When do we decide that Europe must restructure much of its debt?

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years.

The history is, to me pretty convincing. Countries with this level of debt and this level of uncertainty associated with the resolution of the debt are never able too grow out of their debt burdens, no matter how determined and how forcefully they implement the “correct” set of orthodox reforms, until the debt is resolved and the costs assigned. Greece and Europe, in other words, have a choice. They can choose to restructure Greek debt explicitly, with substantial real debt forgiveness and with the costs optimally allocated in a way that maximizes value for all stakeholders, or Greece can continue to struggle for many more years as the debt is resolved implicitly, with the costs allocated as the outcome of an uncertain political struggle.

Until one or the other outcome, the country is not a viable creditor and it will not grow. There is no way to get the numbers to work. If Europe policymakers who oppose a rapid resolution of its debt crisis continue to prove as intransigent over the next few months as they have been in the past week, I suspect that they will only be able to pull off one of their goals, which is to embarrass Syriza and get it thrown out of office.

But I suspect that many European policymakers incorrectly think Syriza is as radical as it gets, and once Syriza is discredited, almost any alternative leadership would be better. I disagree. If Syriza is discredited, and the Greek economy continues to stagnate as I expect, the alternative could very easily be Golden Dawn or some other group of radical nationalists determined to blame foreigners for their problems, and Germany will have set itself up for much of the blame. It is ironic, because in my opinion Angela Merkel is not and has never been the bully that she is made out to be, and the main reason Germany seems to be running the show is that no one else has ever dared to disagree with her or to take any position of real leadership. For that reason she and Germany are being seen as far worse than they actually are.

And this is clearly not just about Greece. Everyone understands that Greece has already restructured its debt once before and received partial forgiveness — in fact once coupon reductions are correctly accounted for Greece’s debt ratio is probably much lower than the roughly 180% of GDP the official numbers suggest. Most people also understand that the Greek debate is not just about Greece but also about whether or not several other countries — Spain, Portugal and Italy among them, and perhaps even France — will also have to restructure their debts with partial debt forgiveness.

What few people realize, however, is these countries have effectively already done so once. This happened two and a half years ago at the Global Investment Conference in London when, on July 26, 2012, Mario Draghi, President of the European Central Bank, made the following statement:

When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro. And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And its not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

As soon as Draghi made the statement to do “whatever it takes”, markets recognized that the ECB was in effect guaranteeing the bonds of EU member states whose credibility was in question, and yields immediately dropped. It is important to understand why this was effectively a kind of debt restructuring. With Draghi’s statement, there was an immediate transfer of wealth from the ECB — or, more appropriately from the group of countries behind whom the credibility of the ECB is maintained, and this means Germany above all — to the governments whose creditworthiness was in doubt.

Not only was their debt effectively restructured, in other words, but they were also granted partial debt forgiveness. I will explain this later, but I want to start off by making two points. First, Draghi’s promise was far from an optimal resolution of the European debt crisis, in part because it does not address the key issue of uncertainty, to which I will return. Second, there is an enormous amount of confusion about debt restructuring, especially at the sovereign level.

Many people believe that any sovereign debt restructuring, and its accompanying implicit or explicit debt forgiveness, is already an admission of failure, with moral and nationalist overtones. But as the implicit restructuring that occurred with Draghi’s promise to do “whatever it takes” suggests, debt restructuring is actually a process that involves increasing the value of the obligations and operations of the restructuring entity. It can be done well, it can be done badly, and it can be done disastrously, but it is a financial operation with a clearly defined goal of improving the overall wealth of stakeholders, and while it is reasonable that stakeholders negotiate the ways in which this additional wealth will be allocated, the negotiation should not prevent the restructuring.

In order to understand the differences between optimal and suboptimal sovereign debt restructuring it is necessary that we understand the relationship between the asset and liability sides of a balance sheets and how the interaction between the two create or destroy value. In this blog entry I hope to address the relevant issues. It will be divided roughly into three parts in which I want progressively to describe what an optimal debt restructuring should accomplish.

  1. Why must Europe restructure much of its debt? The purpose of a debt restructuring is to make all parties better off by increasing the value of the associated instruments and improving future growth prospects for all the relevant stakeholders. Once the existing debt structure adversely affects future growth prospects and reduces the current wealth of the relevant stakeholders, it makes sense to consider ways in which the debt can be restructured so as to improve both current value and future growth prospects.
  2. For most economists, debt is the way operations are funded, and the best debt is the cheapest. I am not suggesting that economists are unaware that certain debt structures are riskier than others, but for the most part they ignore the structure of the balance sheet and focus primarily on the way assets are managed. The moment debt levels become high, however, or create institutional distortions, they begin to affect, and usually constrain, value creation. Debt has four very separate and very important functions, and it is important to understand what they are before deciding what an optimal balance sheet looks like.
  3. Once we understand the role and impact of the structure of the balance sheets, it becomes possible to describe what an optimal debt restructuring should accomplish.

Debt can be thought of as a moral obligation when a loan is extended from one individual to another, especially if there is no interest on the loan. But loans to businesses or to sovereign entities are business transactions, and they should be managed as such. The only moral obligation in restructuring sovereign debt, it seems to me, is for policymakers to fulfill their political responsibilities to do what is in the best interests of their citizens and to participate in a responsible way in the global community. The debt restructuring process is, in other words, morally neutral.

The decision to restructure debt

Normally the relevant characteristics of a bond issued by government are very clear. Needless to say most borrowing agreements specify a series of payments to be made in a specified currency on a specified date, but this is not what I mean when I say the relevant characteristics of a bond issued by a government are very clear. The clarity that matters is in the resolution of the debt.

Let me step back for a moment. Debt is always “resolved”, in the sense that either the obligor makes the contracted payments as expected and without difficulty or, in the case where it is unable to make the contracted payments, there will either be an equivalent payment absorbed by the creditor, in the form of losses and a write down, or some other entity will step in and directly or indirectly make the payment. Put differently, debt is always “paid”, if not by the borrower, then by someone else. The resolution of debt can be explicit, transparent and certain, or it can be non-transparent and uncertain, but however it occurs, debt is always resolved in a way that requires implicit or explicit wealth transfers from one or more entities.

This is true of both private debt and sovereign debt, and it is true whether the debt arises directly or in the form of contingent liabilities. However in the case of sovereign debt, all the costs associated with servicing and paying down the debt are ultimately assigned to different groups of stakeholders. These include workers and ordinary households, small and medium-sized companies, large companies and multinationals, wealthy households, or, especially in the case of countries with very large public sectors, local and central governments through asset liquidation and land sales. Stakeholders can even include foreigners, so in the case where a country’s external debt is restructured with partial debt forgiveness, the debt is “resolved” in part by wealth transfers from foreign creditors.

When I say that “normally” the relevant characteristics of a bond issued by a government are very clear, I mean that “normally” there is no uncertainty associated with how these payments will be resolved. The government runs a budget, in which expenditures are funded in a fairly explicit manner by tax collection and by borrowing, or sometimes by asset sales, and there is an assumption that the costs associated with servicing the government’s outstanding bond obligations will be met through normal budge operations. Governments also sometimes resolve debt by hidden means, by monetizing the debt or through financial repression, in which case it is usually middle class savers, most of whose savings are in the form of monetary assets, who end up paying for the debt.

As long as debt levels are not “excessive” and the government is believed to be solvent — which in the context of sovereign debt always refers to the ability of the government to service its contractual obligations at a cost that is politically acceptable — there is very little uncertainty associated with the resolution of debt servicing costs. Payments will be made out of ordinary budget operations and none of the stakeholders worry that the high debt-servicing cost will force unexpected changes in the way in which costs are allocated and the debt resolved.

Once debt levels are excessive, however, questions arise about the country’s solvency and about the steps the government will take to resolve the debt. This is the difference between a fully creditworthy borrower and one that is not – in the former case there is no uncertainty about how the cost of resolving the debt will be allocated and in the latter there is. As I will explain later, this uncertainty forces stakeholders to alter their behavior, and they do so in ways that always automatically either increase balance sheet fragility further, reduce growth, or both.

What makes matter worse is that when debt levels are excessive it is not just how the costs will be allocated that is uncertain. In most cases the amount of the obligation itself becomes uncertain. This is because depending on how economic circumstances evolve, additional contingent liabilities may be forced explicitly or implicitly onto the sovereign credit. When the government loses credibility, it is almost always the case that total debt ends up being even higher than originally contracted, and there are many reasons why this happens. A slowing economy, for example, may increase the number of bankruptcies that the banking system has to absorb, and because in many cases the banking system is already effectively insolvent, and must be explicitly or implicitly bailed out by the government, already high levels of sovereign debt will rise even further. If the country is forced to devalue the currency, to take another example, the value of external debt will soar, or if slower growth causes fiscal revenues to be less than expected and fiscal expenditures greater, debt will rise further.

This creates by the way a problem that is not sufficiently recognized in the debate about the European debt crisis. A debt crisis must be resolved quickly because there is a self-reinforcing component within the process that can be extraordinarily harmful. High levels of sovereign debt create uncertainty about how the costs of resolving the debt will ultimately be assigned. This uncertainty causes growth to slow by adversely changing the behavior of a wide variety of stakeholders in the economy (as I will describe later). As the economy slows, contingent liabilities within the banking system rise, tax revenues decline and fiscal expenditures rise, all of which push up sovereign debt levels even further and increase both the cost of resolving the debt and the uncertainty about how the costs will be assigned. The consequence of this self-reinforcing deterioration in the sovereign balance sheet is, at first, a slow grinding away of the economy until the market reaches some point, after which the process accelerates and debt can spiral out of control.

But long before things spiral out of control, when debt levels are excessive — and debt levels are excessive as soon as there is wide-spread uncertainty about the amount of the costs and the sectors to whom they are going to be assigned — the economy is being damaged and, with it, political, economic and social institutions are being degraded. With very high levels of debt the decision Europeans face is whether to move quickly to reduce uncertainty and assign the losses to sectors best able to absorb the losses, and in ways that maximize future value creation, or to allow these losses to be assigned implicitly, over many years, and in ways that are hard to control.

This is the heart of the matter. The point of a debt restructuring is to eliminate or reduce the uncertainty associated with the resolution of the debt so that the total value of the debt increases and future growth is not constrained. To summarize:

  1. Under “normal” conditions, the obligations associated with debt are explicit and there is very little uncertainty about how the debt will be resolved. The revenues sources needed to service the debt are clearly identified.
  2. When debt levels become “excessive”, that is when the existing revenues sources are no longer sufficient easily to service the debt, uncertainty arises about how the debt will be resolved and even about the amount of the debt to be resolved. This is exacerbated by the highly reflexive relationship between rising uncertainty and rising debt, so that rising uncertainty associated with the resolution of the debt forces adverse stakeholder behavior, which causes the uncertainty associated with the resolution of the debt to rise further.
  3. How do we know when debt levels have become “excessive”? Debt levels are excessive when the uncertainty associated with the resolution of the debt is high enough to change the behavior of stakeholders. To put it in terms guaranteed to infuriate policymakers, a country has too much debt whenever the market believes it has too much debt. Anyone who does not understand why it is as simple as this does not understand the economic impact of debt.
  4. The purpose of a debt restructuring, then, is to reduce or eliminate the uncertainty associated with the resolution of the debt because this uncertainty automatically reduces value and future growth. If done correctly, a debt restructuring increases the wealth of stakeholders and improves future growth prospects.

Mario Draghi and the 2012 European debt restructuring

This is why I argue that by promising to do whatever it takes, Mario Draghi and the ECB effectively engineered a debt restructuring with implicit debt forgiveness. They changed the contractual terms of peripheral European sovereign debt by implicitly allowing bondholders to put their bonds to the ECB whenever the ECB determined that bond prices had fallen enough to damage Europe more than was tolerable. The fact that both the legal obligation of the ECB to purchase the bonds and the effective purchase price are uncertain does not change the underlying dynamics of the restructuring, and the proof is that Draghi’s statement has caused bond yields to drop to levels that imply a miniscule probability of default.

Notice how the process worked. Draghi’s promised immediately reduced a larger part of the uncertainty associated with the resolution of the debt. The collapse in uncertainty reversed the reflexive process in which rising uncertainty caused declining economic expectations, which caused rising uncertainty. The reversal immediately put the affected sovereign borrowers in a virtuous circle in which declining uncertainty led to improving performance which caused uncertainty to decline further, and while this move by Draghi to reverse the downward spiral was probably necessary, it should reinforce recognition of how intensely pro-cyclical is the dynamic process into within these countries are locked. If it reverses, it will reverse in exactly the same way, and precisely because all market participants know this, even a partial reversal could very quickly intensify.

Ignoring legal and political issues, there are at least two important reasons why Draghi’s promise was far from an optimal resolution of the European debt crisis. First, and most obviously, it reduced the enormous uncertainty that existed at the time, and this is very important because by then it was clear several countries were well along the process in which the debt spirals out of control, but there still remains an enormous amount of uncertainty associated with the debt resolution. Not only are the terms of the implicit “restructuring” uncertain, but in nearly every country in Europe debt is growing faster than debt servicing capacity, most economies are struggling, unemployment is high, the political atmosphere is tense and unstable, and as if all of this were not enough, uncertainty in every country in Europe is linked tightly together so that an increase in uncertainty in any one country automatically causes uncertainty to rise in all countries, in a process often referred to as contagion.

