As 2011 draws to an end, the Euro crisis appears to have taken a rest from the headlines. Perhaps it is just that the holidays have commanded our attention. But my first prediction for 2012 is that Europe will return to the headlines, soon. Given the pause, maybe it is time to reflect on what exactly the crisis is all about. I believe that the crisis needs to be re-framed. We have deluded ourselves about the exact cause and this inhibits progress to a solution.
Start with the idea that for every complex crisis there has, at base, a simple explanation, a simple cause or simple delusion. In the financial crisis of 2007-8 the simple explanation was that the populace of the US and elsewhere deluded themselves with the idea that real estate prices would keep on rising and could never fall. If you were conservative perhaps you thought that price increases could pause, but even the most conservative never thought that prices could, yikes, drop. From that simple “popular delusion of the crowd” lots of poor behavior decisions emanated – most notably taking on too much debt – to finance, and to take advantage of, ever rising real estate prices. When the delusion met reality all sorts of blame, shame and pain was passed out. Truth to tell, we were all to blame, and that includes everybody from house flipper to Investment banker. We deluded our selves.
Interests Rates on 10-year Goverment Bonds (in percent):
The question for the Euro crisis is what was the analogous popular delusion of the European crowd? The first graph contains the answer. (The graph is borrowed Atlantic Magazine’s Best Graphs of 2011.) When the Euro was introduced, the idea that took hold, by governments and consumer alike, was everyone using the same currency should be able to borrow at almost identical interest rates. The borrowing rates of the Euro zone members would converge. “Convergence” was the European crowd’s popular delusion. Greece could borrow as cheaply as Germany. As the graph shows, this delusion lasted for almost seven years from 2001 to 2008 and during this period Greece did borrow as cheaply Germany. So did Portugal, Ireland, France and all the rest. But as the graph also shows, prior to 2001 and the introduction of the Euro as “legal tender” the markets discriminated between the creditworthiness of Greece and Germany. They are beginning to do that again. Greece’s 10 year borrowing rate was 16% in 1996. It is again now. (Actually at the end of 2011 it’s probably almost double that; the borrowed graph was drawn mid 2011.)
The big difference between 1996 and 2011 is that Greece no longer has the ability to redeem its debts in Drachma. It has to now generate Euros, and obtaining those is harder than printing Drachmas. In fact to generate Euros the country has to manufacture and sell more goods to customers who pay in Euros, or buy fewer Euro-denominated imports. That is proving to be difficult because the price of Greek goods in Euros is too high. That is true of Greek holidays, Greek labor, Greek shipping, Greek cotton, Greek olives and the rest. The only solution is to cut labor costs, or equivalently, raise productivity. That is hard to do when you have had seven fat years.
Imagine if you once had to pay 16% on your debts and suddenly some people start lending to you at 5 %. (It was even less by 2006, around 3.5 %.) Well the traditional economic response from the rational buyer of credit, i.e. borrower, is to use more of it. Greece borrowed a lot. It was not alone. All the major countries with higher credit risk in the pre- 2001 period, including Portugal and Ireland took advantage of the largess of lenders. Shame on them! They should not have done it. But they did, so they must pay it back. As long as they could roll the repayment through further debt sales, it was well and good. However after the financial crises the largess of lenders became more rationed. It cost more to refinance. In fact it has got to the point where the refinance rates are usurious. Greece and the rest may not be able to redeem their debts. They may default. Shame on these profligates!
But why chastise them alone?
Isn’t the opprobrium more sensibly shared with the lenders? Didn’t the lenders just mess up? As a credit analyst why would you ever lend to Greece and the rest at 5%, if you previously thought 16% was the correct rate? It was true that they could no longer print their own currency, but that did not mean that could not spend money inappropriately if it was poured upon them. Surely the lenders were the deluded ones.
Exactly who were those irrational lenders? That is the significance of the second graph. (This graph is borrowed from the New York Times, May 2010, and based on then-current BIS data.)
The big lenders were Germany, France and the U.K. Between them they lent the Greek Government $135 Billion (33% Germany, 56% France and 11% U.K.). Collectively those three countries lent a total of $2 Trillion (35% Germany, 45% France and 20% U.K.) to Portugal, Ireland, Italy, Greece and Spain, also known as the PIIGS, at incredibly low rates. The mechanism for the loans was buying the sovereign bonds of those countries. They made bad lending decisions; they should accept the consequences by marking their bonds to market, by accepting the loss. Bad lenders, shame on them!
Why did conservative and sensible Germany lend so much to Greece? Well we are suggesting here that they deluded themselves into the convergence scenario that would magically appear with the introduction of the Euro. Certainly the Euro was not the only vehicle for “Convergence” expectation, cross-country and cross-product subsidization had always been part of the EU, but the fantasy really took flight with the introduction of the Euro. But perhaps there is even more to it than that. Germany is the number one country that Greece imports from. France is number five. One way to think of the whole Euro crisis is therefore as a giant “vendor financing” scheme that went wrong. It will not be the first time that vendor financing schemes went awry – General Motors, Toyota and Ford car leasing programs among others have been prime examples. When those schemes went wrong however the managements (and eventually the shareholders) had to take their lumps and move on. They didn’t stop leasing cars they simply recognized the mis-pricing, re-priced and moved on. Germany and France seem less inclined to do the same.
France strongly resisted taking any kind of haircut (diplomatic-speak for marking to market) and German tax payers do not want to pay for their governments mistakes. European banks who hold European sovereigns don’t want their capital to be impaired through mark to market.
So, shame on whom?
To move forward it’s not shame that needs to be apportioned it’s the pain. The seven fat years don’t have to be followed by seven lean (depression?) years. Re-price and move on. If there were no transfer-union entanglements the lenders, be they governments or private banks would write off the bad loans and then make a decision at what price they were prepared to now lend to a bad credit. Greece and the others could then calculate whether or not the price of still using the Euro at market rates was worth the cost. They may decide to leave the Euro, as might other countries. That does not necessarily kill the Euro. It can still exist for those who want to use it, just as some countries e.g. in Central America, have chosen to use the Dollar as their official currency. A country that uses the Euro in the future will know two things, a) that it surrenders the printing press to the ECB and removes that lever from domestic politicians, and b) that it will face difficult and expensive borrowing unless it keeps its fiscal house in order.
The Euro need not die, but the delusion of “Convergence” will, or already should have. Instead the Germans and French lead other Euro-Zone nations to cling to the delusion. They have proposed even greater mutualisation of fiscal policy among Euro-Zone members. Lectures are forthcoming with regularity from those who made bad credit decisions to those who were deemed to be profligate. This is a posture that might be acceptable from a bank that was setting new loan conditions and rates to a previously recalcitrant borrower, but was still willing to provide finance. Instead what is offered is a “my way or the highway” policy from a collective of lenders who refuse to recognize their own mistake, refuse to mark down their past errors and continue to cling to the “Convergence” objective. It ain’t gonna happen, but if it did it has a greater chance of success as a voluntary consequence of the cost of profligacy, i.e. countries paying market credit rates, than from the demeaning business of being bailed out and lectured to by the very people who pushed cheap credit in the first place.
Enough already! Taking losses is never pretty, for borrower or lender, but it is surely the best and quickest way to correct errors and faulty assumptions. As they say in the bond market, there are no such things as bad bonds, just bad prices. Sovereign credits were badly mis-priced; re-price and move on. Or, to non bond market mavens, when you are in a “Convergence” hole, stop digging.