“Why can’t Greece be more like us?”

Why can't a woman be more like a man?
Men are so honest, so thoroughly square;
Eternally noble, historically fair;
Who, when you win, will always give your back a pat.
Why can't a woman be like that?...

Henry:
Well, why can't a woman be like us?[1]

So the first steps in the third bail out of Greece were taken last weekend.  The terms of this new deal are hard and grating on the Greeks, but the perspective of lending up to €90 billion to a country which has caused private creditors to lose €105 billion in 2012, and which will likely need tens of billions of debt forgiveness from eurozone members should also be grating on European taxpayers.

Above all, there is little trust that, this time around, Greece will change its economic model to fit in the eurozone, relying instead on the reluctance of other members to pull the plug. The Greeks already went through a lot of pain, yet they have nothing to show for it.  PM Tsipras declared that he didn’t believe in the reforms which were demanded of Greece. 

Chancellor Merkel could be forgiven if asked, “Why can’t Greece be more like us?”

Contrary to most commentaries, the main problem of Greece is not the excessive burden of its public debt but its lack of economic competitiveness.  As explained in a previous post, its debts mature over 30 years, interest rate thereon is very low and payment thereof is partly deferred; that is not much of a burden.  Besides, Greece has had a primary budget deficit, that is a deficit before taking into account the payment of interest on its debts.

This time around, the euro safety net has grown so tenuous that either Greece accepts to make big changes now, or it is forced to leave.  Even then, absent changes, it would experience a painful drop in living standards.

The needed changes are huge, the government is ideologically opposed to them, the Greek population is no more enthusiastic, and time is short.  Yet Greece could find examples of small countries within the eurozone which successfully reformed their economies, and did so with far less outside financial assistance and in a relatively short period of time. 

I am talking of the Baltic States: Estonia, Latvia and Lithuania.  Having won their independence from the USSR, these countries switched from a centrally planned soviet economic system to one open to the rest of the world.

What is remarkable however is that the bulk of the reforms took only five years (1992-1997)!

The essential policies that allowed the “Baltic Miracle”, with some variation in emphasis and timing, can be summarized as follows:

·        Anchoring the currencies either via a peg[2] (Latvia, Lithuania) or a currency board[3] (Estonia), to control inflation;

·        Reforming and simplifying the tax system with a combination of lower - sometimes single flat - income tax rates for individuals and corporations[4] and of VAT taxes.  This, combined with prudent public spending helped bring budget balance close to equilibrium[5];

·        Liberalizing prices and markets, and in the case of Estonia, opening up its economy to imports by eliminating tariffs and quotas[6];

·        Privatizating state enterprises to reduce the overwhelming size of inefficient public sectors, make the transition to free markets difficult to reverse, and bring fresh capital into the economy.  In Estonia, privatization was carried out via international tenders to choose a core/majority investor for a given company and then via the voucher system to attract minority shareholders.  Lithuania used the voucher system.  On average, over the 1993-1997 period, annual government revenues from privatizations averaged of 3.4% of GDP.

·        Reforming the pension systems, between 2001 and 2004 with a combination of (1) a solidarity scheme based on Social Security contributions, (2) mandatory personal funded retirement accounts, and (3) discretionary personal retirements accounts.

Critics will point out that the Baltic States’ economies shrunk more that the rest of Europe’s in 2009.  They did.  Clearly they had allowed bubbles to grow, and they were constrained by their strict monetary systems[7].  But that doesn’t take anything away from the remarkable and successful efforts undertaken in the 1990s, before some complacency crept in.

Furthermore, one should note that the Baltics also responded positively to the 2009 crisis by pushing forward deeper reforms in their pension systems and keeping a lid on their budgets. 

By 2014, Estonia, Latvia and Lithuania’s budget balances were +0.6%, -1.4% and -0.7% respectively.  This compares favorably with France (-4%), Greece (-3.5%), Italy (-3%), Portugal (-4.5%) and Spain (-5.8%) for example[8].