Contagion is often presented as if it were “merely” a psychological problem that can be defused by popular faith, but contagion is far more mechanical than this. One of the imbalances within Europe before the crisis, for example, was the imbalance between deficient demand in Germany and excess demand in peripheral Europe, the balance of which determined the level of the euro. This imbalance has become more complex since the crisis, but it should be clear that if any country on one side of the imbalance were to defect, or were to engineer a rapid adjustment (for example if a peripheral European country were to secede from the currency union), the amount of the imbalance would remain the same but it would be absorbed within a smaller group of countries. If Portugal were to leave the euro, for example, Spain would immediately suffer from having to absorb part of the imbalance that Portugal had absorbed, so that a Portuguese defection automatically has a contagion effect on Spain. The contagion also exists through the banking system (problems in one country cause bank portfolios in others to deteriorate, thus increasing contingent liabilities that must be absorbed by the government) and through the value of the Draghi put itself.

This is the second important reason why Draghi’s promise was far from an optimal resolution of the European debt crisis. European debt is locked into an intensely reflexive process in which the value of the Draghi put is a function of the creditworthiness of the ECB, and the creditworthiness of the ECB is a function of the value of its total obligations, including its implicit guarantees. Any deterioration in the creditworthiness of the ECB undermines the value of the Draghi put, and the resulting increase in the uncertainty associated with the resolution of, say, Spanish debt automatically forces up the Spanish debt burden and so further weakens the ECB’s creditworthiness.

We could perhaps ignore this process and hope that it is never set off except for the fact that in every important country in Europe, the debt burden is worsening (debt is growing faster than debt servicing capacity), so that the ECB’s implicit obligations are rising faster than its debt-servicing ability. The recent McKinsey study of global debt has terribly alarming figures for Europe – of the thirteen countries whose debt has risen by more than fifty percentage points in the past seven years, ten of them are members of the European Union, and the top six include Ireland, Greece, Portugal and Spain, all of whose debt has grown by more than 70 percentage points. The ECB’s creditworthiness, in other words, is deteriorating on a daily basis.

Some analysts deny the possibility of credit deterioration in the ECB because of its ability to create unlimited amounts of currency and fully monetize its obligations. Monetizing debt, however, is not the same as resolving it. It simply involves a transfer of wealth from those who are long monetary assets to those who are short — or, to simplify, from Germany to Spain. If the ability of the central bank to force through these wealth transfers were fully credible, as would be the case of the Fed in the US, the PBoC in China, the BoJ in Tokyo, or the BoE in London, these analysts might be right and the question would never arise.

But because sovereignty is not centralized, the ECB does not operate in the same way as these central banks do. Monetizing the debt involves wealth transfers in the same that gold transfers might have done in Europe in the late 19th century. German’s willingness to allow the ECB to guarantee increasing amount of Spanish debt is probably analogous to the willingness of the Bank of France to lend gold to the Bank of England during a British liquidity crisis if it fully expected the crisis to be resolved and the gold to be returned. It would certainly be willing to take some risk because an English financial crisis would have an adverse impact on the French economy, but there is a limit to the amount of risk it is willing to take, and everyone fully understand this.

In fact I see the credibility of the ECB put as one of the biggest “tail risks” in the market. From the early days of the European Union Germany has traditionally picked up the bill for many of the costs of the European Union, including the costs of some fairly petty European grandstanding, and Germany did it again in a major way during reunification, even though we tend to forget the latter because it involved fiscal and sovereign centralization. This history makes it tempting to assume that the determination of the ECB to monetize the sovereign obligations of all member countries, which is based on the willingness of Germany to allow unlimited wealth transfers, is itself unlimited. But this history should also alert us to the likelihood that Germans are unhappy with this arrangement and might at some point refuse to continue writing checks.

In my February 4 blog entry I argued that while German institutions and policymakers are as responsible as those in peripheral Europe for the debt crisis, in fact it was German and peripheral European workers who ultimately bear the cost of the distortions, and it will be German households who will pay to clean up German banks as, one after another, the debts of peripheral European countries are explicitly or implicitly written down. The overwhelming, and overwhelmingly favorable, response I received makes it clear to me that far more Europeans understand this than perhaps their political leaders want to believe. Among other things this suggests that it does not require lack of solidarity with their fellow Europeans to drive ordinary Germans to refuse to pay for the worsening crisis. It could just as easily be their unwillingness to continue to participate in a process in which workers and middle class households in Europe are being forced to pay to maintain policy mistakes that have benefitted mainly wealthy owners of European assets.

With sovereign debt levels rising month after month in Europe, and with several opportunities for adverse shocks any of which could cause a surge in uncertainty, I don’t think we can simply assume infinite German patience, and so the value of the Draghi put must be eroding, however slowly. I am not saying that I think there is currently any question of ECB credibility, but no institution has infinite debt capacity, and none can support a steadily deteriorating debt burden without risking the possibility of an erosion in credibility. Of course if doubt were ever to emerge about the credibility of the Draghi put, conditions would almost certainly deteriorate much faster than anyone expected simply because of the intensity of the self-reinforcing process that caused bond yields to collapse after July 26, 2012. A system that works powerfully in one direction can work just as powerfully in the other.

What are the functions of the liability side of the balance sheet?

It should be clear for the reasons I discuss above that debt levels in Europe are excessive and that there is a great deal of uncertainty about the resolution of sovereign debt. In order to explain why this uncertainty requires that Europe move to restructure its debt, or, to use a perhaps less politically loaded phrase, to reduce the uncertainty associated with debt resolution, it is necessary to understand how debt — and the balance sheet, more generally, by which I mean not just outstanding government debt but the entire financial system and the financial operations of the economy — affects growth. Balance sheets can exacerbate growth in both directions, so that just as financial crises are always balance sheet crises, there is also almost always an important balance sheet component to every growth miracle.

This needs explaining. For most academic economists, “growth” occurs primarily as a function of the way the asset side of the balance sheet is managed. If assets are managed well, their value increases, and the better they are managed the greater the increase in value, so that the growth of the business or the economy is largely a function of the how productively assets are managed. Policymakers who want to increase economic growth, according to this view, would do so by improving the quality of infrastructure, removing legal and regulatory constraints for businesses, better aligning incentives to encourage productive investment and behavior, and so on, in order to improve the productivity with which the country’s assets and resources are utilized.

Finance specialists, however, understand that the optimal management of assets only provides the upper limit of growth for a business. This is because under certain conditions the liability structure of a business can act as a constraint on growth. If its debt level is high enough that either it distorts incentives by distorting the way value is distributed, or it causes stakeholders to respond to uncertainty by undermining value creation, or it exacerbates the impact of adverse external shocks, not only will growth in the value of the business entity be much lower than it could be, but in fact it can easily become negative. Financial specialists refer to the process — in which the rising probability of default forces stakeholders to alter their behavior in ways that undermine growth — as the incurring of “financial distress” costs.

What financial specialists often don’t understand, however, is that the liability structure of a business can also goose growth above its “natural” level. When it reinforces behavior or exacerbates shocks, periods of growth are often periods of very high growth. This becomes obvious from the observation that it is often the highest of flyers during boom periods that are most likely to collapse or get into trouble as soon as a boom period reverses. At least part of their growth during the boom was not sustainable, but was instead the consequence of a distorted balance sheet that exacerbated the positive shocks typical of a “boom”.

The same process occurs within any economic entity, including a national economy. It is not an accident that in nearly every case in history in which countries have excessively high debt levels or have undergone debt crises, policymakers have never been able to keep their promise that, with forbearance from creditors and the implementation of the right reforms, the country can grow its way back into full solvency. Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.[1]

Debt matters. For most orthodox economists debt is simply the way operations are funded, and what matters mainly is the cost of the debt, or at best the cashflows associated with debt servicing. But in fact the liability structure of the balance sheet of any economic entity has several functions that significantly affect economic behavior. This is as true of small economic entities, like households and businesses, as of large, like countries or even the global economy. The main functions are:

  1. The liability structure is the sum of the way assets and operations are funded, and debt can be used either to fund investment or to reallocate consumption over time.
  2. The liability structure affects the ways in which operating earnings and economic growth are distributed. For a business entity, the various ways in which the debt servicing agreements are indexed and their levels of seniority determine how operating earnings after taxes are distributed, with the residual going to owners. It is a little more complicated when we are dealing with a national economy, but the principle is the same. What matters for a national economy is that the government is a hugely important player, and the ways in which it collects taxes, both direct and indirect, the investment decisions it makes, and the policies it implements to enhance or undermine certain kinds of economic activity, whether explicit or implicit, collectively act as the primary determinant of how growth in the economy is distributed among different stakeholders. As a consequence all stakeholders will adjust their behavior in response to their perceptions of how government policies will affect them.
  3. The liability structure also determines how exogenous volatility and external shocks are absorbed, and here is that the concept of balance sheet “inversion” can be especially useful. As I explain in my book, The Volatility Machine, an inverted balance sheet is one in which borrowings are structured pro-cyclically so that they reinforce external shocks by automatically causing behavior to change in ways that exacerbate the impact of the shock (unlike a “hedged” balance sheet, which automatically dissipates shocks). External currency debt, inventory financing, short-term or floating-rate debt, asset-based lending, and margin lending in the stock market, can all be highly inverted forms of borrowing because a rising market allows investors to increase their purchases, which pushes prices up further, and a declining market forces investors to sell, which pushes prices down further.

The structure of a country’s banking and financial system can also either exacerbate or dissipate external volatility, in the former case by imbedding pro-cyclical mechanisms into the economy. In China, for example, because its rapid growth was driven primarily by investment, which tends to be heavily commodity intensive, rapid growth pushed up global commodity prices nearly tenfold during the first decade of this century. Of course business entities that ran the largest commodity inventories profited heavily at the expense of their more prudent competitors, and this caused a “Minskyite” shift in the composition of industry towards greater speculative risk-taking by rewarding commodity speculation heavily. This process of course caused the financial system to become increasingly exposed to commodity price risk, so that the faster China grew, the more rapidly Chinese banks were able to expand credit, which itself caused the economy to grow even more rapidly and commodity prices to rise further. Of course the whole process went into reverse once Beijing, recognizing the deep imbalances that were building up within China, moved to slow investment growth, and we are only now seeing what will turn out to be a long, drawn-out process of pro-cyclical adjustment.

In economies with highly inverted balance sheets, shocks can be so self-reinforcing that periods of rapid growth become growth “miracles” but, as happened in nearly every growth miracle case in history, the subsequent periods of decelerating growth can swiftly degenerate into collapse or lost decades of unexpectedly low growth. In Europe’s case, the intensively reflexive relationship between sovereign creditworthiness and the domestic banking system may be he most worrying form of inversion. For the banks in peripheral Europe a substantial share of liquid assets consists of their government bonds, so that any deterioration in sovereign creditworthiness would cause enormous losses for the banks, but because the main source of contingent liabilities for the government is the banking system, losses in the banking system would immediately cause the sovereign creditworthiness to deteriorate. Balance sheet inversion is the single most important reason for sovereign financial crises, as I explain in my book, but policymakers are not nearly as terrified by it as they should be.

  1. Finally, expansion or contraction in the liability side, which occurs most easily in the form of expansion or contraction in credit, can speed up or reduce expected growth in operating earnings or GDP.

How does a badly structured balance sheet constrain growth?

There is an enormous difference in the level of sophistication between corporate debt restructuring and sovereign debt restructuring. In the discussions in Europe, most of which are dominated by discussions about Greece, there have been suggestions by Finance Minister Yanis Varoufakis as well as analysts like Martin Wolf and Wolfgang Münchau, both at the Financial Times, about aligning debt servicing payments with the Greek ability to pay, for example in the form of GDP-linked bonds. But aside these few, much of the focus seems to be on determining what combination of coupon and principle will lead to the maximum annual payment Greece can manage over the next two or three years.

This is a very bad way to decide on how to restructure the sovereign obligations of Greece or that of any of the peripheral European countries that are likely to follow. The debt restructuring should be designed to maximize stakeholder value so that all players are better off after the restructuring than before. Key to a successful restructuring is the elimination, or at least the substantial reduction, of the uncertainty surrounding the resolution of the debt. I would argue that there are at least five components to a good restructuring and these can best be understood by recognizing the ways in which a badly structured balance sheet can constrain growth:

  1. High borrowing costs.

Obviously, the higher the real borrowing costs, the greater the growth constraint, but there is a very important point that is missed in the discussion. It is always easy for a borrower to reduce its borrowing cost by taking on risk. So, for example, short-term borrowing, debt denominated in a major currency rather than the borrower’s currency, or debt that grants optionality to the lender (for example, by allowing the lender to put the bond back to the issuer on a specified date before its final maturity) will always involve a lower interest rate for the borrower.

This is almost never a good strategy for a borrower that needs to restructure its debt. The biggest risk of lending money to higher-grade borrowers tends to be interest rate or currency risk. To lower-grade borrowers, of course, it is the risk of default, and the pricing of its obligations is very sensitive to changes in the perception of default risk. This means that any reduction in borrowing costs that comes about by the borrower’s taking on additional risk is usually less than the direct or indirect cost of the additional risk on the rest of the borrower’s obligations. A country that is forced to restructure its debt should never agree to lower borrowing costs if this means that it has to assume additional default risk.

But this doesn’t mean that restructuring countries cannot benefit from granting optionality to their lenders. If the optionality results in an overall reduction in balance sheet inversion, the borrower benefits in two ways: it reduces the borrowing costs on the specific debt instrument and, by reducing the probability of default, it reduces the direct or indirect cost of the rest of the borrower’s obligations. How could this work in the case of a Greek restructuring?

