, Spanish debt is okay but media coverage is 'irrational' about the situation.)

 

[AlephZero]

But that doesn't change the fact that the public debt is low, and that the (bad) private debt is probably owned by the UK.

Do you have any evidence for that assumption? (In any case, "Spanish private debt owned by the UK" seems a strange way of doing the accounting, even if you are talking about British nationals with second homes in Spain)

Some numbers from http://www.bbc.co.uk/news/business-15789385

Spain in 1989:
Government debt 39% GDP
Corporate debt 49%
Houshold debt 31%
Financial sector debt 14%
Aggregate 133%

Spain now:
Government 71%
Corporate 134%
Household 82%
Financial 76%
Aggregate 363%

Compare with Italy:
Government N/A in the link
Corporate 81%
Household 45%
Financial N/A in the link
Aggregate 313%

 

[MarcoD]

Do you have any evidence for that assumption? (In any case, "Spanish private debt owned by the UK" seems a strange way of doing the accounting, even if you are talking about British nationals with second homes in Spain)

I extrapolated that from the BBC reference you gave, I'll look it over again to see if I didn't get the charts wrong.

Oops: The arrows seemed to be contrary to my intuition, but the foreign UK debt could also be read as the collateral used for investment, and close UK/Spain ties. Hmm, I think I got that wrong to translate that to UK investment, apologies, it is French and German debt - not UK. (Apologies again. My original reasoning was that Germany and France hold Spanish debt, and the Spanish hold UK debt, therefor, the UK is 'working' to pay off the Spanish debt. I think I got the spread number wrong, though.)

Some numbers from http://www.bbc.co.uk/news/business-15789385

Spain in 1989:
Government debt 39% GDP
Corporate debt 49%
Houshold debt 31%
Financial sector debt 14%
Aggregate 133%

Spain now:
Government 71%
Corporate 134%
Household 82%
Financial 76%
Aggregate 363%

Compare with Italy:
Government N/A (I'll fill in 120% here)
Corporate 81%
Household 45%
Financial N/A in the link (which would mean 67%)
Aggregate 313%

But that's the problem with external debt, right? First, external debt sometimes is high whereas the numbers are meaningless, Luxembourg has around 3,400% GDP external debt.

Second, not all debt is bad. If companies invested in production capability by upgrading their machine park with cheap money, then that is a solid investment. Also, household debt is okay if invested in real-estate instead of consumed. So what to do with these numbers?

Third, there is the point that you can't add all these debt together. Sure it says something about an economy, but normally you wouldn't find, in a scenario where IBM has large debt and Apple none, IBM a healthy company, but you could claim that on average, the IT sector is doing okay. (And still you wouldn't know since IBM might be investing and therefor outpace Apple in a few years.)

It looks to me that Italy's government has far larger problems than their economy, and the Spanish government hardly has a problem with debt but solely with the economy, the youth unemployment. As long as they can service their debt, even with 50% youth unemployment, nothing is the matter.

 

[MarcoD]

Do you have any evidence for that assumption? (In any case, "Spanish private debt owned by the UK" seems a strange way of doing the accounting, even if you are talking about British nationals with second homes in Spain)

I am still in economy class 101, but puzzling a but further. First, it is odd that Spain would have invested that much in the UK, that doesn't really make sense, right? So there is something strange about the UK debt owned by the Spanish. I think I figured it out.

It has to do with the UK having its own currency.

Say investors in Spain want to sell to the UK. If they find an investor, he pays in British pounds, fine. So a Spanish bank ends up with pounds, doesn't know what to do with it, but it is worthless to have it laying around so the bank buys UK treasuries, and uses those as collateral to buy Euros, and the deal is finished.

So, yeah, the UK debt hold by Spain may well be British investment. Then again, it may also be the result of UK tourists buying sangria, or pensionistas buying homes. No idea.

No idea if this makes economic sense though.

 

[sfs01]

Some numbers from http://www.bbc.co.uk/news/business-15789385

Spain in 1989:
Government debt 39% GDP
Corporate debt 49%
Houshold debt 31%
Financial sector debt 14%
Aggregate 133%

Spain now:
Government 71%
Corporate 134%
Household 82%
Financial 76%
Aggregate 363%

Compare with Italy:
Government N/A in the link
Corporate 81%
Household 45%
Financial N/A in the link
Aggregate 313%

The glaring omission in that article is however the same statistic for the UK, with aggregate debt at 469%. Even after gratuitously subtracting the contribution of the London financial sector, it remains above that of Spain in the underlying source (http://www.mckinsey.com/mgi/.../debt.../debt_and_deleveraging_full_report.pdf)

 

[MarcoD]

I hope that the all of you are not too bored with the subject, but the situation is getting grim. Looks like they either solve it or maybe this, maybe next, year we will see countries defaulting and possibly banks topple over.

Interestingly, that means that maybe in a year I'll be standing in line for free food?