The Ongoing Collapse of Greece's M2

Greece is going through something equivilant or worse than the Great Depression that occurred in the U.S. and Europe in the 1930's right now.  One of the hallmarks of this is their recent spate of public suicides as reported on by Reuters here.

Athens in April 2012 (photo: Jake Zalium)

The effects that this economic collapse has had on the people of Greece is nothing short of a tragedy.  This is not to excuse the role that Greeks have had in creating an unbalanced society, but their participation in the Euro has made them unable to help themselves through monetary policy, and their fiscal situation has made themselves completely dependent upon other Eurozone countries to finance any fiscal remedies (which have been non-existant, and in-fact negative, or "austerity programs").  I believe that Greece should exit the Euro for their own sake.  It would probably not be the best action for the rest of Europe, but Greece is facing a fate far worse by staying in the Euro, than by leaving.

All of the catastrophic pain that they would experience over the immediate term after exiting would help alleviate the long term hopelessness of what is an impossible recovery right now.  The fact is that Greece cannot recover within a currency that refuses to devalue itself despite economic conditions.  The European Central Bank has offered a great deal of lending to Eurozone banks in an effort to stimulate private and public lending.  While that has had some effect, it has not reversed the decline of Greece's M2, which has been in a tailspin for the past two years.

To review, the M2 is one of the broad measures of money within an economy.  It includes currency, money in checking accounts, savings accounts and short term CD's.  The annual decline in the M2 for 2011 in Greece was 15%.  It was 10% in 2010, and down an additional 1.9% from its peak in September 2009.  This decline has continued to get worse in 2012.  That has been about two and a half years of continual decline in the M2 for Greece.  I do not know of a country that has had economic growth while also having declining M2.  It sounds impossible.  The worst part of this situation is that as long as Greece is that this trend looks to remain the same for as far as I can see.  Surely that is not forever, but I do not know how this will change with Greece within the Eurozone.  They have little to no control over their own macroeconomic conditions.
One of the ironies of a potential move back to the Drachma is that the ten year program to exchange Drachnas for Euros ended March 1, 2012; perhaps to be reversed soon.

Will the ECB's 'fine tuning' Avert a Crisis?

The European Central Bank (ECB) just offered their first of two "fine tuning operations."  These seem like the opposite of fine tuning, because the first is one of the largest loan operations in ECB history.  They loaned 640 billion euros to banks at 1% for three years.  The second fine tuning operation will take place March 22, 2012.

Mario Draghi (photo: Daniel Fallenstein)

This comes after ECB President Mario Draghi had announced that he wouldn't be purchasing sovereign debt to hold down the interest rates.  The ECB was criticized for this stance, and comparisons to Nero playing his fiddle while Rome burned were made.  Part of this might be a misunderstanding.  One important thing to note is that the ECB does not work exactly like the Fed.

When the Fed wants to increase the money supply, they enter into repurchase agreements with banks involving short term Treasury securities.  When they want to make longer term monetary policy decisions, they purchase the securities or bonds outright.  So, the Fed doesn't buy U.S. debt directly from the U.S. government but it allows for them to have influence over the U.S. bond interest rate and prices in addition to providing liquidity to the banks and the economy at large which is the ultimate goal.

The ECB operates slightly differently.  When they want to make monetary policy decisions, they loan directly to one of their member banks.  That loan might be short or longer term, depending on the policy goals.  So their influence on sovereign debt interest rates is much more indirect.

This action by the ECB is the first credible step that they have made to stabilize this crisis.  For one thing it directly injects much needed liquidity into the economy.  If banks purchase sovereign debt, it could push down yields and provide much needed breathing room for Greece, Italy, Portugal, Spain, etc.  Of course, they don't have to... and in the days following these loans, the yields for Italian bonds which have really become the weather vane for Europe, have not gone down.

This might mean that one of the key differences between the ECB and the Fed, might be a critical problem for Eurozone countries suffering through this debt crisis.  This "fine tuning" is a positive first step towards stabilizing the Eurozone, but if interest rates do not fall, the ECB should consider modifying their loan program in March towards a more Fed-like system.