  1. It could issue a dual currency bond. Borrowers understand that there is some probability that Greece will exit from the euro, either permanently or temporarily. By allowing buyers of this bond to choose at some point in the future between payment in euros at the contracted rate or payment in the new currency at some rate, either specified today or linked today to some index. Investors would only switch payment options under optimal conditions for Greece, when its currency is expected to do well and interest rates fall, allowing Athens both to reduce its borrowing cost and to stabilize its balance sheet. After the 1994 peso crisis. Mexico issued a dual currency bond whose final payment was linked, at the investor’s option, either to dollars or to pesos. The offering was hugely successful and palpably changed expectations about the Mexican outlook.
  2. It could allow investors to index payments to an asset whose performance is positively linked to economic performance — oil, for example, in the case of Venezuela — so that investors receive a higher-then-contracted payment only in the case that Greece’s economic performance is better than expected. Options linked to GDP or to real estate prices or to the Athens stock market (perhaps even to olive oil or to the number of foreign tourists?) accomplish this purpose.
  3. Because Greece imports a number of commodities, it can also share the benefits of any fall in commodity prices by agreeing to pay a higher coupon if the price of a specific commodity falls below a certain price.

One of the great advantage of these structures is also too little appreciated by issuers, investors, and bankers. Even if the expected payment of an instrument with optionality is identical to that of an instrument without optionality, simple arithmetic makes the former more valuable for the investor even as it is more valuable. This is because there is an asymmetry in the discount rate such that higher expected payments are discounted at lower rates and lower discounted payments at higher rates. If the optionality is linked to a liquid asset and detachable, the investor can immediately capture this value directly.

  1. Financial distress costs.

Earlier on I pointed out that all the costs associated with servicing and paying down the debt are ultimately assigned to different groups of stakeholders. These include workers and ordinary households, small and medium-sized companies, large companies and multinationals, wealthy households, or, especially in the case of countries with very large public sectors, local and central governments through asset liquidation and land sales. Stakeholders can even include foreigners. When uncertainty arises about how sovereign debt is likely to be resolved, all of these stakeholders must alter their behavior to protect themselves from bearing a disproportionate share of the costs. Their effect in reducing growth is what is referred to in finance theory as financial distress costs.

The process is both automatic and straightforward. The ways in which a country incurs financial distress costs include:

  1. Workers understand that unemployment is likely to rise and remain high and so they tend to cut back on spending. They also tend to unionize, and their unions become more militant in their relationship with business.
  2. Ordinary households worry about future income or consumption tax increases, and so they too cut back on spending, and because they also worry that their savings will be confiscated to pay the debt, most usually in the form of inflation, financial repression, currency depreciation, or frozen deposits, they often withdraw their savings from the domestic financial system.
  3. The best educated, the young, and people with the most valuable skills emigrate as the excess debt weighs down future growth prospects.
  4. Small and medium-sized companies, fully aware that during crises wealthy businesspeople often bear the brunt of public anger, worry about being expropriated or forced to pay higher taxes, and so they disinvest and become reluctant to hire additional workers even in the exceptional cases when they need them.
  5. Large companies and multinationals also worry about expropriation and taxation and so disinvest or move operations abroad.
  6. Banks worry about deteriorating collateral values and cut back on risky lending.
  7. Exporters worry about currency depreciation or confiscatory rules on foreign currency, and so they drive down inventory and reduce the amount of earnings they repatriate.
  8. Wealthy households move money abroad to avoid higher income or asset taxes.
  9. Foreign and local creditors reduce loan maturities and raise interest rates.
  10. Policymakers respond to the increase in social and political instability by shortening their time horizons.

These changes in behavior in response to rising uncertainty about how debt will be resolved are probably the most damaging impact of a debt crisis because they erode not just economic institutions but also social and political institutions. They can also be intensely self-reinforcing, so that as stakeholders respond to rising uncertainty, their responses collectively increase debt, reduce growth, and exacerbate balance sheet fragility (by shortening debt maturities, for example), all of which only increase uncertainty. One of the saddest aspects of this process, historically, has been that typically the most sophisticated, who are often the wealthiest, are the first to protect themselves, and the least sophisticated are the last, with the result that the distribution of losses is asymmetrical in a way that maximizes the social damage.

  1. Misaligned incentives

High debt levels often create disincentives for business entities to behave in line with the interests of the economy overall. The most obvious example of this is in countries that have currency and balance of payments crises. The urgent need for foreign currency often results in short-term policies that penalize businesses with foreign currency, including businesses that generate foreign currency. The result is that instead of encouraging businesses that increase the available pool of foreign currency, these policies discourage them. Latin America in the 1980s suffered from this misalignment of interests.

The same occurs when debt restructurings involve complex currency or debt repayment regulations, the rationing of credit, or significant distortions in the price of credit. In these cases business managers are more heavily rewarded not for innovation and productivity growth but rather for managing their way through the regulatory process. For example, when Venezuela had multiple foreign exchange rates during the late 1980s, a significant amount of resources was expended by business managers to allow them access to favorable treatment. In China, until about 3-4 years, to take another example, interest rates for bank loans were so heavily repressed that it was widely admitted that companies that had preferential access to bank loans spent more time trying to justify taking on more loans than they did looking for the most productive ways in which to invest the proceeds. With such low interest rates, almost any investment generated returns that exceeded the cost of funding it.

In Europe the determination to remove any possibility of flexibility in the use of the euro may be creating misaligned incentives. If countries like Spain were permitted temporarily to leave the euro, it would be possible to create agreements in which Spanish incentives were very strongly aligned with European interests. Assume for example, that Spain were permitted to reintroduce the peseta with an agreement that it would return to the euro five years later at a rate that implied a 20% depreciation in the currency, and this agreement was supported by debt extensions and the credibility of the ECB. This would immediately provide short-term relief for the Spanish economy while at the same time creating very strong incentives for Madrid to put into place the productivity-enhancing reforms that would make the currency fully viable once it rejoined the euro.

  1. Exacerbating of default probabilities.

Highly inverted balance sheets exacerbate the impact of external shocks. While positive shocks reduce the probability of default and negative shocks increase the probability of default, the impact is not symmetrical and in fact is highly concave. The result is that the probability of default is always higher when balance sheets are more inverted, and so the return that investors require is automatically higher too.

  1. The impact of deleveraging on growth.

Except in the case where all resources, including labor, are fully and efficiently utilized, and frictional costs are low or negligible, increasing leverage usually results in faster growth and deleveraging in slower growth. Highly indebted countries must urgently reduce their default probabilities, and the easiest and most obvious way to do so is to use free cashflow to pay down debt as rapidly as possible.

What must a good debt restructuring do?

Once we understand why distorted balance sheets and excessive debt burdens raise costs, undermine social, political and economic institutions, and constrain growth, and the various ways in which they do so, there are a number of fairly automatic lessons that can be drawn:

  1. Debt restructuring should not be delayed. This is the first and most common mistake made throughout the modern history of financial crises. The costs associated with an excessive debt burden begin to accrue immediately and include the undermining of social, political and economic institutions necessary for economic recovery. The longer the crisis persists, in other words, the greater the long-term cost to the country. Historically in the case of an external debt crisis there has always been strong pressure from the creditor governments to delay recognition of insolvency if this recognition could force the creditor banks into insolvency themselves. In that case the creditor banks need time to recapitalize before they can acknowledge the losses, and it is only after the banks are recapitalized that creditors finally “discover” that the borrower is insolvent. Given the potential size of the European losses, however, it may take many years of unnecessary economic destruction before German and other European banks are finally healthy enough. [2]
  2. Debt restructuring must address short-term liquidity constraints. This point is generally well understood and is often resolved in the form of ad hoc institutions, for example the Draghi put in the case of Europe.
  3. The debt restructuring should be designed not to reduce the value to creditors but rather to maximize value to stakeholders. The exchange of fixed payment instruments for equity-like or variable-payment instruments in which payments are indexed to economic well-being, for example GDP-linked bonds or coco bonds, can raise the total value of debt instruments significantly while boosting growth.
  4. It must assign the costs to those best able to bear them and whose reduced income will have the least negative impact on future growth. In most cases the resolution of debt is done implicitly over a long time, and usually in the form of financial repression or explicit taxes, so that the costs are effectively assigned to middle class households. This tends to worsen income inequality and weaken consumption. One of the goals of a debt restructuring should be to ensure that the costs are assigned in a way that is least damaging to the economy over the longer term.
  5. It must reduce the impact of external shocks, mainly by indexing payments to revenues and wealth creation, so that the probability of payment difficulties declines.
  6. More generally it must reduce uncertainty about resolving the debt. This is the main reason for a rapid and explicit debt restructuring because it is the uncertainty that undermines the economy.
  7. It must line up incentives so that foreign and domestic stakeholders are rewarded for productive behavior and policymakers are rewarded for long-term policies.

These are not necessarily easy or obvious things to do, but the important point to understand that is that with or without an explicit restructuring, the cost of resolving the debt is going to be borne by different sectors of the economy. The main difference is whether this happens explicitly or implicitly and whether it happens quickly, or it is allowed to drag on for many years, creating conditions of low growth and high unemployment and causing damage to the social, political and economic institutions that will generate growth over the future.

In many countries in Europe there is tremendous uncertainty about how debt is going to be resolved. This uncertainty has an economic cost, and the cost only grows over time. But because most policymakers stubbornly refuse to consider what seems to have become obvious to most Europeans, there is a very good chance that Europe is going to repeat the history of most debt crises. After many years of denying that they are insolvent, and many years of promises that reforms will be implemented that will set off enough growth to resolve the debt, policymakers in countries like Spain will be forced either to change their positions or they will be forced out by voters – simply because economic conditions will have deteriorated so drastically that a restructuring can no longer be put off.

Monetary policy is as much about politics as it is economics. It is about some of the ways in which wealth is created, allocated, and retained. Debt restructuring involves allocating wealth in the most efficient way. It does necessarily not mean, however, defaulting on payments. The only goal of a debt restructuring is to reduce the uncertainty associated with the resolution of the excessive and growing debt burden. There are many ways to do so, and in many cases they require significant debt forgiveness, but pretending that all will be fine if we only grit our teeth and wait longer has almost never turned out to be true.

For now I would argue that the biggest constraint to the EU’s survival is debt. Economists are notoriously inept at understanding how balance sheets function in a dynamic system, and it is precisely for this reason that we haven’t put the resolution of the European debt crisis at the center of the debate. But Europe will not grow, the reforms will not “work”, and unemployment will not drop until the costs of the excessive debt burdens are addressed.

 

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[1] In Carmen Reinhart’s “A Distant Mirror of Debt, Default, and Relief” (NBER Working Paper No. 20577, October 2014) the author looks at 42 default and restructuring episodes in the 20th Century and finds that “the post final debt reduction landscape is characterized by higher income levels and growth, lower debt servicing burdens, lower external debt, sovereign credit ratings and capital flows behaved differently in the interwar and modern periods; in the latter case ratings recover markedly.” It is only after the debt forgiveness, they find, that growth picks up.

[2] In the case of the LDC Debt Crisis of the 1980s, American banks spent most of 1982-88 rebuilding their capital, in part thanks to large hidden transfers from American households spurred by a steep yield curve. It is not a coincidence that two years Citibank announced its reserve position, in May 1987 (within a year of which the weakest of the top ten US banks were also sufficiently reserved) that the first formal debt forgiveness was negotiated, for Mexico, with the issuance of the first Brady bond in 1990. In the German case I expect that part of the debt will be gradually nationalized (as is already happening) while Berlin will take steps to boost bank profitability at the expense of middle class German savers in order than banks can write down the remainder. It is only then that we will see widespread political support of debt restructuring and partial forgiveness, if history is any guide.

125 Comments

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  1. MP- excellent ideas. Do you know of a historical example where a soverign nation collaterallized their “bridge” loan with land and/or infrastructure (such as Pireaus Port or Peloponnese Pennisula). You provide examples of consumable items such as commodity-index bonds, oil and cocca, and dual currency bonds, but not actually granting assets. Many corporate restructurings are done by liening the property of the company. Could Greece do the same?

    • Greece could rent out some islands to Germany. When China granted the UK a 199-year lease on Hong Kong and the New Territories it did so in a position of weakness. Nevertheless what China got back from the UK was indisputably a much more valuable asset than would have been the case if Hong Kong had been developed by China. A similar benefit to Greece might be obtained by renting islands to richer countries in the EU.

      • Greece could also never get those islands back. I’d be very careful doing something like that. “Renting” or “leasing” something to someone else who’s actively hostile towards you, is wealthier then you, and has more/better guns than you is a good way to get stuff stolen.

      • China was forced to rent hk to uk hundred years ago.’and it’s more like a political problem than an economic problem actually.there PRC spent a lot to get it back,and I don’t think Greece can get them back in the future.

    • It could, Cypriot, but this might be politically difficult and, more importantly, collateralizing loans doesn’t resolve the problem of inversion. It only addresses the creditworthiness of the loans, although I think creditors would be right to wonder whether they would be able politically to seize assets in the case of a Greek default.

      It might be interesting to note in this context that most of the Brady bonds issued to resolve the LDC Debt Crisis had principal collateralized by 30-year US Treasury strips (and in some cases rolling interest guarantees also collateralized by strips). In these cases the collateral was considered credit-enhancing because in case of a default the bondholders would receive the strips from the Fed, who had been selected to hold the collateral.

      As an aside, in the late 1990s I was teaching emerging markets finance at the Columbia Business School and I spent some time with the students working out the Brady bonds and their strengths and weaknesses. Just to forestall any impatience on the part of my students who might want me to spend more time on deals I was currently working on and less time on “ancient history” (I worked on Wall street at the time running liability management and Latin American capital markets desks) I remember promising them that all this sovereign debt restructuring stuff was not useless knowledge and that at some point in their careers they would wish they knew more. This stuff goes out of fashion but, like bell bottoms, it always returns.

      • Good comparison Marilyn, the Greeks could lease the land, rather than lien or sell the land, preserving some degree of sovereignty, and gain efficiency to the public sector at the same time. There is no shortage of capital to develop a new city-state from scratch- particularly if it can access the EU tradezone.