Today, the Baltics enjoy faster economic growth, far lower debt levels and healthier employment than Greece.

In conclusion, small democratic countries can and indeed have made profound reforms in their economies, with great success.  The key ingredients were:

1.     Facing an even greater danger (Russia for the Baltics, implosion for Greece?),

2.     Having the support of their population,
3.     Ensuring that their governments and technocrats believed in free-markets,
4.     Applying shock therapy and speed.

Greece has #1.  It lacks #2 and #3, but it is its choice whether to change or not.  Smaller, worse off European countries did.  And in Athens, economic advisers from  Tallinn will be more welcome than those from Frankfurt.

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[1]   My Fair Lady – An Hymn to Him.

[2]  Latvia pegged its currency to the SDR while Lithuania pegged his to the US dollar.

[3]  Here the anchor was the German Deutsche Mark.

[4]  In 2000 the Estonian system was modified to tax corporations only on their distributed profits (as Chile did in the 1980s).  Lithuania adopted an income tax abatement on reinvested corporate profits.

[5]  Except for the period 2010-2012 where the deficit grew to around 9%.  However the same policies greatly helped bring the budget deficits to around zero in 2014.

[6]  In subsequent years, Estonia negotiated bilateral agreements and joined the EU which watered down this policy a bit.

[7]  Estonia joined the eurozone in 2011, Latvia in 2014 and Lithuania in 2015.

[8]  Source: Eurostat.

21012 in review: Greece revisited

As the year comes to a close, I feel that it is healthy to revisit the posts written so far and to assess how events have tracked our expectations and predictions.  This is the first installment of the series.

It has been our view that Greece would not be able to fulfill its commitments to the rest of EU and that the adjustments it needed to make were so great that it should and would leave the eurozone, at least temporarily, if not this year at least next.  We have also felt that the single most effective tool at its disposal to correct excessive debt loads was privatization of public assets, which it has refused to implement: of some €300 billion in privatizable public assets[1], only €50 billion were earmarked for sale, and to-date, cash proceeds to the Greek government have been €1.8 billion only. 

So far, Greece remains in the eurozone despite having spectacularly failed meeting its targets and carrying unsustainable debt loads.  Last March, the Greek government agreed to a series of targets with the Troika (European Commission, ECB, IMF), such as bringing its debt-to-GDP ratio down to 120% by 2020; despite a severe “haircut” imposed on private creditors, that ratio stood at 150% by mid-year and was budgeted to rise to 189% by 2014.  Such huge “miss” was due to both a collapsing economy and rising debts.  The budget deficit target will be missed as well.  Further adjustments include more cuts in public sector salaries, pensions and other social transfers, and of course, better tax collection.

Faced with unattainable goals, the Troika decided to fudge, increasing the 2020 debt-to-GDP goal to 124%, reducing interest rates on loans to Greece, returning realized profits on previous ECB financial aid operations and requesting Greece to buy back debt[2] (at a discount) before disbursing the next aid package.

This next disbursement of €34.4 billion is not assured yet.  It is also huge as it represents 17% of Greek GDP[3].  It is worth noting that Germany has become increasingly skeptical of the viability of the Greek rescue, and not without reason: Greece keeps missing its targets, its debts remain very high and the above mentioned budget cuts are likely to stoke further political instability and push an ever larger share of the economy underground, reducing tax revenues and distorting further the economy.

Having forced private creditors to take a €106 billion loss without putting its debt on a realistic recovery path, Greece will ask the same from its public creditors next.  Despite the IMF insistence, the eurozone has so far adamantly refused, although chancellor Merkel recently acknowledged the inevitable, sort of.  Large scale privatizations continue to appear out of the question.

The problem is that, while another round of debt haircuts appears necessary, it is not sufficient to get Greece back on track.

