The Euro Crisis and a Tale of Two Graphics

Filed Under (Finance) by Morton Lane on Jan 12, 2012

 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.

Daniel Hamermesh on Recycling

Filed Under (Environmental Policy) by Nolan Miller on Jan 31, 2011

Daniel Hamermesh has an interesting post over on the Freakonomics blog about his recent trip to Germany and their approach to recyclingGermany has quie strict recycling rules, and Germans are required to separate their “excess” into bio, packing, paper, white glass, green glass, brown glass, and everything else.  As in the US, the recycling requirements raise the prices of recyclables (e.g., think of the deposit tacked onto cans and bottles in many states).  However, Hamermesh points out the additional benefit.  The extra effort needed to property sort and recycle everything (and he reports there’s no recycling on Sundays) probably discourages people from buying recyclables in the first place.  This latter effect, he proposes, might be more important for the environment than the actual recycling.

This got me thinking about ways we could kill two birds with one stone in this country.  Environmental economists like to think about “double dividends” such as how environmtal taxes have the dual benefits of helping the environment and allowing the government to reduce other taxes.  Well, what about if we required, say, 10 push-ups every time a person used a plastic water or soda bottle?  This would help people get in shape, and, given our national aversion to exercise, would probably result in a large reduction in bottle use as people move to reusable containers and find other ways to avoid a little exercise.  Think about it.  The possibilities are endless …

A Personal Reflection on “the Night that Changed the World” – November 9, 1989

Filed Under (Uncategorized) by Jeffrey Brown on Nov 10, 2009

Twenty years ago today, I stood – along with hundreds of German citizens – on top of the Berlin Wall in front of the Brandenburg Gate.  The night before – November 9, 1989 – East Berlin’s Communist party spokesman, Gunther Schabowski, had announced that East Germans would be allowed to travel to West Germany.  After 28 years of travel restrictions, East and West Berliners alike immediately took to the streets.  By the time I arrived at the Brandenburg Gate on the night of November 10, chaos still reined.  Indeed, as I climbed up the wall and jumped down onto the East Side of the Wall – after ceremoniously taking a whack at it with a hammer borrowed from an ecstatic West Berliner – my progress was immediately blocked by a line of East German soldiers.  There they stood, shoulder-to-shoulder, standing before a line of water cannons that were aimed straight at those of us foolish enough to jump down onto their side of the Wall.  Coming only 5 months after the Tiananmen Square massacre in Beijing, none of us knew just how the East German military would react.  Fortunately, this demonstration turned out very differently. 


I knew at the time, of course, that I was witnessing history.  After all, the Berlin Wall was the ultimate, tangible symbol of the East-West divide that marked the Cold War.  As an undergraduate at the time (it would be another decade before I earned my economics PhD), however, I did not have the training to fully appreciate that I was also witnessing the end of the most powerful and persuasive economic experiment ever conducted on the relative merits of free-market capitalism versus central government planning.  Even lacking the terminology to fully describe it, however, I could see the results of the experiment.  As I walked the nearly-deserted streets of East Berlin on November 11, I was stunned by the obvious economic decay in the East: the old cars that spewed emissions, the often-bare shelves in the stores, the poor quality food, the decaying buildings.  Not to mention the enormous display of “revealed preference” by the tens of thousands of East Berliners so anxious to escape to the West. 


It was one of those experiences that left an indelible mark on my thinking.  And while I could not quite find the words to describe it at the time, I instinctively understood that whatever they were doing in East Berlin, it clearly had not worked.  In the following weeks, as I also visited Prague during its democratic demonstrations, as well as Budapest, I quickly discovered that the failings of central planning were not unique to East Berlin.  It has been a disaster everywhere.    


I credit Alan Greenspan’s book, “The Age of Turbulence,” for helping me put it all into appropriate perspective many years later.  He noted (page 131) that:


“Controlled experiments almost never happen in economics. But you could not have created a better one than East and West Germany, even if you had done it in a lab.  Both countries started with the same culture, the same language, the same history, and the same value systems.  Then for forty years they competed on opposite sides of a line, with very little commerce between them.  The major difference subject to test was their political and economic systems: market capitalism versus central planning.  Many thought it was a close race.”


He goes on (page 132) to note that:

“The fall of the wall exposed a degree of economic decay so devastating that it astonished even the skeptics.  The East German workforce, it turned out, had little more than one-third the productivity of its western counterpart … The same applied to the population’s standard of living.  East German factories produced such shoddy goods, and East German services were so carelessly managed, that modernization was going to cost hundreds of billions of dollars.”


Finally, (p. 382) he notes that “The fall of the Berlin Wall exposed a state of economic ruin so devastating that central planning, earlier applauded as a “scientific” substitute for the “chaos” of the marketplace, fell into terminal disrepute.  There was no eulogy or economic postmortem.  It just disappeared …”


The economic and financial market disruption of the past 24 months has been difficult for many in the U.S. and around the world.  To those who have lost jobs, witnessed their 401(k) values plummet, or watched helplessly as their house values fell below the balance of their mortgage, it is tempting to want the government to protect us from these risks. But we should be careful what we ask for. 


The lessons learned from the failed central planning experiments of the Cold War are not just lessons of history.  They are fundamental lessons about how to successfully structure an economic system.  Given a choice between a system that assumes the government knows best and a system that allows individuals and markets to operate freely, I will always choose the latter.