        MP, I am not sure collateralizing land or leasing a city-state is any more difficult than other proposals you mention- they are all hard and improbable. I disagree with you [cautiously] about a land-lease transaction not-reducing the inversion of the sovereign balance sheet. A land-convertible bond, or a 100-year structured lease on the Pelopponese would be comparable to selling equity, and greatly reduce the debt inversion. Greece could easily collect €300 billion from such a structured offering, and immediately payoff the inverted debts to the Troika. The new private creditors to Greece, (ie, those providing the €300billion) would be much more aligned with Greek economy and make meaningful efforts to produce value from the Pelopponese. Also, the non-Pelopponese part of Greece would likley benefit from the economic transformation taking place in the New Pelopponese as China has benefited from Hong Kong.

        The Pelopponese is approximately 5 million acres (2m hectares) and worth at least €6000/acre just as range/farmland, easily reaching a €300 billion level of equity. The opportunities are endless on such a prime piece of real estate. 1) Agriculture (let the Israelis irrigate), 2) Energy infrastructure (pipelines and LNG terminals into Europe), 3) Banking and tax loopholes (hire Irish, Maltese and Swiss bankers), 4) Manufacturing (as member of EU and millions of opportunity seeking immigrants from Arab lands, the Pelopponese could have lower labor costs than China), 5) Beach Resorts (obvious), 6) Ship Buiiding, 7) Rent Naval Ports (the Russians would love to move from Syria) …. Raising €300 billion in private equity for a Pelopponese city-state seems simple- the world is awash in capital. However, getting the Greek government to provide a 100-year lease and a “special economic zone” where current public sector regulations do not apply is hard.

        Economic fundamentals can make the impossible happen- and much better if the debt is restructured explicitly rather than implicitly. The good news is that Tsipras and Varoufakis have shown an appetite to take an innovative path and confront reality. The bad news is that historically, these restructuring are most commonly accomplished through war and chaos, not through private and voluntary transactions.

        • “The bad news is that historically, these restructuring are most commonly accomplished through war and chaos, not through private and voluntary transactions.”

          What happens when you lease your land and the people leasing your land decide that they want your land and productive capacity while they already have guns. In Europe, every part of their financial system runs through the banks. The reason the system developed in that manner is so that central governments can control who can/can’t buy assets/gain influence in their political systems.

          The reason these things end up in war is because when you think about things from a game theory perspective, the country is often times better off by starting war than by delaying it anyways. So as soon as one country gains an advantage (or a perceived advantage), war starts.

          It’s unfortunate that of all the people that understand the art of warfare, very few are good at economics/finance. It’s also just as unfortunate that of those who understand finance/balance sheets/economics well, then don’t understand the art of warfare well.

          Those who think warfare is about killing/massacring people and wiping out enemy citizens do not know/understand warfare. Unfortunately, this is what most on the left seem to think. If we work under such delusions (I blame Marxist thought for a large part of this problem), we’re not gonna change anything.

        • You are right, Cypriot, but only because a loan collateralized by land is very different from a convertible. In your first comment I understood you to mean the former, in which case the bondholder is long delta but short kappa, and his delta position is likely to be very close to one, so that his delta exposure is already close to zero, and highly concave with mostly downside risk. The point of the collateral is to reduce his short kappa and the make his delta less concave. This is good for the lender, but it barely improves inversion because the slope of the delta is too close to zero.

          For non-option guys, this just means his upside is limited and in fact capped by the face value of the bond, and his downside is up to 100% of his investment, and if conditions improves dramatically, the lender and the borrower do not share in the improvement. The collateral is just an attempt to reduce the downside risk. Lest you think I put this in option terms to show off, please let me try to convince you instead that thinking about how the value of stocks and bonds change by first disaggregating them into their fundamental positions (all financial instruments are portfolios consisting of nothing more than one or more long or short positions in risk free forwards and long or short positions in puts or calls) creates a richness in the analysis that makes it almost impossible ever again to think in other terms. And if the math behind all of this frightens you (all those damned greeks), don’t worry. The math of risk-free forwards is embarrassingly easy, and highly advanced maths is useful only for pricing options.

          For analytical purposes all you really need to know is how to draw the four option payoff schedules (long put, short put, long call, short call), draw the value schedules for each, understand why delta is the slope of the value schedule, and understand how changes in kappa push out or push in the value schedule — and this all sounds far more complex than it really is and involves no more math than the tiny bit of calculus involved in calculating the slope of a curve at any single point (in fact if you know when the delta is 50, and when it approaches zero or one, you know enough). I could literally teach you everything within thirty minutes. If you get the intuition, you can ignore the mathematical calculations. In fact my finance mentor once told me that you can always tell the difference between a mathematician and an economist because the former always starts off by drawing sloppy graphs and the latter by writing equations.

          The richness that emerges from an options analysis is astonishing, and in my years at teaching advanced finance and arbitrage at Columbia I was famous for saying that options explain EVERYTHING. I think I still sort of believe that, and the appendix to my book, “The Volatility Machine”, uses an options framework to show that deeply discounted sovereign debt is like a long call option on the country (as traders used to say) and not like a short put option (as economists sneeringly corrected them, having learned that debt is like a short put option but never having understood that this is only true when the delta is close to 0), and the appendix has generated some very kind comments about how it illuminates the ways changes in sovereign credit and underlying volatility affect creditors and borrowers.

          But of course if you meant a convertible bond, and not a bond collateralized by land, everything changes. The kappa goes from negative to positive, the delta is no longer limited

          But to get back to your comment, if the bond does indeed allow you to convert into the land, then your short kappa and flat delta suddenly become long kappa and steep delta, and this creates the right kind of upside for creditors (they get paid more when the borrower is better off) while sharply lowering the cost of debt servicing and reducing balance sheet inversion.

          • How funny, options are my life (derivatives trader), and I view almost everthing from an optionality perspective- I could not agree more with your perspective. When I first commented about a land-collateralized loan- I was simply brainstorming about using the assets in Greece to payoff the debts, and the lien vs convertible had not bubbled up. Your comments and subsequent conversations with others has refined it avoid balance sheet inversion. I wish Greece luck, along with the rest of the EU. Podemos and Syriza promise to make 2015 interesting.

          • Speaking of the options framework. I worked on research last semester whereby I was studying winner-take-all effects from nonlinear payoffs. Then, I went on to take a look at error propagation and how small, seemingly minor errors in the dosage can create major impacts on the response. I actually ended up using a call option payoff function as a way to model fixed cost heuristics with the cost of the heuristic on the system as an analog to the option premium. I basically proved that in systems where error propagation can be crazy and highly nonlinear payoffs are involved, adding a fixed cost payoff function that limits your downside is essential for the survival of the system. I basically proved the efficacy and rationality of religion in social systems. I always laugh when people say that being religious is irrational as those people have a crappy definition of rationality.

            Also, the reason I think math guys (by math guys, I mean me) start off by drawing sloppy graphs is because a visualization allows us to just operate by intuition to a large degree and we suck at drawing. I love pictures, charts, and graphs.

            Also note that you’ll never find a math guy that uses lined paper. We hate lined paper so it makes it difficult for us to keep everything in line and everything looks slanted (even though it may be neat).

  2. Not wishing to detract from the quality and relevance of this excellent piece, Tim Geithner’s recollection of Draghi’s speech implies that Draghi made it up on the fly:

    http://www.telegraph.co.uk/finance/economics/11226828/Tim-Geithner-reveals-in-the-raw-how-Europes-leaders-tried-to-commit-financial-suicide.html

    If this version of events is true, does this also mean that a realignment (of obligations) can be created inadvertently? Or that it can be imputed constructively by a market that sees what it wants so it can turn?

    • He may have made up the phrase on the spot, Ryan S, but I don’t think an ECB commitment would have been made so lightly, especially given that it has been challenged by many in Europe, especially in Germany. The article suggests that in fact it wasn’t a policy made up on the spot but already had german backing. But even if the whole thing is a misunderstanding, as long as the market treats it as credible, it serves to reduce some of the costs of the uncertainty associated with the debt until debt levels have become high enough that it starts to damage perceptions of the ECB’s credit. If Draghi were then to announce that there never was any intention on his part and that the market completely misread him, I suspect that ECB credibility would be much worse. One of the great powers a central bank has is the ability to hint at things which the market takes seriously. I don’t think Draghi or anyone else would want the ECB to lose this ability.

  3. Mr. Pettis. I have a strong intuition that your reasoning is sound. Regrettably, I’m a mathematician by trade and my knowledge of economic principles and identities is spotty at best. I would like a way to follow your reasoning that is more grounded math and equatios. Would you be so kind as to suggest some material? At least some foundational material, so I can follow your books more easily.

    • Economists are infatuated with math and the appearance of math, J Mickleson, but they are mostly very poor mathematicians and misuse it horribly. I went to university originally planning to be a physicist and am pretty comfortable thinking mathematically, and I can tell you that what economists need is an intuitive understanding of mathematical models and a little calculus and probability, not much more. Because you are a mathematician if you can get a decent grounding in basic economic principles and read up as much economic history as you can, you will quick have a higher level of sophistication than most academic economists.

      You should read up on the basic balance of payments and national accounts accounting identities. It has been a long time since I have done that, but I am sure there are many readers of this blog who have studied economics much more recently than me and can point you out to some useful basic textbook.

    • I’m a math guy too. Be happy you didn’t study economics. You have rigor. Apply your rigor to economic concepts to construct and develop models as you please, but make sure that it is rigorous. If you do that, you’ll find different ways of thinking about things that’s more fundamentally sound than spouting nonsense economic theory.

  4. If one wanted to do the right thing for the long term, one would listen to your suggestions. But if one wanted to take a much easier shortcut for the same beneficial result, one would simply revise the statistics and remove the appropriate amount of debt as if it had never existed. It’s not a joke. The Fed removed $2.5Tr of debt from the Flow of Funds statistics between the first and second quarter of 2014, equivalent to 14% point of GDP. By doing this, the Fed effectively “restructured” US debt in the sense you give to this expression in that it anchored in the mind of all stakeholders the fact that the US economy had deleveraged. To the extent everybody believed it, the amount of debt forgiveness achieved by this measure was precisely $2.5Tr. And so US GDP growth promptly accelerated to 5% the following quarter. The incentives of all stakeholders had apparently been perfectly realigned. Precisely as you suggested. Just a lot easier. For Europe, this solution would make perfect sense. Given the time these guys spend in meetings to formulate policy, this would be a tremendous boost to Brussels productivity: big GDP boost achieved by a 2 minutes decision (usually it’s the reverse) and your McKinsey debt ranking looks a lot better. Sometimes, the most simple ideas are the best.

    • Muddling transparency is usually a good thing when there is too much liquidity in the markets, but it becomes a terrible thing when the market dries up. But debt matters for a lot more than its cosmetic appearance. Debt has to be serviced, whether or not you hide it by disguising your balance sheet, so the impact of debt cannot be disguised for long.

      • Why not admit that the Euro was an il-advised experiment that does not work? And that the growth solution lies in the dissolution of the EZ?

        I can’t understant why so many otherwise brilliant economists continue to cling to the belief that Germany and Greece should share monetary policy.

        • In what currency is the debt to be repaid? If in Euros (or New DMs) Greece is in a worse position, if in New Drachmas then German and French creditors are just as bad off as if the debt is written down. It also further undermines the Spanish, Italian ,etc. credibility to repay thus bringing forward a crisis their governments would like to postpone. Over the longer term this might help the southern economies grow more but in the short run it has many of the same distributional consequences that must be solved. Or so it seems to me.

          • “If in Euros (or New DMs) Greece is in a worse position, if in New Drachmas then German and French creditors are just as bad off as if the debt is written down.”

            Isn’t this kinda the point? Someone’s gotta pay. At some point, the debtors will realize they have the leverage and set the rules of the game. The question is when.

            In Hungary, the Hungarian people took out mortgages with currency denominated in Swiss Franc and Japanese Yen. Then, when the Hungarian people couldn’t pay the debts, the Hungarian government gave foreign creditors two options.
            Option 1: Our citizens will pay you 60% of what you’re owed in Hungarian Forint.
            Option 2: You get nothing.

            The choice was obvious. I suspect something similar happens in Europe.

        • Thnaks for suggesting that I am one of those “otherwise brilliant economists”, but I am not sure which of my writings have convinced you that I think the euro can and must work as it is constructed. Since 2001 I have argued that it would not survive its first liquidity contraction, and in my February 4 piece i argued that by preventing normal adjustment mechanisms it help create the destabilizing savings imbalances in Germany. Without major changes, I have never believed the euro could survive.

          But lets be clear about a few things. The fact that you and I might believe that Europe’s current institutional set-up makes the euro unsustainable or excessively costly does not mean either than the euro cannot exist or that Germany and Greece cannot share a common monetary policy. If Mississippi and New York City can share a common monetary policy, and if Anhui province and Shanghai can share a common monetary policy, then very obviously so can Germany and Greece.

          As I see it, there are only two really interesting questions. First, do Europeans want monetary union? In spite of my strong family, birth, and historical ties with France and Spain, at the end of the day I am a US citizen, and so it is not my decision, but if it were, I would say that yes, Europe should evolve towards monetary and political union.

          If the answer to the first question is yes, then the second question is: what are the conditions that will allow Europe to evolve towards a functioning monetary and political union. These conditions are not that hard to identify, and while there is political resistance, and almost insurmountable resistance if the loony right wing nationalists win, as they are increasingly likely to do, well functioning monetary and political is certainly possible to achieve, just as it has been achieved in the US and China and other large and diverse economies.