Nowhere in Europe has the pain been greater than in Greece:  Nominal GDP dropped 7.6% from €232.9 billion in 2008 to an estimated €215.1 billion in 2011.  It is expected to drop close to 7% this year.  Labor costs have been greatly reduced and external accounts have adjusted considerably, although in large part because of low internal demand: the trade deficit[4] for the first nine months of 2012 was €10.1 billion compared to €18.6 billion in 2009 and €32.7 billion in 2008.

For the period 2009-2012, the Greek GDP will have fallen as much as that of Chile did in the early 1980s, yet the comparison stops there.  Chile carried out profound structural economic reforms during its depression years while Greece hasn’t.  Unless Greece invests massively to become more productive and to shift its output towards greater value added products, unless it shrinks its public sector, unless it designs a tax system that is efficient without being confiscatory, the above adjustments will prove to have been cyclical rather than structural.  So far, the situation is grim: for example, total investment as a percentage of GDP has gone from 23.7% in 2008 to 14.5% in 2011 and is likely to drop further this year.

At this stage, the odds of Greece remaining in the eurozone are slim although less dismal than they were last March.  To remain, it is necessary that Greece get a large debt reduction, but it is not sufficient.  Besides reforms it also needs the European Union, which absorbs over 62% of its exports, to recover too.

So far, it seems to me that Greece’s condition has gone from desperate to critical; perhaps there is room for further improvement.  The eurozone countries are starting to acknowledge that they can’t fully collect their loans to Greece.  They have yet to decide which avenue is best for them: granting a large haircut as the final boost to a recovering country and fellow eurozone member, or cutting their losses to a country exiting the eurozone.

I remain in the camp of the skeptics.

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[1]  As per former ECB Board member J. Stark.

[2]  Essentially directed at the new bonds which Greece issued as part of its private debt restructuring.

[3]  Source: UBS.

[4]  Excluding oil products which are not included in the official time series.

Revisiting privatizations

Over the course of last year and this year, I have advocated that European countries facing excessive indebtedness and sub-par growth should consider selling public assets.  In the case of Greece, I noted in 2011 that ex-ECB board member, Juergen Stark, had estimated Greek public assets available for sale at around €300 billion; this was to be compared with a national GDP of €240 billion and an overall sovereign debt of €320 billion.

I also advocated the same course of action for others, such as Italy, Spain and France.  The benefits of such a policy would be to increase overall economic efficiency and to raise funds to reduce national debt.  It could also help develop a large and stable pool of savings for future retirees.

I also noted that the best example of what this policy could yield was the Chilean experience in the 1980s.  This is one in which I was closely involved as a banker and investor.  Back then, Chile received no outside financial help, in stark contrast to the current European situation.  Yet, thanks to well conceived debt-to-equity and debt prepayment programs, it managed to reduce its external commercial debt by one third without alienating international markets.

Therefore I was happy to read an interview of Mexican billionaire Carlos Slim in which he too advocated the sale of public assets as a necessary although not sufficient condition to get European economies back on track.

Countries are often reluctant to part with public assets, for very human reasons:

1.      Bureaucrats will lose a sinecure and a power base while employees may see their benefits cut back and even be terminated;

2.      Selling assets during a crisis is bound to bring less than optimal prices;

3.      Deep pocketed foreigners will take advantage of their momentary weakness to take control of national assets;

4.      Public services, once privatized, will be rationalized, resulting in higher tariffs and smaller geographic coverage.

 Indeed, reducing bureaucracy is one of the benefits of privatization.  In many instances, public employee benefits are far more generous than those accruing in the private sector, and the difference represents a subsidy which is unfairly borne by the latter and should be eliminated.  Privatizations often result in job cuts, but the resulting hardship can be controlled and reduced with compensatory and retraining policies and by the opening of new private job opportunities in a resurgent economy.

It is obvious that, at least in the beginning, public assets will be sold at depressed prices, but getting optimum prices is not the name of the game, putting the economy back on track is.  Besides, the cost of a weak economy with a depressed job market is far higher than the money left on the table, so to speak, by selling assets early.  And experience in Brazil and Chile has shown that, if privatizations are accompanied by sound fiscal and economic policies, markets soon adjust and subsequent asset sales command higher prices.

