The Greek bailout is merely an exercise in wishful thinking — that, first, 95% of bondholders will accept it and second that Greece’s economy will return to growth sometime next year.
But it should get everyone past the March 20 bond rollover and perhaps even slow down the capital flight from Greece, and buy the authorities some time to deal with Portugal, and then Ireland and then …
But it needs to be remembered that this is, and always has been, primarily a banking problem and that the world remains in the grip of sustained bank deleveraging, similar to what kept Japan in depression for more than 10 years in the 90s and beyond.
The crisis has its roots in two events in 1995: Bill Clinton’s drive to increase home ownership and the creation of the euro, which was eventually introduced in 1999.
Clinton’s 1995 document, “The National Homeownership Strategy: Partners in the American Dream”, combined with the repeal of the Glass-Steagall Act of in 1999 which unleashed the banks, and led directly to the explosion of subprime mortgage lending that brought American banks undone in 2007.
The creation of a single European currency, also between 1995 and 1999, led to that continent’s own subprime bubble and bust — that is the explosion in lending to Greece, Portugal, Spain and Italy by French and German banks.
In 2008 the US government stepped in and recapitalised the American banks. It had the borrowing power to do it and despite a massive increase in its own sovereign debt and a subsequent credit rating downgrade, the US is still able to borrow readily from the bond markets. (It did muck up the rescue operation, however, by drawing the line at Lehman Brothers, thinking the investment bank didn’t matter.)
European banks took the single currency to mean uniform credit-worthiness and happily lent to sovereigns that they otherwise wouldn’t have touched with a shillelagh.
Then in 2009-10, when US banks were deleveraging furiously, European banks stepped in and took up the slack because the true value of their euro sovereign loans had not, at that point, become clear. According to UBS’ bank analysts, French banks in particular borrowed US dollars heavily in the interbank market to build up US dollar assets.
By 2010 they had become the world’s biggest trade financiers, commodity trade financiers, and very big in shipping, aviation and commercial property.
As a result European banks entered 2012 in a precarious state: $US26 trillion assets were backed by just $US12 trillion in deposits and $US2 trillion in equity.
And now European governments, including Germany’s, are in no position to recapitalise them, so they must try to prevent the default of their customers where possible and provide funding to keep them liquid while waiting for the markets to recover sufficiently to give them capital.
The European Central Bank’s LTRO (long term repurchase operation) in December, and then again this month, is designed to remove the immediate risk of a Lehman-style European bank liquidity crisis but it provides no solution to the government debt issue.
The problem with LTRO is that the banks have to post collateral with the ECB to get the money, and when they do that two things happen: existing lenders are subordinated and the collateral gets a haircut (is reduced in value) by up to 65%.
That means a troubled bank that needs LTRO money can quickly go through its entire balance sheet posting assets as collateral and still not get enough cash.
As for the latest Greek bailout, nobody seriously believes it will hold. The forecasts on which it is based assume GDP contraction of 1% in 2013 and growth of 1.4% in 2014, which means a return to growth sometime late next year.
This, to say the least, is a heroic assumption considering its GDP shrank at a horrible annual rate of 7% in the December quarter and the government must now impose further budget cuts of €325 billion.
But even with these assumptions, Greece’s debt only gets as low as 157% of GDP before starting to rise again, and certainly not down to the required level of 120%. And since private bondholders have been subordinated to government lenders (because the ECB has refused to take a haircut) they won’t be back lending to Greece for a long time, if ever.
Greek GDP is now about €220 billion and falling. It has a persistent current account deficit, increasingly impoverished citizenry, massive capital flight and a bankrupt government. It is going nowhere fast.
The question for the world economy is whether European banks can be propped up long enough for the devaluing euro to work its magic on France, Germany, Netherlands, Austria and Belgium and allow the banks to recapitalise themselves.
And the problem is that to do it they need to deleverage, by $US3 trillion according to UBS’ analysts. That will offset the effect of the euro and act to depress the economy.
Increasing bank leverage produced the boom of 2002-2007; decreasing bank leverage is doing the opposite, and still has years to run.
*This article was originally published at Business Spectator
Excellent round up alan!
This is the first time I have seen (in Australia) a comprehensive and detailed account of what is happening. You are correct that it still has years to run and that the Greek bailout I will be amazed if it lasts until after the April Greek elections. The Greek people are waking up to the fact that it is death by a thousand cuts versus a guillotine and are rejecting the former.