          I would submit that an explicit resolution of the debt is probably a precondition for the survival of the euro, and that is one of the points in this article, but I don’t see why anyone would argue that it is impossible for Germany and Greece to share a monetary policy without also accepting that the US and China have failed to impose their own currency unions.

          • If Mississippi and New York City can share a common monetary policy, and if Anhui province and Shanghai can share a common monetary policy, then very obviously so can Germany and Greece.

            …but I don’t see why anyone would argue that it is impossible for Germany and Greece to share a monetary policy without also accepting that the US and China have failed to impose their own currency unions.

            Michael, the monetary union of the USA and China was driven by the demand for economies-of-scale in the fixed capital Industrial Age. We are moving to a post-Industrial Age (post tangible resource scarcity) Knowledge Age, wherein capital will not be stored money but rather knowledge. I am the progenitor of this hypothesis.

            I detailed my expectations for the monetary future of the world.

            Thus all these discussions about restructuring the dying paradigm of usury, NAV, fixed ROI, central banks, centralized monetary systems, are all irrelevant. We are moving to decentralized, anonymous monetary systems. Even if you believe my comment is insane, please let it be published to your blog as matter-of-record that differentiates maverick from rigor. For the future will reveal who was correct.

          • The Post-Industrial Age will not be the “Knowledge Age” as you say. The primary input in the Industrial world was fixed capital. The primary input in the Post-Industrial world will be human capital. Human capital is not knowledge and consists of far more than that. Also, economies of scale never existed in the data and we’re already out of the Industrial world.

          • Suvy, manual labor is fungible but finely-grained (i.e. bottom-up) innovation is not, c.f. my 3 seminal essays linked from my prior comment. In the Industrial Age, the fixed capital costs were the majority of the cost of production. In the Knowledge Age, innovation is the majority of the cost of production. This epochal paradigm shift fundamentally alters finance, money, and investment (c.f. my Rise of Knowledge essay), including the Theory of the Firm. The Mississippi River won’t help the USA (even if Russia doesn’t nuke New Orleans). Data wasn’t innovation. The salient concept apparently flew over your head. Insight trumps the rigor of math (and I do higher-level math as well). TheWest is toast. Asia will rise.

          • It’s not innovation. Innovation was just as valuable in the Industrial world as it is in the Post-Industrial world and the Pre-Industrial world. The ability to use steel swords instead of bronze swords or even the ability to manage forests well was a gamechanger in the Pre-Industrial world.

            It’s not innovation. It’s the form of capital. It’s shifting from fixed capital (as you clearly understand) to human capital.

            BTW, geography matters just as much. What about stuff like infrastructure. Apparently, you don’t need power grids so large mountain ranges no longer matter. Water transportation infrastructure and the development costs to build that? Who needs water? Who needs food? People don’t need to eat. Irrigation systems? They’re not necessary anymore. Wait…

          • Suvy wrote:

            Innovation was just as valuable in the Industrial world as it is in the Post-Industrial

            I already refuted that. If you don’t understand that all by myself (where the cost of my computer and living expenses were insignificant), I generated roughly a $million in revenues when I programmed CoolPage, then you don’t understand the transformation underway. In the Industrial Age, I would have needed to build a factory to produce a product to sell. Now one only needs to send off a design to a 3D printer. Tangible costs are becoming irrelevant. It is all mental now costs now.

            Suvy I dumbfounded by your stubborn unwillingness to comprehend a simple concept.

            Shelby wrote:

            In the Industrial Age, the fixed capital costs were the majority of the cost of production. In the Knowledge Age, innovation is the majority of the cost of production.

          • “I already refuted that. If you don’t understand that all by myself (where the cost of my computer and living expenses were insignificant), I generated roughly a $million in revenues when I programmed CoolPage, then you don’t understand the transformation underway.”

            That’s not knowledge. That’s human capital. For you to build that page, I bet it took a lot of investment in yourself, didn’t it? With 3-D printers, you need the ability to use them. I can give you knowledge about them, but it doesn’t help you use anything better. What you’re saying contains the same logical fallacy as saying that knowing more about cars will make you a better driver.

          • Suvy, if I understand your rebuttal correctly, you are asserting that majority of the cost in the post-Industrial Age is not the mental work that it takes to produce each product per my example of how my fixed investment and personal expenses were insignificant relative to the revenue I generated when I created CoolPage, but rather the long gestation period from my birth to the age where I could do that work.

            Thus you appear to be arguing that there is still a huge fixed capital investment in the development of human capital.

            I can prove you are wrong in two ways.

            1. Illiterate, isolated African children were able to teach themselves how to program Android within 5 months with nothing other than laptops that didn’t even need electricity, i.e. they had a hand crank generator.

            2. During the time I was programming CoolPage, I was also supporting the gestation of two children born 1996 and 1999, and this expense was an insignificant fraction of the revenue I generated when I created CoolPage. My seminal Rise of Knowledge essay is apropos and will become canonical.

            Sorry, you will just have to accept that mental productivity trumps finance now and thus your models must change.

          • Sure, there may have been a few African children that taught themselves how to do things with Android, but much of the world doesn’t even have power. If you ever go to the poorest parts of India, those places barely have power for 3-4 hours a day. Even basic public health is a major problem while literacy is, in many places, not even possible. Having high-speed internet is a luxury.

            I spend much of my free time interested in finance scouring the internet for whatever I can find and my opportunities would be highly limited anywhere else. Let’s even ignore the fact that the most tradeable and liquid markets in the world are, by far, in the US and ignore the fact that any trades in other places would have to be made in weird ass hours. In many of these places, a reliable and relatively fast internet connection is impossible. If I wanted to get online in some random place to buy a security whose underlying share is some ADR in China, I’d be hard-pressed to do it almost everywhere.

            In other countries, even basic public health is a real issue. In terms of my diet, health, and lifestyle, living the way I do outside of the US is very difficult for me. The most valuable skills that we have aren’t even skills to code (my most valuable skill set isn’t my intelligence). I wouldn’t have been able to develop those skills anywhere but in the US (I include the much of the developed world here, but not all of it). I constantly see cousins and family members that’ve moved here I and I immediately see the difference in their potential, their way of thought, and themselves once they move here and live here for a while. One of my cousins is an enrepreneur and he specifically told me there’s nowhere else he could do what he does except the US (I’m in the same position). One of my other cousins literally came here with nothing, started working and stockpiled cash. He tried some things and they didn’t work. He started over and now runs several businesses. He wouldn’t have had the opportunities anywhere else.

            All I can give is my personal example and I’m highly limited if I move anywhere else. I’m sure I’m not the only person like this and I regularly interact with some of the brightest kids from even China that come here and feel, in large part, the same way. I see it all the time.

          • Suvy I wrote CoolPage in 1998 from Nipa Hut in a squalor community in Mindanao. I was infested with weekly bouts of Giardia, had a karaoke blasting in my ear 16 x 7, I’d turn my head and my underwear and spoon would be gone. I reached the low of eating only rice because I had run out of funds and none of my boomer relatives would loan me even $100 because they wanted to punish me for my decision to go international and rustic.

            Sorry there is internet access in most of of the world now. There are some 3 billion at least on the internet by most estimates. Up from a 100 million back when I launched CoolPage. And to think I had a million users and thus 1% of the internet, all coming from a Nipa Hut in squalor.

          • Suvy, when I first explored Manila in 1991 (just after Mt. Pinatubo erupted), I noticed all these smoky, smoldering shantytowns, e.g. tiny abodes in along river banks constructed of scrap materials, and I was wondering where all these sharped dressed professionals strolling by were living. Someone informed me they live in those cardboard shacks with only crawl space. If you saw them at the office you would have never known.

            It was quite an eye opener and attitude adjustment for a 26 year old westerner.

          • There’s a difference between having access to an internet connect vs having access to a reliable and fast internet connection. In many cases, as you duly noted, there’s extremely poor public health. When you have people with polio on the side of the street begging for money, that’s not something easily fixable. There are social costs to having an environment like that.

            I’ve had Giardia as well–that shit sucks, but when I got it in other parts of the world, it took me a lot longer to cure because I wasn’t eating clean although it did go away even though I was taking antibiotics. Then, I got it a second time that only showed up after I came back from the plane ride to the US. As soon as I got back, I started eating like clean and it went away in <36 hours.

            Not everyone has the same skill set you do and the systems most likely to thrive are the ones that can take advantage of the skill sets of all of their citizens. Sometimes (usually), the most important part can just be simple finance. In the case of 3-D printing, I did my undergrad and masters from an engineering school that had technology in 3-D printing and all sorts of other stuff. Even the best engineering schools in most of the world barely have the most basic computer programs to serve engineers. Now, take something like the drought in California. I bet you this drought in California actually came because the 20th century was the wettest century California has had in some time and that it's the nature of California. If this continues, I could easily see California becoming the world's leader and revolutionary in desalinization technology within a few decades. Most places in the world, if confronted with that scenario (and some are, including Yemen BTW) would turn to civil war.

            Granted, it would be a very different kind of war we've seen in previous centuries. Most of these regions are extremely poor and there's no chance of nuclear war in almost all of these places, but that doesn't mean there won't be war, starvation, and disease. We've seen this historically where you see massive population declines in much of the poorest parts of the world.

            Many of these poor places import much (or even most) of their calories and energy in a world where global trade and shipping is cheap, safe, and protected. In a world where global trade and shipping is not cheap, safe, or protected, a whole bunch of bad scenarios open up. Am I saying what's going to happen?

            In much of the other parts of the world, you have small farmers just scraping off small plots of land and going to other plots of land and it's completely unsustainable. You wipe out massive amounts of vegetation to create arable land that gets used with no crop rotation, then move to the next plot like it's nothing. This results in rising water tables, breakouts in disease, famine, poverty, and war. This is reality in many parts of the world–particularly with rice. Rice is extremely labor intensive and requires lots of water. Even though I'm South Indian where everyone eats rice, I hate rice. I also think it's very unhealthy, which is another reason why I avoid it, but everyone else loves it and eats it regularly. This is because environmental externalities aren't priced in. It might even environmentally be better to switch to large capital based production which'd make the agriculture far more sustainable, send yields through the roof, and increase the quality of food. The problem is that institutional constraints are set up in such a way that make everything unsustainable.

            These are structural issues that aren't easy to fix by any means. When you're forced to raise a family under such constraints, it becomes very difficult to operate.

            I've seen mass poverty in shanty-towns living in the streets (it's everywhere in the city I was born). I don't come from boomer parents and, quite frankly, I find their view of the world disturbing to say the least. Trust me, I understand your frustration. What scares me is "democracy" in the name of giving these people power to enforce their will.

          • Exploding fertility rates combined with the large importation of calories, massive water usage, large scale environmental degradation, and fucked up institutional structures is not sustainable or robust. You will see massive starvation and disease if these trends continue. I think massive population corrections are a real tail risk in the next 50-100 years.

          • 1. In any decentralized, voluntary participation free market, the control of resources (e.g. savings, knowledge, etc) are always power-law distributed. The leaders will drive the rise of the post-industrial (a.k.a. Knowledge Age) economy and their fixed capital costs are insignificant component of their cost of production.

            2. The relevance of the masses is they are fodder for the vested interests who control the political collective and they are vested into the Industrial Age where the control over finance, stored monetary capital, and fixed capital traits give them their power. Thus all the NSA totalitarianism, War on Terror, etc.. Our political masters are marching towards a one-world reserve currency. But the Knowledge Age is fledgling away from their power. They think these fodder are their asset to maintain control, but the Knowledge Age will simply hand them all the liability for those fodder and none of the control, e.g. taxing virtual anonymous commerce will be impossible.

            I could go into more detail on your other points, but suffice it to say we are headed into a tempest and a radical paradigm shift for humanity (as was the analogous case for the rise of the Industrial Age, which as you may know required the Black Death in Europe to raise the value of labor).

    • So, are you saying that the FED monetized USD 2.5 trn in 2014 ? That would be shocking news to financial markets. Could you provide some more information and sources on this? Thanks.

      • No, the Fed monetized about $500bn in 2014.

        What i’m referring to is that in the second quarter 2014 release of the Financial Accounts of the United States (the quarterly statistical bible for the US economy and the main source for debt data), the Fed rewrote the recent debt history of the US back to 1995 due to a change in statistical sources and methodology. As a result, $2.5 Tr of debt – equivalent to 14pt of GDP – simply vanished from official statistics. Now, it is as if it had never existed. By a happy coincidence, the more pronounced the debt build-up was over the 1995-2014 period, the more pronounced the revisions. The Fed effectively erased the most embarrassing traces of the colossal debt build-up it has consistently encouraged in the past 20 years. ZeroHedge picked up on it recently and provided a chart comparing the data before and after revisions which is self-explanatory (http://www.zerohedge.com/news/2015-02-25/magical-debt-disappearance). You can go to the Fed web site and compare the first and second quarter release of the Financial Accounts of the United States to see for yourself the difference.

        That is absolutely not shocking news to financial markets. Actually, they don’t give a damn. I have asked several US economists about this and met no interest whatsoever. Nobody wants to spoil the party. Don’t fight the Fed, and all that. As John Kenneth Galbraith famously wrote with reference to the late 1920’s: it is “unwise to be sane at a time when sanity exposed one to ridicule, condemnation for spoiling the game, or the threat of severe political retribution”. This perfectly summarises the present state of psychology, for exactly the same reasons as in the late 1920’s.

        I fully agree with Michael Pettis that debt matters for a lot more than its cosmetic appearance. I am only observing – in amazement – that this not too subtle accounting trick on US debt was taken at face value and all the commentaries since (including in the comments section of this blog) has been that the US has deleveraged. Reality is about the long term. Perception is about the short term. Given its impact on the perceived deleveraging of the US economy, this accounting trick has in practise the same effect – in the short term at least – as a debt restructuring in the sense that Michael Pettis gives to this expression in his article.