Rich multinationals or vulture funds are often the bugaboos that discourage countries from privatizing.  The reality is that it all depends on how privatizations are structured.  In Chile, most privatizated companies were bought by local entities, sometimes operators, sometimes financiers, sometimes by consortia which included local pension funds; in the case of the largest privatizations, special financing was made available so that local households could buy into blocks of shares that had been reserved for them (the so called capitalismo popular).  In Mexico, it is worth remembering that the largest privatization was won by a consortium of Mexican, American and French interests led by Mr. Carlos Slim who retained effective control.  I might also add that, in my experience, foreigners who have bought local companies on the cheap in times of great national stress end up paying a fair price over time, as governments find ways to extract more money or consideration from them.   One can only look at the electric utility sector in Brazil where the current government is trying to force through a new tariff regimen.

One large and apolitical source of funds to tap in order privatize public assets would be national pension funds.  These were instrumental in similar projects in Latin America and some Nordic countries.  Unfortunately, countries such as France, Italy and Spain largely rely on pay-as-you-go pension schemes, and their pension funds control very small pools of funds (0.2%, 4.6% and 7.9% of GDP respectively).   By contrast, pension funds in countries such as Chile (67%), Finland (82%) and the Netherlands (135%) are much larger and offer far more strategic flexibility.  It would be highly controversial in France in particular, but just imagine if it had a pension pool of 1 trillion euros!  If Italy had €900 billions and Spain €600 billion!  Such funds would dwarf the much maligned hedge funds and vulture investors; they would also match their long term investment horizons with the government desire to find stable institutional investors.

Finally, there is the fear that privatized public services will no longer serve the public, or that tariffs will be raised too high.  With sound regulations, the former concern can be allayed.  The real question is whether essential services should be subsidized, and if so how, or not.  If a country decides that the provider of such services should subsidize them, then privatization may not be appropriate.  Witness the continuing frictions between Telmex and the Mexican government on this issue, or worse, the case of the energy sector in Argentina or even EDF in France.  Countries can’t have it both ways: they can’t privatize and then control prices.  Ultimately though, tariffs may initially increase and then gradually decrease as most of the efficiency gains are passed on to customers.

The current debate in Europe has little chance of bringing about a workable solution to the prevailing financial and fiscal problems:  drastic austerity, be it via spending cuts or tax increases, cannot work because it is socially and politically unacceptable; fast growth is unrealistic because, in the absence of other measures, it is equivalent to Northern member countries subsidizing their Southern fellow members and cosigning their debts.

Austerity is necessary, but its focus should be a combination of shrinking the public sector and making the economy more efficient.  Privatizing public enterprises should be the key driver of this effort.

Growth based on EU subsidies and wealth transfers is a non starter; but growth based on a leaner, more flexible private sector is possible and sustainable.  Indeed, examples of this are easy to find in recent history.  Part of the privatizations proceeds should be earmarked to retrain downsized employees and to help them bridge a conversion period leading to new jobs in the private sector.

Finally, privatizations are essential to reduce sovereign debts in a manner which doesn’t disrupt markets, encourages new investments and keeps financing costs affordable.

At the end of the day, return to fundamental financial equilibrium and economic growth is possible but no single silver bullet exists that will do it all.  Rather, European democracies will need to find a workable balance of some austerity, some tax increases, gains in efficiency and delayed but better quality growth.  To that end, a broad privatization program is essential to help achieve many of these goals in a sustainable and socially acceptable way.  It would also provide the opportunity to establish a modern and potent retirement pension fund industry.

Nowhere man (homo economicus)

Like all career generals, top economists prepare themselves for the day when their theories can be put to the test of reality (or is it the other way around?).  Certainly, the so-called Great Recession that has hit the US since 2008, then morphed into an existentialist crisis for Europe, and now challenges China’s investment driven growth is such a opportunity.  And indeed, we have seen a wide array of economists make the case for their deeply felt diagnoses and attending cures.  Yet they have little to show so far.