The Avoidable Catastrophe

European Union leaders concluded their latest summit, with their usual small solutions to enormous problems.  Here is a link to their release, detailing their new agreement.  They have decided to offer up more funds for member state bond market stabilization and redoubling their efforts at austerity, which has only exacerbated this problem thus far (including a ridiculous tax on countries that go over the 3% rule).  They still have Italy contributing 17% and Spain 11% of the EFSF funds, which sounds ridiculous given the fact that they are currently mired in severe deficits and Italy is already paying high interest rates to service its debt.  The only good thing to come out of this summit was that nobody has left the Euro (yet).

During the summit, fears and rumors led to multinational corporations reportedly moving their money from countries rumoured to be exiting the Euro to presumed safe countries.  That also probably compounded the bank runs problem in Greece.

Despite markets being up Friday, these problems will likely continue as none of the them have really been solved.  This means that none of the uncertainties that have created deflationary conditions in southern Europe will go away, and the economic conditions will continue to deteriorate.



European leaders signing the Treaty of Rome in 1957



Speculation of this variety does not help, but for countries that could be forced out or leave the Euro, this could amount to an economic catastrophe.  Their country will likely be almost immediately bankrupt unless Eurozone countries agree to continue bailout loans, or a bailout fund through the IMF.  It is hard to imagine that their currency will have any reputation as a store of value.  Their central banks will have little in the way of credibility to create monetary policy.  This will leave these countries in something like a liquidity trap because any monetary policy they try to employ will have little effect.  Deflation will be immediate and substantial, and it will be difficult to turn that around towards inflation or GDP growth.

A liquidity trap is defined as the point that monetary policy is no longer effective because bonds and money are perfect substitutes.  This situation is slightly different, because there will likely be so little demand for bonds, coupled with little central bank credibility that they will not be able to hold down interest rates to stimulate the economy in a meaningful way.  This means that monetary policy will be an ineffective tool to stimulate the economy.  Similarly, these countries will likely not have full sales of their bond offerings, and will have to cut government expenses even more significantly.  GDP will almost assuredly nosedive.  This should be classified as something worse than a liquidity trap because it will be a situation where neither monetary nor fiscal stimulus will be possible.

IS-LM in a Liquidity Trap (Krugman)

What would be left of the Eurozone will not be spared from a significant contraction.  Mark Cliffe of ING speculates that the new currencies would plunge.  His white paper speculates on a full break up of the Euro, but similar movements would be felt from select countries exits.  Similarly, northern European countries will inevitably feel the effects of the severe economic contractions of southern European countries in the form of contractions of their own.  These contractions could last a year in the case of northern Europe and years of severe contraction for southern economies.

The only possible heroes are the European leaders, but it looks as though they are still not truly believing in their own shared destiny.  The main villain can easily be viewed as the European Central Bank (ECB).  Their strong currency position has strained the growth of southern European countries, and even this Spring, they raised rates because of inflation fears.  Thursday, they cut rates, but at a paltry .25%; when Greece, Spain and Italy were literally having capital streaming out of their banks, economy, and even geography.  Much of this agreement seems to be stressing an increased ECB role, but hard to imagine them doing what is necessary to help southern economic conditions.  They will be acting as the operating agent of the EFSF and ESM funds to purchase sovereign debt.  Hopefully they will be more active in that pursuit, than they have in monetary policies.


Solution:

I would argue that there is still time and opportunity to avoid this recession.  I think the best solution is to pool credit risk.  An agency such as the European Stability Mechanism or the European Financial Stabilization Mechanism or another more robust agency could purchase all the debt of all member nations, and in turn issue Euro bonds.  The Eurozone, in total, has a debt to GDP ratio of 85%, which is below the United States and within an acceptable range.  The Euro as a currency has and would continue to have significant transaction demand, and the ECB would continue to have legitimacy and credibility for creating monetary policy.