        It was of course purely sarcastic on my part to suggest that Europe should use the same tactics. As a matter of fact, the Europeans also do play around with debt statistics. That’s exactly how Greece managed to qualify for the Euro in 2001.

        • “No, the Fed monetized about $500bn in 2014.”
          Any source on that? Thanks.

        • What Galbraith didn’t get is that you don’t tell suckers they’re suckers. Why? For the very fact they’re suckers. You need to play a sucker to catch one. The best thing to do is to short the suckers/insane lunatics. Then, the sensible guys need to take charge and reset the system while laughing at the retards who went bust in the previous system.

          Galbraith is, as ironic as it may be, not cynical enough. In other words, he’s kinda naive (like virtually everyone on the left who seems to be incapable of understanding game theory).

  5. Mr. Pettis,

    Are there short term pricing changes that can positively effect a countries economic structure, providing short term relief to existing imbalances? Specifically, can the recent drop in oil prices effect imbalances and what other, if any, commodities can have such a positive effect?

    I recall a Council of Foreign Relations talk that said, roughly, Americans will have an extra $900 to spend because of oil consumption savings. Will we not see a rise in personal consumption as people have more money to spend? Perhaps a rising dollar will offset these effects in Europe, but a real rise in household income seems like a significant boost. Perhaps this does not help Europe as much as it helps China: lower shipping cost (although the Baltic Dry Index has hit a historic low), more disposable household income, and easier diversification.

    My rambling knows no bounds. My question is, can commodity pricing effect economic imbalances? It seems intuitive that pricing which so clearly has winners (consumers) and losers (producers) can provide short term economic relief that allows a country to more clearly manage its imbalances.

    Great read. I enjoy your writing.

  6. Thank you for this excellent clinic on debt. I wonder about the distortions arising from derivatives and the high financial costs to the few of debt restructurings, hence their pressure on the political authorities or ECB. My perception is that the logic, sophistication and reasonableness of your analysis will be lost for want of dispassionate actors.

    • Maybe, Alan, but by hook or by crook a bunch of us (including Martin Wolf, Steve Keen, the guys at the Levy Institute, the INET economists, quite a few financial historians, all Minskyites, Lord Adair, Charles Goodhart, and several others) are forcing debt and balance sheet dynamics back into the heart of academic economics, and although from the responses I am getting I suspect that it is among PhD students and undergraduate economists that we are making the greatest impact, and so it may take another decade or so before academic economics loses some of its irrelevance, it will happen.

  7. “One of the saddest aspects of this process, historically, has been that typically the most sophisticated, who are often the wealthiest, are the first to protect themselves, and the least sophisticated are the last, with the result that the distribution of losses is asymmetrical in a way that maximizes the social damage.”

    I am very interested by the fact that I read this excellent post on the same day that the FT published an interesting article about how Chinese property buyers (wealthy Chinese buying property in other countries) have started to become so significant as to create a backlash – i think the article was focusing on discussions in Australia about this. I wonder Prof Pettis if you see in this trend what you describe above – the sophisticated / wealthiest people taking steps to protect their net worth ahead of what they see as a difficult time for China?

    (PS sorry if this posted twice, not sure what happened)

    • It probably is, Jacques. When debt is “resolved” by depreciation, inflation or financial repression, it is usually those who save in the form of bank deposits or easily manipulable monetary assets (government bonds, perps, etc — remember how middle class German savings were wiped out in the early 1920s?) who get killed, largely because they don’t have enough wealth to pay the transactional costs involved in finding alternative, safer forms of savings.

      I think they also tend to be more patriotic. Three years ago I was speaking to family friends in Spain (he is a lawyer and she a journalist) and suggested that they might want to consider taking at least part of their savings out of their Spanish bank and putting it in a German or Swiss bank, just in case. My suggestion set off quite an angry fight. She said they had a duty to protect their children’s university money and must transfer those savings to Germany. He responded angrily that to turn his back on Spain when it was in trouble was too disgusting to contemplate, and that if everyone behaved like she wanted Spain’s failure would be guaranteed, so he refused to allow it.

      How could you not admire both of them? And yet if Spain is ever forced to leave the euro, their kid’s college money will be halved. Call me a cynic, but somehow I think among the wealthiest Spaniards this argument never came up.

      • I disagree that this man was a true patriot. The real wealth of a country isn’t in its bank accounts, but its people and their skills. The idea that keeping money in some bank is gonna help the country while you’re taking the risk of the kid’s college money being halved is, in my opinion, not good for the country. Investing in the future is one of the most important thing healthy societies do and you do that by investing in children, not by protecting bankers and banks.

  8. Excellent essay, excellente…needs to be widely distributed.
    I would contend that th credibility of central bank policy making is now very low, maybe non-existent. Yet European governments still rely on central banks to pull th rabbit of stability, growth and full employment out of a hat. So Mr Draghi’s put leaves me cold. It will simply increase th riches of th rich and exacerbate inequality without in any way securing sound growth and full employment in Europe.

    Nor is th true role of th central banks known to th citizenry. They are the trade union for th banks and their prime concern is securing th prosperity and stability of the banking system, their clients, not that of society at large though of course they always try to make it seem so. It is up to finance ministers and Treasuries to safeguard th interests of th citizen and the taxpayer which in this crisis which has been running since 2008 they have lamentably failed to do. There are ways and means for closing down failed banks and setting up new ones. It has been done many times in the past. But it wasn’t done in this crisis and th upshot is that the crisis gnaws away and we have many central banks still trying to run fragile banking systems which have plenty of liabilities but questionable assets, like European sovereign bonds.

    Don’t know what end game is but there is one certainty: what cannot last, won’t.

  9. “— Spain, Portugal and Italy among them, and perhaps even France — will also have to restructure their debts with partial debt forgiveness.”

    Who shall Spain, Italy and France ask for debt forgiveness? Their own domestic financial institutions?

    • In part, Herbert, but please remember that countries that run current account deficits by definition run capital account surpluses that balance to zero. If you read my February 4 entry you will see that in the few years before the crisis, Spain’s current account deficits added up to 25-30% of GDP or more, which is just another way of saying that net foreign inflows added up to that number, and if you assume (very correctly) that Spanish investors lent or invested abroad, the gross inflows are greater than the net inflows by the amount of gross outflows.

      These are huge numbers. Some of the inflow was equity investment, and some was Northern retirees buying summer homes (although they usually borrowed most of the purchase price, so it does not show up as a capital inflow), but for all that there is no question that there were a lot of foreign loans to Spain. You don’t need to read actual loan documents, in other words, to know that Spain borrowed quite a lot from abroad. The numbers are broadly similar for France and Italy, except that France gross outflows were probably bigger.

      You can also look at it from the other side. After running large deficits in the 1990s, countries like Germany have been running some of the largest currency account surpluses in history after 2000-01. Therefore by definition their net capital outflows must have also been some of the largest in history. Given that before the crisis Europe as a whole exported very little capital on a net basis (i.e. its current account was close to balanced), it isn’t hard to figure out the direction of flows.

      • According to Eurostat, 69% of Italian sovereign debt was held domestically in 2013 with the equivalent data being 59% for Spain and 41% for France.

        Is it eccentric to assume that any substantial restructuring would leave the respective banking systems insolvent?

  10. “Are there short term pricing changes that can positively effect a countries economic structure, providing short term relief to existing imbalances? Specifically, can the recent drop in oil prices effect imbalances and what other, if any, commodities can have such a positive effect?”

    You really should read his previous article on inverted balance sheets to see the extreme of the answer. Sadly, in my now 4-5 months of trying to reconcile economics, it is one of the best things I have read.
    Michael. For someone so focused on global economics-politics, you should really watch what is going on in Brazil right now. It is really the perfect storm to the nth exponent. Not sure if it is the end before a new beginning or just simply the beginning of the end. The past 2 days the truckers have closed large parts of the highway system shutting down commerce and creating shortages. Petrobras is a mess, the President is a joke, the governing party are all criminals, currency is weak, inflation is very noticeable…and on and on and on… but the weather is nice!

    • In late 2011 and early 2012 I made 12 predictions, one of which was that within the next decade or two we would see another round of global sovereign defaults, not just in peripheral Europe but also in Latin America, Africa and Asia. You don’t get any prizes if you guess that Venezuela and Argentina were among my top candidates for Latin America, Derivs, but with iron ore at $190, and my expectation that it would drop below $50 within five years, I have to say that I really worried that Brazil might get into trouble too, especially when it proved almost impossible for me in 2012 and 2013 to convince all but a handful of senior bankers and policymakers in Brazil even to consider the possibility of a dramatic Chinese slowdown. I don’t follow the debt numbers closely enough, but I do worry about Brazil. The good news is that the worse things get, the more likely Arminio Fraga returns to government, and as his friend I would not wish on him the ageing process it will involve, but I do think he is one of the few guys who can sort things out over the long term.

      • OpenThePodBayDoorsHAL

        Excellent stuff. D. Stockman reminds of some very basic formulas: Productivity leads to Income; Income leads to Savings; and Savings leads to Investment. Skipping the first three with more and bigger borrowings is good fun but in the end someone always pokes an eye out. Delaying the eye-poking moment is also fun, but when things reset it’s like a game of musical chairs. Money good collateral keeps a few of the chairs in the game: shiny stuff in a vault, reliable cash flows from stuff people can’t do without (food, a roof over their heads), and (in the case of sovereigns) men with guns and the power to tax. The real fly in the ointment is when the musical chairs game destroys the currency in question along the way. When excess debt leads to policy changes, those changes ought to be fiscal, not monetary. With fiscal, at least some good chairs are still in play when the music stops. But if you trash the scrip…none of the chairs is left standing. Or maybe the best way to overextend the analogy is that monetary games put so many chairs on the floor…that they become meaningless.
        The root problem is we’ve conflated fiscal and monetary, with “money” issued as debt. But the Fed can’t print the interest, they can only print the principal. The simple math of this is that it’s grow…or die.

  11. In normal circumstances, indeed the debt overhang hinders growth, but this is the EU. Could it be that Greece and the rest. have way more credibility in a German-led union with implicit debt default (very low interest burdens) than as totally independent countries with explicit debt default?

    Also, what about the quality of the growth? Is a new cycle with debt forgiveness and more borrowing fueled unsustainable growth (pensions, government, weed collecting Olympic stadium, etc.) desirable? Not that this will realistically happen unless the Germans go dumb.

    The optionality was also proposed by the Greek Finance minister and sounds OK in theory. Do you know if it is still considered or if not, why not?

    • And how about the choice of the Greek people (80%) that want to stay in the EU? It is true that they hope for the best of both worlds, but in the end will they prefer “independence” and explicit default or the implicit default and EU/German dominance?

  12. Very interesting indeed

  13. Dear Michael,

    thank you for this. I wholeheartedly agree and have actually proposed a german led debt restrutring for the Eurozone already in 2012 (while still being at the Boston Consulting Group). recently I wrote an oped for a german newspaper repeating the proposal. Here is the translation of the draft: The victory of Greece’s left party, the Syriza, in the elections on January 25, 2015, is symptomatic of fundamental changes in the European mindset. With the impressions of Syriza’s success fresh in their minds, politicians from other countries too will sense an opportunity to strengthen calls for renouncing austerity measures and demanding debt waivers for governments and private sectors. Opposition parties in Italy were united in their stand against the Euro well before the elections in Greece last Sunday, while in Spain, the left-wing Podemos party – founded just about a year ago – has been leading the opinion polls. Likewise, France too has had its struggles with austerity measures for years, irrespective of which parties formed the ruling coalition, and the Front National, led by Marie le Pen, has been dominating the incumbent parties’ agendas. In the meanwhile, the European Central Bank (ECB) has begun socializing the sovereign debt of European countries – despite its numerous assurances to the contrary. In a common currency area like the Eurozone, the concept of limited liability is merely a theoretical construct.
    The German government, for its part, is left with no option but to conclude, that the crisis management strategy it proposed and implemented, has simply failed! Austerity measures – which incidentally were seriously implemented only in a few countries like Greece, Ireland, Portugal and Spain – are about to come to an end. The joint liability, which Germany was so vehemently against, will be introduced through the back-door via the ECBs balance sheet. As a currency, the Euro will intentionally be weakened in order to enhance its acceptability among the Eurozone club members.
    High time for change in Germanys approach to the crisis! The existing strategy is doomed to failure anyways. If this has to be the case, then at least with some hope for reducing the potential additional damage to Germany and Europe. In order to achieve that, Germany needs to lead the initiative from the front, and not just be a reactive follower.
    What needs to be done? Below is a proposal for saving the Eurozone in a way that would safeguard Germany’s interests too:
    1. Admit the facts: Policy makers need to communicate the message very clearly, that between 3.0 and 5.0 trillion Euros of government and private debt in Europe will not be served in an orderly way. This excess debt needs to be written off.
    2. Pool the debt overhang: Excess debt should be pooled into a debt redemption fund, with all the Eurozone countries bearing joint liability for it.
    3. Pay off the debt: Start an orderly process for paying off this debt over a period of at least 20 years. Such longer maturity periods will help to reduce the cost saving pressures that many Eurozone countries are facing.
    4. Issue Eurobonds: The debt relief fund (in step 2 above) will be refinanced by Eurobonds specifically issued for this purpose. These bonds, with joint liability of all Eurozone countries, will have long maturity periods, low coupon rates and should be amortized on an annual basis.
    5. ECB intervention: The ECB could purchase some of these bonds, thus ensuring long-term financing for this debt legacy at low interest rates. The greater the portion of these bonds purchased by the ECB is, the smaller will be the burden on the domestic budgets of the member countries.
    6. Show solidarity: Countries like Greece, Ireland, Portugal and Spain are unlikely to be in a financial position to be able to deal with their debt overhang by themselves. Better positioned countries, especially Germany, will need to make generous contributions to counter this. Economically, this is equivalent to offering debt waivers – though in this case, extended over a longer, and hence better manageable – maturity period.
    7. Cap the liability: A mandatory feature of socializing the unserviceable debt across the Eurozone in this manner is the establishment of a fiscal union, in which individual member states give up their budget sovereignty. Alternatively, there needs to be a clear understanding, that as in the USA, there will be no joint liability for servicing the debt obligations of individual member states in future. In this latter case, all member states would start with debt levels of 60 per cent of their GDP, to begin with. Capital markets would then be free to determine the interest rates on the outstanding debt – based purely on the creditworthiness characteristics of the respective countries, and without interference from the ECB.
    8. Implement real reforms: Relieved of the pressure of severe austerity measures, Eurozone countries would find it easier to agree upon a common growth agenda: free up and mobilize the labor market, adopt targeted immigration policies, make investments in education, innovation and infrastructure.