He’s a nowhere Man,

Sitting in his Nowhere Land
Making all his nowhere plans
For nobody.

Traditionalists have thundered against the wasteful ways of the consumer society and its propensity to spend itself to exhaustion, mostly with money borrowed from any willing lender, investor or speculator.  The cure is simple: let them fail, lance the boil and wait for nature to heal itself.  Unfortunately, and as we have seen when applied in some places, this triggers economic collapse, societal tensions and political instability.  But not recovery.

Doesn’t have a point of view,

Knows not where he’s going to,
Isn’t he a bit like you and me?

Others, who quote Keynes, have argued that the state should step up to make up for the reduced demand from the private sector and thus avoid an economic depression.  Some have also argued that such boost would also result in some degree of inflation which would help reduce the excessive indebtedness of both private and public borrowers.  We haven’t seen much inflation in the US where this approach was tried; on the contrary, prices have been stable but public debt has surged and little of that fiscal stimulus has found its way into worthy investment projects for a variety of reasons.

Nowhere Man, please listen,

You don’t know what you’re missing,
Nowhere man the world is at your command.

A variant of the Keynesian school of thought is epitomized by the Japanese economist Richard Koo who has made the persuasive argument that the current crisis of excessive private sector indebtedness doesn’t respond to traditional monetary policy as debtors focus on reducing their debt outstanding, even if interest rates are at rock-bottom.  In his view, the state had to crank up spending and go on as long as necessary;  in most wealthy countries, funding this fiscal effort should be doable as private sector savings would generally equal public sector borrowings.  While his reasoning is powerful, the example of Japan, which, by and large, has followed his prescription, is not: twenty years after its real estate bubble burst, Japan is still doing poorly while its public debt is soaring.

He’s as blind as he can be,

Just sees what he wants to see,
Nowhere Man can you see me at all?

Yet another group put its hopes on reforms, sometimes stated vaguely, or extravagantly.  By definition, reforms will change the way people work and live, will produce some winners and losers and can cast a pall of uncertainty that will last for several years, for reforms take years to be debated, agreed and implemented.  Successful reformers have been able to fine-tune the process so that change took place while stability was preserved and expectations were not let to run wild, with fear or overexcitement.  But reforms alone didn’t work. 

Doesn’t have a point of view,

Knows not where he’s going to,
Isn’t he a bit like you and me?

There is no lack of example of countries overcoming deep financial or economic crisis; there were no magical wands, excessive debts were not transmuted into savings, orthodox measures such as public spending cuts were combined with currency devaluation and strong foreign direct investments; and yes, there also were some policies that were “unorthodox” in their days such as privatizations, tax cuts and private pension reforms.  But what these countries also had was strong political leadership, capable and willing to carry out painful recoveries and to rally their nations behind the effort.

Nowhere Man, don’t worry,

Take your time, don’t hurry,
Leave it all ‘till somebody else
Lends you a hand.

Chile was engulfed in 1982 by the Latin American debt crisis despite having carried out wider economic reforms than the rest of the region.  Its downfall however was precipitated by an overvalued peso and excessive US dollar borrowings.  Because it was governed by the Pinochet-led military junta, Chile, unlike its neighbors, received no international financial help and was left to solve its problems on its own.  It did so by first nationalizing the banks (closing a few unviable ones), devaluing the peso, controlling public spending and restructuring its private and public debt in a way that was both fair and conducive to stabilizing and even raising foreign productive investments.  It has often been argued that having an authoritarian government helped Chile carry out unpopular policies.  This is true to some extent only; there were times in 1984 and 1985 when the position of the government was precarious; besides there have been many examples of authoritarian governments that were miserable economic failures. 