Creating a true fiscal union (as opposed to the current proposal which merely acts as an enforcement agency of the 3% rule) would also be important to insure that this does not become a repeated problem, and (of course) to pay down the Eurobonds, and pool more government expenses.  These two solutions (Eurobonds and fiscal union) might cause Eurozone nations to rethink whether they actually want to remain in the currency.  It is hard to imagine EU members that have not adopted the Euro join this arrangement which would leave countries like the U.K. and Sweden out.  For that reason, I think secondary treaties such as a greater European community (but explicitly non-EU) would be important for keeping important commercial and economic ties, while being excluded from a federal system and unified currency and bonds.

It does not look like enough European leaders are interested in this arrangement.  I think we are still staring at a difficult situation in Europe that hasn't really been solved.  If conditions continue to deteriorate, European leaders will be forced to hold another summit, and who knows how much longer bond markets are going to tolerate these half-steps.  They're barely tolerating it now!

If countries leave the Euro, France and Germany will instead likely be somewhat forced to bail out banks that will be overexposed to southern European debt or too weak to withstand this recession (Commerzbank, which is trading at an awfully low price of € 1.37 might be the first) or face a more severe recession of their own.  Southern Europe will be have negative economic growth for years.  It should be considered a failure of leadership that Europe was not able to find a way towards this solution over the past year and a half.

We're Gonna Need A Bigger Boat

via Bloomberg

It is starting to really hit the fan in Italy as yields on 10 year Italian bonds hit 7.4%!  This was always the country that everyone was worried about when they were talking about the other PIGS (Portugal, Italy, Greece, Spain), and it looks as though Italy is almost tipping over.  This recent market action has been the main cause for the President of the Council of Ministers, Silvio Berlusconi, to resign.  This news has not stopped the market from driving up the yield for Italian bonds further.


Palazzo Montecitorio, Rome (photo: Marco Assini)


It remains to be seen what, if anything, the Eurozone can do to help the Italian bond market, as they have with Greece.  Economists and market watchers have long said that Italy is too big to get the same "fixes" that Greece received.  The wheels keep churning at the Italian Ministry of Economy and Finance, they'll be having new bills issued tomorrow, and more 10 year bonds next week.  This might be the one of the more interesting months in economic history, as it might see one or more countries exiting the Euro.  It seems the economics blogosphere is abuzz with that idea, and rumors are spreading that top French and German officials are already discussing how it would happen.

Most currency changes are done years in advance so that all market participants understand what is happening.  The Euro was introduced over a three year period, initially (1999) only electronically, and older currencies were still accepted physically until 2002.  It is likely that if the Euro shrinks in terms of countries, or if it is scrapped altogether, it will happen quickly.  If Greece reintroduces the Drachma, or Italy the Lira, it will be almost overnight.  This will be an awful shock to the economy.  Deflationary pressures will be enormous, and productivity losses could be severe due to loss in the medium of exchange because large economic areas won't have currencies for a period.  It will be ugly, but the uncertainty of how ugly is enormous.

Is Europe Equipped for this Financial Crisis?

European finance ministers met last weekend in Wrocław, Poland without reaching an agreement on Greek debt.  Decisions like this are difficult for any political process, but the scale of this problem and the nature of Europe's political power structure leaves me wondering if Europe will even be able to come to an agreement on any bail outs, bankruptcy, or similar issues.  There is not a strong federal infrastructure, which means that any agreements are constructed somewhat ad hoc and dependent upon near consensus to reach a feasible agreement.  So it seems that there are many ways that these intense negotiations could derail, and a difficult road to a potential agreements.


Wrocław, Poland (photo: Stefan Schlautmann)

There are many ideas being floated to solve these issues.  One includes a larger role for the European Union (E.U.), others include Euro bonds.  Philipp Rösler, Vice Chancellor of Germany, is calling for new procedures that would allow Greece or other nation states in the European Union to declare bankruptcy.  He has also announced his opposition to Euro bonds.  In an op-ed for Die Welt, Rösler continues to oppose increased central powers in Brussels, instead preferring a code for member state budgets and sanctions against straying countries.