    The establishment of a debt relief fund is not a new concept. The council of economic experts mandated by the German government had put forth a similar proposal concerning government debt a few years back already. Under the current circumstances, however, the scope of this proposal needs to be broadened, so as to include private debt too. Countries like Ireland, Portugal and Spain are facing unsustainably high private debt levels, which they would only be able to service through refinancing with long-term Eurobonds – supported by ECB intervention as and when necessary. We will be able to lay the basis for a real reform agenda in Europe, only when we have reduced the immense burden of the debt overhang legacy.

    The financial costs of these moves to Germany could turn out to be significant. Depending upon the total value of debt that is mutualized and the conditions under which the debt relief fund is refinanced, Germany’s liability could run up to about a trillion Euro. This is almost exactly as much as the estimated adverse impact of the energy transformation (“Energiewende”) that Germany hastily embarked upon.

    I can already hear the critics shouting: Isn’t this unfair towards those who did care to keep savings? Why on earth should we be bailing out the creditors? Isn’t the ECB intervention tantamount to direct public sector financing, which in turn would have inflationary repercussions? How can we be sure, that we won’t be in this same mess again in a few years? Why at all should Germany be doing this?

    The answer to the first of these questions is easy: Yes, in fact it is really unfair! But the damage has already been done, and all that we can decide upon now, is how we want to bear it out: By unilaterally stopping the debtors from making repayments? By fueling inflation? Or rather by means of an orderly process? Given the potential collateral damage of the first two of these, I strongly favor the adoption of an orderly process.

    Likewise, it is true that this would result in bailing out the creditors – in this particular case, banks and insurance companies. But here too, what would be the alternative? If we let banks bear the brunt of it, their losses would have to be salvaged by taxpayers’ money. Going for creditor participation – as in the case of Cyprus – would also have a severe, adverse impact on the German depositors. If it is the insurance companies that lose out, their customers would end up bearing losses either directly as in case of life insurance, or indirectly through higher premiums as in the case of property insurance.

    Getting the ECB involved in order to resolve this issue will also be viewed with a lot of skepticism, and quite rightly so. Are we again being confronted with the inevitable prospect of hyperinflation, following direct injection of funds into the public sector, as seen in Weimar previously? Contrary to the ECB’s decision last week, the mechanism proposed above would be a one-off action only, whose financial scale will have been defined, and well-confined, in advance itself. Getting rid of the debt overhang problems would boost the European recovery, thus making further intervention by the ECB redundant. Finally, it would be possible to assess the monetary impact of such a proposal with much greater accuracy than is the case in the current scenario, where there seems to be no foreseeable end to the ECB interventions.

    Implementing the above measures is still no guarantee, that we will not face a financial crisis again. This makes it all the more imperative, that when negotiating the terms of the debt relief fund, we incorporate binding provisions, which foster comprehensive European integration and/or enforce a no-bail-out clause. These terms would then be equally binding upon future governments too. In the light of recent developments, there might understandably be reservations regarding the feasibility of such a proposal. However, as long as we are committed to the Euro, we have no better alternative.

    It is particularly in the interests of us Germans, as main creditors to the Eurozone economy, that we find a constructive resolution of this debt crisis. We were able to generate large trade surpluses by selling goods and services to our customers on credit. Now that we know for certain, that the customers are not in a position to repay us in full measure, we are faced with a bad an irrecoverable debt problem. Much as we’d dislike accepting it, we simply won’t be able to come out of this without bearing losses. We can only decide, in which form we prefer to face these losses, on what basis we would like to distribute them socially equitably amongst ourselves, and what we could realistically expect to get in return from our debtors.

    All this will only be possible, if we put across our interests properly and clearly. That is why the German government itself needs to spearhead this initiative. A debt restructuring plan for the entire Eurozone, rather than a haircut just for Greece. Mutualizing the debt through an open and transparent procedure, rather than through backdoor dealings. Collectively tackling the debt overhang legacy, rather than taking on unlimited liability.

    This would not be the first time, that Chancellor Merkel would be making a spectacular volte face. The celebrations of extending the life of German nuclear power plants in order to ensure long-term stable power supply and to consolidate Germany’s competitive position were hardly over, when a phase-out of nuclear energy was implemented with immediate effect following the Fukushima tragedy. That too, although Germany is exposed neither to earthquakes nor to tsunamis. The fear of a possible voter backlash was simply too daunting for Ms. Merkel. The situation with the Euro bailout schemes today is no different. So far, a significant portion of the electorate seems to be supporting the ongoing efforts. However, the day is approaching, when the economic reality – that Germany has in effect assumed massive liabilities for debt, through backdoor dealings, and without commensurate returns or adequate participation rights – will have unfolded. The likelihood of reaching a tipping point, where voter sentiments are adversely fueled and their support thus lost, is increasing by the day. The German government can only prevent this from happening, if it itself spearheads the way out of its current European policy.

    Dr. Daniel Stelter is the founder of the German think tank Beyond the Obvious (www.think-beyondtheobvious.com ), focusing on strategic and macroeconomic issues. Previously, he worked from 1990 to 2013 as a consultant at The Boston Consulting Group (BCG), most recently as Senior Partner and Managing Director and member of BCG’s Executive Committee. From 2003 to 2011, he was in charge of BCG’s Corporate Strategy and Finance practice area.
    Since 2007 Daniel Stelter advised international clients to prepare for the challenges of the unfolding financial crisis. He co-authored BCG’s “Collateral Damage” series and the book “Accelerating Out of the Great Recession,” which won the getAbstract International Book Award 2010.

    In April 2013, he published his book, “Die Billionen Schuldenbombe” (The Trillion Debt Bomb), in which he describes the overindebtedness in the Western world, how politicians are evading the problems and what measures can point the way out of the crisis.
    His latest book “Die Schulden im 21. Jahrhundert” (Debt in the 21st Century), a critique of Thomas Piketty`s “Capital,” is currently on the bestseller list in Germany.

    • How can austerity measures come to an end when the 3% deficit rule remains?

      What the German elites fail to recognise is that austerity measures have weakened the ability of indebted countries to repay debt. The elites have assumed that they will be able to profit from the privatisation of periphery countries assets but as Michael points out the longer the period of debt uncertainty the worse it is for all stakeholders.

      By now the German and French banks will have been recapitalised to the point where they can withstand a euro breakup. AFD is starting to eat CDC votes and Angela Merkel will soon be in a position where she will not have even the choices she has now.

      The Germans have refused for years to reflate the Eurozone by allowing national govts to use fiscal measures to drive growth. The will be export growth due to a weaker euro but the higher US dollar is hurting US and developing country growth. QE has an asset price effect but will it see European banks lend more to local businesses?

      From what I have seen in the way of forecasts Europe is expected to grow gdp by 1% this year. I think this is kicking the can down the road and wasting the monetary bump from QE.

      Maybe 2017-2018 will see the separation of the Eurozone into two halves as the present situation finally becomes unsustainable.

    • I really hope you are able to influence the debate Daniel. I met last year some senior German officials from one of the larger among the small parties (left of center) and they discussed with me, very gingerly, if the way to save Europe and German’s place in it is to turn this explicitly from a fight between greedy Germans who deny the huge benefits they received from the euro on the one hand and lazy corrupt peripherals who ate, danced and siesta’d away hard earned German savings on the other, to a class fight between German and peripheral workers who were screwed in the name of competitiveness, and middle class savers who will be screwed as they clean up the banks, on the one side, and German and peripheral bankers, business owners and financial and real asset owners from Germany and the periphery on the other.

      What a tough question. If you present this is as the former, I don’t think Europe survives and I think we risk that long-term antagonism develops between Germany and the West. If you present it as the latter, I worry that the political winners will be those who are nastiest and the most irresponsible, and, I don’t think Syriza, Podemos, and even Ukip can hold a candle to Golden Dawn, the Front National, and others, including in Germany, when it comes to spouting hatred. Some of my prejudices may be incorrect — for example I think Europe has no choice but to acknowledge and absorb its Muslim population with a little more generosity — but if I am right, anything that helps the rabid nationalists to control the debate is almost guaranteed to be negative for Europe in the long term.

      The only “good” solution, I think, is for the centrist parties to reopen a responsible debate that accepts the need to resolve the debt and assign the costs efficiently, and recognizes that monetary union might take another decade or two to lock in, and so some flexibility is not a death sentence (after all it took the US 70 years to pull it off), and it may be necessary to acknowledge that some at least temporary retreat from globalization and free trade is necessary to pull it off, which should make both the right and the left happy.

      Of course like most economists I do not think the euro can survive without fiscal centralization. Alexander Hamilton pulled it off in the US in part by giving away the capital to the South, in exchange for Federal assumption of the state debts (which meant that Southern states with little debt and Northern states with tons of debt were suddenly made equal when it came to repayment), but although with that New York lost the chance to be the capital of the US, it never stopped running the real show.

      Perhaps Germany has to cut a similar deal, except this would include massive debt forgiveness in exchange for real fiscal centralization (and that means control of taxes), and wherever you put the capital (Naples, for all I care), Germany and its northern allies would still really run the show because of their size of their populations and the almost comical reluctance among peripheral nations to associate one with another.

      • The US also has a Constitution and a federal structure that contains checks and balances. I don’t think that a common currency isn’t necessary for the US to exist or to function properly (excluding war scenarios), but the Constitution is a requirement. Each state in this country has a lot of autonomy and the idea of social democracy in the US is nonexistent.

        For Europe to be able to have the kind of system that you’re talking about, you need a political structure that allows for Germany and Greece to share a common currency. Currently, it doesn’t exist and I doubt Europeans even find a republic like the US as a worthy goal to work towards. It means that the idea of nation-state democracy goes down the tubes in the name of functional republicanism (which is far superior). Europe needs a Congress with two houses, a President with term limits, an independent judiciary, a separation of powers, and all that other good stuff that we take for granted here in the USA. What does that mean? It means you need to find a way to convince Germans and Greece to be on the same court system where the system can adapt and strengthen from conflicts between those two peoples.

        You needs ways to settle disagreements. You need a system that can resort to rallying behind a common leader in times of war. You need institutions that currently don’t exist. The current parliamentary system has no separation of powers and isn’t a factional system. In order to unite a diverse entity like Europe, you need either
        1. an empire of some kind where you subjugate other peoples
        2. you need a republic with the primary political unit being the faction.

        The US has (2) and China has (1). Europe has neither as of yet. Europe has no concept of liberty and most Europeans I interact with seem to, quite frankly, detest the idea of liberty. I don’t see how you can have a functioning republic that consists of many different factions if you have no concept of liberty.

        • Suvy- don’t forget where the enlightment and liberty took root. America is built on European ideas and institutions. Liberty is deeply in Europe, but latent to the American perspective.
          A word of caution on THE constitution truly protecting liberty… many countries emulate the american constitution today- with very little liberty being born (nation building in Iraq is a good example).

          No doubt that Europe lacks the formal government institutions that America has, but Hayek (theory) and Doug North (emprically) have shown the evolutionary nature and un-designable nature of government institutions. European institutions look like a very disorganized desk compared to a clean and tidy desk of an american student of government. But the EU beauracrats know where everything is placed on the desk- and feel not slightest improvication to cross-out, erase or even tear off a piece of paper. It looks like chaos from abroad, but it is an accomplishment of many millenia- and should be celebrated.
          Europe does not need a clean and formal federated constitution like the USA, it simply needs to a crisis to reorganize its desk. That kick in the ass is coming, and the crisis likely lies within our lifetime. I have more faith in Europe surving the war/crisis due it flexible and messy government institutions than most other parts of the globe. America being the exception.

      • Isn’t the “almost comical reluctance among peripheral nations to associate with one another” a good indication that Europe should never have formed a monetary union to begin with, and should not aspire to fiscal union?

  14. Michael, you mention;

    “One of the saddest aspects of this process, historically, has been that typically the most sophisticated, who are often the wealthiest, are the first to protect themselves, and the least sophisticated are the last, with the result that the distribution of losses is asymmetrical in a way that maximizes the social damage.”

    Is there anyway to prevent this regrettable reality? I would also think that these same actors, being politically connected, would promote actions both delay action at the beginning, buying time to move assets, and later pushing for a quick resolution to take advantage of the distressed prices for remaining assets.

  15. Look, the hypotheses are too difficult to test. Is Greece a story of contingent banking liabilities, or the failure of trust in institutions, and fiscal contraction in the presence of positive multipliers? How many developed countries have had Greece’s debt/GDP, anyway?