But Chile’s success in handling its crisis can be attributed to other important factors as well: unlike other countries, Chile cleaned up the financials of public companies before it privatized them; it insured that many ordinary Chileans could benefit from large privatizations thanks to its so called capitalism popular; from the beginning, it promoted free markets and private investments.  Finally, Chile offered a number of intangibles which are generally overlooked yet were of critical importance, such as a fair and predictable legal system, a very competent core administration where corruption was absent.  To this day, this remains one of the best turn-around stories.

He’s a nowhere Man,

Sitting in his Nowhere Land
Making all his nowhere plans
For nobody.

Brazil had been an intractable basket case for two decades, with endemic hyperinflation and spiraling public debt when F. H. Cardoso, then minister of Finance, launched the Plano Real in 1994.  The plan’s insight was to break the vicious cycle of expected inflation and general indexation without imposing price controls.  It did so by creating a money of reference (the Unidade Real de Valor- URV which was in effect indexed to the US dollar, not to domestic inflation) alongside the money of exchange (the cruzeiro), and setting it initially at a high level.  After confidence in the URV was won, the URV became the new money of exchange, the Real.  The strength of the Real was preserved by setting positive interest rates, by controlling public sector spending at times via financial negotiations with Brazilian states and by large scale privatizations.  FHC’s credibility helped him carry out his key policies, although former allies reproached him his free market initiatives which he nevertheless had the courage to see through.

Some elements are common to these turnaround examples: currency devaluation (delayed in the case of Brazil as the key problem was internal debt and lack of faith in the currency), public spending cuts, free market emphasis for greater efficiency and accountability, generally, policies that are consistent and understandable for the public, and leaders who are competent, honest and unafraid.

Homo economicus has a lot of ideas, and while there is always room for new policies, abolishing "no pain no gain" is not one of them.  In the end, he is only as good as the homo politicus to whom he reports and from whom he should get support.

Reply to George Soros' June 26 FT article

In his Financial Times article of June 26 (How to shift Germany out of its cant do mode, June 26), George Soros explained that avoiding a euro meltdown was just a matter for Spain and Italy to agree to structural reforms in return for which Germany would agree to a mutualisation of a “significant portion of their outstanding stock of debt”, such German agreement having been withheld so far mostly because of domestic politics.  This remains to be seen.

In Italy, Prime Minister Monti has been keen to push through reforms, yet has found great resistance from a variety of Italian vested interests.  In Spain, reining in the discretionary powers of provincial governments has proven difficult.  Although they were not mentioned by Mr. Soros, Greece has done very little to reform its bloated public sector while France has rejected the German economic model.

Structural reforms on the scale that is needed take years to be debated, approved and finally implemented.  And this is when populations are not dead set against them.  Therefore, a debt mutualisation today would have to rely on promises (couched in the form of laws which can be later amended) which will become reality, at best, over a much long time-frame.

There is a say that if you owe little, it is your problem, but if you owe a lot it becomes your creditor’s problem.  As a creditor, Germany is fast approaching this point of no return.  Given that hundreds of billions of debt are in the balance, it is very doubtful that the threat of fines or penalties would sway delinquent countries or compensate Germany for the financial burden it would assume.

A larger issue is whether such reforms would be successful in securing the place of the weaker countries alongside Germany in the eurozone over the long-term.  I would love to swim a relay with Lochte, Phelps and Adrian, but, however hard I train, our team wouldn’t make the Olympic cut.

Finally, it remains to be seen whether Europeans truly want a federal system, one where pensions will be determined in Brussels and be based on the German system, or where the size of national public sectors will be shrunk to converge with that of the best performing countries.

In my view, Germany will not accept an early mutualisation of European debts for the above reasons.  Nor will Austria, Finland and the Netherlands.  If push comes to shove, they may consider exiting the euro; yes, the strong deutsche mark would make German exports less competitive, but it would also make the repayment of euro-denominated debts a bargain.