What is being demanded of Greece is similar to what was demanded of Germany post ww1 and far worse that what was demanded from them post ww2. Greece will default no question and until then all that is happening is tax payer money is being siphoned off into banks that have made bad investment choices. In other words its a rip off of public funds by private enterprises. No Australian money should be spent on this and the support of Europe via IMF funds is to be opposed. But look at what happened when abbott rejected this idea, he was roundly criticised and he quickly changed his tune to fall into lockstep with his masters.
European banks took the single currency to mean uniform credit-worthiness and happily lent to sovereigns that they otherwise wouldn’t have touched with a shillelagh.
There it is in a nutshell.
The ‘United States of Europe’ was a nice pipe dream.
@Chris Tallis: “What is being demanded of Greece is similar to what was demanded of Germany post ww1 and far worse that what was demanded from them post ww2.”
… which makes the irony of Germany’s current position all the more stark.
Regarding the common internet meme that the Wall St meltdown was all ‘the government’s fault’ (ie. Freddy Mac and Fannie Mae). Various people like to point the finger at Bill Clinton who enacted government legislation to provide more credit to lower income owners for home ownership. Clinton made amendments to the 1977 Community Reinvestment Act (CRA) and later directed Fannie Mae and Freddie Mac to make more subprime loans.
However, these critics always forget that Fannie and Freddie were also under pressure to do the same from their stock holders to maintain profit growth. The external banks and mortgage companies also wanted Fannie to help them make more loans to sub-prime borrowers.
This September 1999 Article from the New York Times is rather prophetic.
http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage-lending.html
In 1995, Fannie and Freddie and other Government-sponsored enterprises began receiving government tax incentives for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the Fannie Mae and Freddie Mac with the subprime market. In 1996, the Department of Housing and Urban Development set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005 by the Bush administration.
However, it is important to note that as % of market share, sub-prime remained steady (and in fact fell) during the last term of Clinton’s administration. See http://upload.wikimedia.org/wikipedia/commons/thumb/e/ef/U.S._Home_Ownership_and_Subprime_Origination_Share.png/800px-U.S._Home_Ownership_and_Subprime_Origination_Share.png
Additionally, The Financial Crisis Inquiry Commission reported in 2011 that Fannie & Freddie “contributed to the crisis, but were not a primary cause. The CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.”
Many other studies conducted by other groups (e.g. Bank of Interational Settlements, Federal Reserve Bank of San Francisco) showed that there was no evidence to support the idea that the CRA was behind the sub-prime crisis.
GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. Presumably this is because GSE mortgages made under the auspices of the CRA were in regions with little possibility for capital gain, therefore they were not speculative loans. Remember that by 2007 a vast amount of sub-prime loans were known to default at the first payment. However the lenders knew they could still make money by re-financing the debt against the appreciation of the house. These sorts of tactics presumably would not work in regions were CRA-backed mortgages were issued.
Actually governments defaulting on their debts is quite common. All European countries and also Great Britain, defaulted on their war debts to the US in 1932.
So much so that so that Hoover had to be content with a moratorium on interest payments for most of the countries however Germany defaulted both on interest and principal. Finland was the last European country to default.
I guess the main question for Europe and the remainder of the world financial system is what are the simple answers. As everybody recognises the level of debt in the US, Europe,UK , Japan etc is not sustainable.
Economists keep referring to debt to GDP ratio assuming that there has to be some growth in GDP for a country to move forward with its debt reduction. No doubt true in the normal course of things.
However somebody has just written off approx. €100bln of Greek debt. Where did it go?
Well of course it is simply a balance sheet exercise of moving from one side to bottom.
What nobody in the market wants to talk about is the REAL value of assets in the world banking system(the pretence of Basel 3).
Of couse even the corner store owner knows that the only solution is to take all the write downs to REAL value and start again. The sooner the better of course but politics requires sensitivity to the populace so what brave man is going to say “Let’s start gain!”
Alan, as always thanks for your expert assessments. I’ve heard some trace the crisis back to Alan Greenspan’s policy of increasing the money supply to minimise interest rates.
1. Do you think that is enough of a contributing factor to mention?
2. Has the ECB simply borrowed (created) that money to ‘bail out’ Greece?
3. It appears that Germany is once again the strongest economy in Europe. How do they keep doing that?
4. Why isn’t inflation higher?