Philipp Rösler (photo: Liberale)

Rösler plays a new, but pivotal role in the European sovereign debt crisis.  He has recently assumed the Chair of the Free Democrat Party (FDP) in Germany.  This is the party that helps Chancellor Angela Merkel's Christian Democratic Union (CDU) party form a majority in the Bundestag.  Rösler has only been chair since May when Guido Westerwelle stepped down following terrible regional election results.  The party declined further in last Sunday's elections in Berlin.  The FDP has declined after not delivering on promises to lower taxes.

82% of Germans are unhappy with the way that the German coalition government has handled the European sovereign debt crisis.  With disapproval levels so high, German political instability could be an additional hurdle to any European debt negotiations.  Germany has a parliamentary system, so while the next scheduled election isn't until the Fall of 2013, another election could happen earlier if Merkel cannot survive a no-confidence vote.  In that case, a snap election would be 60 days after the dissolution of the Bundestag.  Rösler stated this week that his party remains committed to that coalition.


Merkel's Union party is still atop the polls as of this month with 31% support, but Social Democrat party gains are threatening to overtake them with 29%.  Because there are five semi-viable parties in Germany, coalition governments are the norm.  The question is: how long can the FDP continue to stay in a coalition while their numbers are plummeting?  Will they need to make a change in political stance in order to maintain their viability?

COMPLEX INTERNAL POLITICS

This shows some of the complexity problems that Europe is dealing with.  Every member state has their own political processes that their politicians are trying to gauge and win.  These domestic politics may be at odds with larger continental politics.  For instance, at the negotiations in Poland, Finland was demanding collateral for their loans, which likely contributed to the non-agreement.  It is doubtful that one party kept that group from agreeing to more loans, but it shows how difficult it will be to satisfy everyone.  In cases such as these, how can markets truly judge which way governments will act?  These uncertainties are adding to market pressures.  With Greek default looking increasingly likely and even imminent, markets are wondering what a Greek default would look like, and how it will impact the Euro.

This lack of certainty is fueling frustration.  83% of Germans recently said that they were dissatisfied with the amount of information that they received regarding current European events.  These events have been difficult for me to judge, but I always assumed that was because I was on this side of the Atlantic.  I can't tell if I should be happy, relieved, or more worried that continental Europeans are just as frustrated as I am at the lack of information coming out of Athens and the other capitols of Europe.

Tomorrow, Greece has interest payments on two bonds worth over 768 million euros bonds to pay.  They have said that they have enough cash to pay them, but there was also a recent story that less than 75% of banks are going to repurchase Greek debt when it comes due again.  If fewer institutions are willing to buy Greek debt at any interest rate, there is little that anyone can do to stop a default.  If Greece does default, I don't know if anyone knows exactly what that will mean.  Will they stay in or out of the E.U.?  Will they stay in or out of the Euro?  Are those mutually exclusive?  If they stay in, how are other countries affected by Greek commitments?  If they stay in, how much sovereignty do they retain?  Do they become a second tier nation within the E.U.  Also, if Greece does default, wouldn't they actually need to devalue whatever currency they have anyways to regain their competitiveness?  There really are so, so, so many questions.

This situation is likely to continue deteriorating, with any Greek default only adding to problems in Italy and other economies.  Even if there were a strong popular consensus, I think it will be difficult for the European Union to arrive at large decisions like this in crisis situations.  Given their current fractured opinions, compromises seem even more difficult, and as such, a catastrophic financial crisis seems more likely.

Leonard Cohen - "Everybody Knows"

The German Dilemma

Simon Maughan of MF Global summed up the current European financial situation very well when he was interviewed last Wednesday on Bloomberg Surveillance.  He posed the question:

Spoken like a true banker, but that is Germany's current dilemma.  Maughan also spoke about Basel III and other European financial issues.

Simon Maughan on Bloomberg Surveillance (MP3) via Bloomberg