Rather than forcing a decision that won’t be accepted and will resolve little, it might be better to focus on what can be preserved: a Europe of 27 countries where the weakest will be helped to the extent they help themselves.  One option suggested by the economist Richard Koo would be to ensure that a large portion of new sovereign debts be issued to domestic investors and remain in their hands; this may raise the financing cost but in return it would ensure greater financial stability.  It would also preserve greater strategic flexibility. 

Another would be to accelerate privatizations in Italy, Spain and Greece.  Vast resources could be freed in the process which would help reduce the size of sovereign debts.  Greece has over €300 billion in public assets which could be sold; it committed to sell €50 billion; so far it has sold a minute fraction of the latter number.  If a country declines to sell public assets, why should its euro partners guarantee its debts?  Why should the IMF and financial markets agree to a rescheduling, or even a restructuring? 

Other measures to foster growth and employment include reforming labor laws.  Yes this takes time, but then all reforms do.  There is no shortcut.  Some will argue that markets won’t wait.  Perhaps.  But historynshows that markets tend to look ahead, and it is likely that a credible reform program will elicit a favorable reaction in the form of greater investor interest and creditor cooperation.

In the end, some more countries may have to reschedule or restructure their sovereign debts.  But contrary to what is often written, this does not signify the death knell of economies; only the absence of coherent policies and the capricious application of laws do.  One only has to look at the example of Chile in the 1980s when it received no international financial aid yet engineered the longest lasting economic recovery in Latin America.  Indeed, even though debt-to-equity terms were more onerous than in neighboring countries, investor interest was much higher.  Or take Brazil under the leadership of F. H. Cardoso, first as minister of finance and then as president.

Debt mutualisation, as Mr. Soros advocates, sounds great and stirs the right emotional cords of generosity, European solidarity and immediate relief.  In my opinion though, it is unrealistic and insufficient.

Contrary to what European politicians would want us to believe, this is not the first time that countries, large and small, have had to face debt and spending difficulties.  The ways out are well known and they work.  But they are not quick or painless.

European hieroglyphics

You can find anything on the Internet, even a site that translates English into hieroglyphics.  According to Quizland.com, the tablet at left says “We do not understand financial markets”, and it could be the motto of the Eurozone leaders.

In its rejection of Anglo-saxon free markets, Europe has been under the delusion that these can be willed away or bent to the wishes of political and other leaders.  One can recall Mr. Trichet, then president of the European Central Bank, flatly stating that Greece would not restructure its sovereign debt, and his “ruling” being repeated by a large chorus of European politicians; or President Sarkozy, after each summit with Chancellor Merkel, declaring that the debt problems had been solved by the negotiation of a new memorandum of understanding and that markets would thus have to fall in line.

When this didn’t work, several futile ideas were proposed, like creating local credit rating agencies (presumably under close scrutiny from eurozone governments) to write credible reports yet refrain from calling for unwanted debt downgrades.  As pressure kept mounting, intricate rescue plans were offered, which had the principal merit of multiplying euros earmarked for intervention funds as if they were fish and loaves of bread.

This state of mind isn’t unique to politicians and bureaucrats; it is shared by bankers as well.  For years, the top banks of Europe have operated under the guidance and protection of their governments.  In so doing, they ended up believing the messages delivered to the “gullible masses”, that the state always gets it way, and that, by staying in the governmental wake, so would they.  This led many banks to rely excessively on wholesale funding, to under-reserve, to feel comfortable with lopsided loans-to-deposits ratios and to be undercapitalized. 

Eurozone banks believed that they could bluff their way through the current crisis.  Indeed, only one, Unicredito from Italy, had the courage to raise $10 billion of fresh capital at a huge discount to market price.  But markets quickly wised up, forcing a liquidity crisis at the same time as a solvency one was worsening.  By then, the most exposed Spanish banks couldn’t access the markets.

The solution to the latest Iberic crisis is true to form, so far: opaque, uncertain as to timing and bound to close markets further.  Opaque because such terms as interest rate, final maturity and conditions have not been disclosed; uncertain as it is not clear whether Spain has formally asked for a rescue package for its banks and what the trigger for recapitalization would be; finally, the recapitalization will be funded by loans to a Spanish agency, thereby increasing that country’s debt burden, and will be chanelled through the ESM to assure seniority over private creditors; this will make future access to the markets that much more difficult. 

The causes of Greece and Spain’s financial troubles are different, but in both cases the eurozone rescue packages, while clearly designed to reduce risks for the institutions that provide help, in effect raise them.  Greece private creditors were handed a 75% effective loss (which has risen to 80% since) to insulate official creditors, and official creditors gained preferred status on the money they lent to Greece.  The private creditors’ loss is greater than the 75% one forced a decade ago by Argentina which was (rightly) characterized as an effective spoliation. Greece abandonned a very reasonable €50 billion privatization program.  Sovereign  bond contracts were retroactively amended by the state.  Net net, financial markets have no rational motivation to return to Greece any time soon and eurozone states are now ‘it”.

In Spain, the sovereign debt will be raised by some 12% to fund the bank rescue, it is not clear what reforms will be required of the recipients, whether the bad banks will be liquidated and how much further help will be needed by the government.  If the bank rescue loans rank ahead of regular sovereign bonds, it is pretty clear that any holder of Spanish, or maybe even Italian, government bonds better sell them in a hurry.  This will leave the eurozone countries to hold the bag, except that their bag of tricks will soon be too small.  At the end of the day, a lack of capital in Spanish banks was remedied with an increase in debts of the Spanish state.

As the eurozone dithers, risks of implosion are rising.  When one country after the other receives financial assistance, it drops out from the pool that will fund the next sovereign borrower in need.  Clearly, Germany, being the last one in line, is on the hook to fund everybody unless the process is changed. 

Spain is make-or-break for the eurozone.  If it fails, Italy gets into the line of fire and, in my opinion, Germany leaves the eurozone because it would have neither the means nor the desire to mortgage its future to save everybody in the eurozone.

What can be done?  If I were head of government in the eurozone, I would try to prepare for the day when Germany refuses to help out.  This means controlling public spending in a way that is politically acceptable: means testing programs, reducing civil servant headcount through attrition and, inevitably, across the board spending cuts as well as some tax increases.  More controversial would be labor laws reform to foster hiring of the young and, yes, pension reform.  These last two issues are hazardous to a president job security, but the payoff is worth a try.  Mr. Hollande has demanded that the CEOs of public sector companies limit their salaries to 20 times that of their employees and that the CEOs in the private sector likewise restrain themselves.  This may be nothing more than demagoguery, or it may be the necessary first step to ask everybody to share in the pain. 

Finally, the deleveraging pain could be alleviated by privatizing public assets.  According to Mr. Stark, ex-board member of the ECB, Greece has over €300 billion in public assets it could sell.  It was supposed to sell €50 billion.  Spain, Italy and France have much more to sell.  Markets can be of great use in gathering funds and setting fair prices for public assets.  Argentina, Brazil, Chile and the UK did it not so many years ago.  It could and should be done today. 

Perhaps another reason why I think that it is crucial that European countries accelerate reforms on their own NOW is that I have real doubts about the future of the eurozone: I am pretty sure that if it survives it will be as a reduced group of more homogeneous countries. Even then, I wonder if ”deep integration is possible”. 

Are most of the eurozone inhabitants willing to let Brussels bureaucrats run their lives?

Are the French willing to align their labor laws and retirement age and benefits on those of Germany?


Short of a full federation US-style, how much, or little, integration do you need to run a common currency alliance on a sustainable basis?  The truth is that we don’t know. 

There is a big world out there, and if it is that big it is thanks to free markets.  Europe's mistake has been to be built to keep the barbarians out, so to speak.  Relatively less effort was dedicated to pool resources and compete on the world stage.  If the eurozone is to succeed, it needs to be redesigned to make a core Europe as competitive as it can be on the world stage.

By the way, the Tweety Bird standing over the English lawn means “no” in hieroglyphics.