    France and Italy can and will afford to reduce their debt burdens. This is not Latin America where few people other than the elites own taxable assets. As for the “transfer of wealth” away from Germany on 26 July 2012, do we see that in the data? “Contingent” is sometimes too easy a word. It lets us live in a world free of data.

    To add to that, the recent European debt dynamics are perfectly rational in a world of vanishing long-term yields, and ignoring history’s lowest-ever yields in an analysis of debt sustainability generates incorrect affordability fears. Worrying about rollovers in ten or twenty years’ time is, at the moment, beside the point.

  16. Csteven,

    I think this is basically what you’ve been trying to tell me that I need to incorporate into my way of thought. Is this the message you’ve been trying to get across?

    • This was meant to be a joke BTW.

      • Without looking, I have both seen, and read Dugin, a Rasputin-like figure, who I believe, at least openly, fell from “grace”, as it were, in Putin’s favor, it was implied, a few years ago, during the height of the good times, we are re-establishing the Imperial Russia project, before the Olympics. What a contrived mass of non-sense that is, both complicated, missed of multiple genres of thought, interspersed with paranoia, delusions of external others, trends of the world, problems of the world and bogeyman in the world that is jsut too fantastical, confused and opaque to wade through.

      • Hmmmm…..if you read his work, “Fourth Political Theory”, it is an absolute admixture of what I would view of post-modernistic diversion, along neo-imperial pathways, under some sophisticated admixtures, theoretically, from science and philosophy. Confused, paranoid, as I have said before.

        And while some of his propositions in this piece, satanism, etc….are a bit preposterous….a careful, suspend any emotion one might have in relation to what he says at each moment, review of post-modernism, and what is being done under the vein of post-modernism is true. I am sorry but Identity theory does not carry the same weight as Einsteins theory of relativity. It just doesn’t, no matter how many times as identity theorists, creationists, and, other, essentially, art and literary critics would have it be so, merely because in the choosing of what to study under empirical methods and scientific principles implies a certain amount of subjectivity into the design, because we choose it. Essentially, post modernism does seek to equate all on such flimsy grounds, where a twinge of subjectivity in empirical science, does not make the supposed scientific study of unicorns as equal as genetic testing, per se (although Hollywood, Bollywood, Nollywood, et al would love were that the case, along with K street, Madison Avenue and Fox news.)

  17. Michael, thank you for a wonderful piece.
    This is the most clear-headed analysis of the European situation I have seen.
    It is a great teaching tool.

  18. Left unsaid is the problem of assigning costs to those unwilling to shoulder them. Democracy only works if the people (at all levels) have sufficient character and understanding to take responsibility for themselves and voluntarily alter behavior to fit circumstances.

    You have discussed this aspect with regard to China and the threat to political stability even though they are not a democracy. When it comes to democracies the ability to reach a political agreement for the assignment of cost will be the ultimate test.

    I am not optimistic.

  19. Now, the Greek Syriza government has agreed with European creditors to keep following largely the same path as in recent years.

    Politically, this means that the struggle has to be reframed from the “Greece vs. foreign creditors” used during the election campaign to “honest Greek citizens” vs. “Greek tax dodgers” now that it is acting as responsible government. Looks like the “workers” never really stood a chance vs. the “elite”. Or perhaps Greek workers (among others) shot themselves in the foot by withdrawing a bit too much deposits from the Greek banks in recent months, thereby undermining the bargaining position of Syriza in the negotiations with the Eurogroup. Who knows? In any case, the “low labor share camp” has easily won that battle against the radical Greek minotaur and is now even stronger than before.

    Economically, this path is unlikely to change much to the Greek debt sustainability issue and Syriza likely has no illusions on that. But the calculus here might be that it will be enough at some stage for Greek government bonds to become eligible again to central bank monetization. Greece will simply rejoin the concert of nations in this monetary printing stage of civilization. Indeed, debt monetization remains seen – across the full political spectrum and across all continents – as the one and only solution to the excess debt burden in an objective community of interests of governments and capital owners at the expense of the middle-class.

    It is of course quite possible that Syriza can pull off some of these reforms, which might unlock productivity and raise value added in the Greek economy. Their best asset is not being tainted by the previous decades of mismanagement, even though they could not alleviate even a small portion of the inherited debt burden. But, whether or not Syriza succeed (which we have to hope for for Greece after 5 years of great depression), these are very conventional ideas. There’s nothing especially radical about Syriza. Michael Pettis sounds a lot more radical who wants to address the global and regional imbalances. That’s a lonely stance at this time. Nobody has any interest in that, it seems. Instead, imbalances will be maintained (the euroglut will be maintained, the Chinese glut as well, the US will have to decide in the near future whether or not to keep absorbing all this and putting it on the shoulders of 95% of its population) ; the capital elite will continue to capture and enjoy the super-profits arising from these imbalances, further amplified by the asset reflation policy, with may be a small kickback in the form of a wealth tax on previously reflated asset values or tighter tax scrutiny ; the poor will be provided with a floor at the poverty line (eg. food stamps) ; the middle-class will pay disproportionately through no wage growth, no return on savings and higher tax and be squeezed. This is the plan for assigning the losses. Could this be the interpretation of the political theatre we just witnessed in Greece ending with Syriza’s apparent U-turn? Time will tell.

  20. Michael … thank you for your good work

    In the context of resolving debt obligations, can you further elaborate on why a fully sovereign currency issuer (FED, BoJ, PBoC, etc.) can “force through these wealth transfers” whereas the ECB (also a sovereign issuer) could not? What is needed for the ECB to “centralize” the necessary “sovereignty” to act as the FED, BoJ? And once that full sovereignty is fully centralized, can debt levels ever be deemed “excessive” in the eyes of the bond market (I presume you imply that is how/when we know debts are too high)? For example, when, if ever, do you think the “market” will say Japan’s debt is “excessive” (250% debt/GDP and… 0% int rate)? After all, you say “no institution has infinite debt capacity”…

    Finally, can you hash out how Spain (and Greece?) would benefit from leaving the EZ and by reintroducing the Peseta (Drachma), if only temporarily? FinMin Varoufakis has gone to great pains to explain why he did NOT want to exit the EZ. He does not see the “sovereignty” privilege (as in devaluation) as the panacea for Greece. Barry Eichengreen seems to agree as he doesn’t believe Greece’s exports would benefit from it (see RT News Boom Bust interviews, Feb26-27).

    • There are three ways to become “competitive”, PBlacque, which means labor costs decline relative to labor productivity. One is to increase labor productivity by investing in infrastructure, education, better legal and financial institutions, etc. Two is to force down wages and prices domestically. Three is to force down the value of the currency.

      The first way is of course the best way, but it is the hardest, it takes time, and it usually takes borrowing capacity. To give you a sense of how hard it is, Germany, the great “success story” of the post euro period, had almost no productivity increase at all. It became competitive by slowing wage growth at home while wages and prices in the rest of Europe, driven by massive, cheap German capital, surged. This increase in German competitivity would normally have been undermined by a rising Deutschemark, but thanks to the euro, Germany could eat its cake and have it too. Spain is trying to increase productivity by reforming labor laws and making it easier to start businesses, but in a world of weak demand and excess capacity, it isn’t obvious that making it easier to produce more goods and services will unleash much new entrepreneurialism. We might argue that this would have worked ten years ago, but probably won’t do much good today.

      The second way, lowering wages and prices, is very easy. All you need to do is to fire workers and force up unemployment. Unemployed workers will eventually accept lower wages, employed workers will be so terrified of losing their jobs that they won’t demand raises, and eventually after many years you have finally become competitive again, although because the productivity of unemployed workers declines over time, you have to reduce wages by more than you might at first assume. If the world economy is doing well, the pain stays mainly at home. In a world of weak demand, however, your lower wages reduce global demand further, and so you are effectively trying to gain a greater share of weaker total demand. This almost inevitably sets off foreign retaliation and so everybody plays the same game of reducing total demand while trying to grab a greater share of what is left. This can go on quite a long time.

      Finally you can devalue, and your competitivity immediately improves. The problem, however, is that devaluing also reduces your contribution to total global demand while increasing your share, and so might set off retaliation (the so-called currency wars). Some people will tell you that the other great disadvantage of devaluation is that it increases the real cost of your external debt, which is why austerity (unemployment) is the least bad way out. They are half right, of course. Devaluation does increase the real cost of external debt, but lowering wages does exactly the same thing in exactly the same way.

      As for the claim that devaluation won’t help Greece because it has nothing to sell, this is nonsense. The belief arises among people, including many economists, who think that trade imbalances are driven by bilateral trade rather than by capital flows. It can be by the former, but it can also be by the latter, and in Europe today it is clearly the latter. If Greece has no way of generating foreign inflows on the current account, it is a little strange that it managed to avoid a balance of payments crisis for so many decades and then suddenly decided to have one at exactly the same time as Spain, Italy, Portugal, France, and everyone else. Of course I have no doubt that I will immediately be inundated with demands that I specify exactly what it is that Greece can sell, and when I say I have no idea, they will say I have proven myself wrong.

      Actually it only proves two things. First, it proves that I am not enough of an export in the Greek economy to know too much about what Greeks make besides olive oil, wine, tourism, fashion, and fruit — all perfectly exportable things, I would have thought, and I assume that if wages are low enough, someone somewhere can come up with an idea or two of things Greeks can produce. Second, economies are very complex things, and it doesn’t require that you predict precisely how an economy absorbs an exogenous shock to predict that macroeconomic impact of the shock. Of course if you begin with the assumption that Greeks are unutterably lazy and incapable of working at anything, then of course I will be proven wrong, but aside from being the grandson of Greek immigrants, whose American business made them quite rich within one generation, and one of whose children (my father) became a world famous geologist and engineer, making me skeptical about the claim that Greeks are incapable of producing anything, I still have to wonder why these horribly lazy and incompetent people waited to have their crisis at the same time everyone else did if their crisis was not caused by macroeconomic distortions in the European economy but rather by their infinite laziness and incapacity for producing things that can be sold.

      Devalue the Greek currency and the Greeks will export more, import less (which they will then produce at home) and welcome more German tourists to their islands. I am pretty sure of that. This doesn’t mean that there are not many reasons not to leave the euro, and it will certainly not solve most of their problems, but the idea that devaluation cannot possibly affect domestic production is very questionable, and can only be justified, it seems to me, by some pretty powerful stereotypes about laziness, incompetence and stupidity.

      • Thank you for your long reply to my second question. No doubt the extra policy space afforded Greece by a Grexit and devaluation could be beneficial. I think it was a Syriza mistake not to clearly argue that that was the inevitable consequence of further austerity with no debt cut.

        I would really appreciate your thoughts on the first part of my question? Do sovereign currency “issuers” enjoy greater advantages than “users” when resolving national debts (domestic and foreign owned)? If yes, why isn’t the ECB capable of same?

        Thanks

  21. Trying to post comment … error message keeps appearing … pls advise

  22. The article implies is that excessive debt and financial distress costs are getting in the way of increased production within the country; or more likely are actually forcing down production. Within a country everything produced has to go somewhere, therefore
    Production –consumption = accumulation (investment) + net exports
    The value of production is allocated among the various stakeholders, and on average all stakeholders benefit if production increases. This article tells me that the objectives of a restructuring are both to allocate the costs (divide up the pie) and to facilitate increased production within the country so that there is a larger pie to divide up. A successful restructuring needs to be implemented in a way that encourages increased production. The longer this is put off the more production loss is incurred and therefore the smaller the pie. Conversely, the sooner the restructuring can be accomplished the sooner changes are made that allow increased production. The promise of a larger total pie resulting from increased production is the incentive for individual stakeholders to agree to a restructuring, even if it involves some level of haircut.
    In some cases it might be feasible for a debtor to settle debts by selling off existing assets. In the case of Greece this does not seem to be a politically or economically feasible solution. What the creditors are able to recover appears to be primarily a function of the excess of production over consumption (plus necessary investment) for the country as a whole. While a short term financing/debt rollover plan is important, I think the big question the creditors of Greece should be asking the new government is this: What is your strategy for increasing production within Greece. Any acceptable strategy must increase production significantly more than it increases consumption. If they do not either have, or quickly develop an effective strategy to increase production, it would seem that their efforts are doomed from the start.

  23. If I follow the economic argument correctly, it seems that the political optics of “just restructure all european debt” and “someone always pays for the debt” (apologies for the oversimplification) will turn out to be “Germans are now covering all European debt, forever”. And while this may be in the best interest of Europe and even Germany, that seems to me to be a politically unsustainable path. People are not perfectly rational, and the day will come when nationalist arguments aren’t a Greek monopoly.

    • These are my thoughts as well. If the solution of the Eurozone mess is for Northern Europe to carry on subsidizing southern Europe for ever, then we will start hearing a lot about German Nazis and for me they are a lot more scary than Greek Nazis.

      • These are strange comments, Tarrou and Dr. Maulik. Beginning in 1990, with the Mexican Brady bond, the unbearable debts of nearly thirty LDC’s were written down by American, European and Japanese banks. In the 1930s, and again in the 1950s, the unbearable debts of Germany were written down by the United States. Also in the 1930s the unbearable debts of dozens of other European, Asian and Latin American countries were written down, along with the unbearable debts of many American banks. In the 1840s the British (and to a lesser extent the Dutch)., were forced to write down the unbearable debts of several American States, including Pennsylvania, at the time the third or fourth richest country in the world (had it been a country), prompting in part Charles Dickens’ famous US tour in which, among other things, he demanded that he get his money back (he didn’t, but his speaking tours were obscenely profitable).

        In 1890 the British were forced to write down Argentina’s unbearable debt and their banking system nearly collapsed. I could go on for pages, but you get the point. In every case the defaulted borrower subsequently experienced very rapid growth and the rueful lenders were not forced at all to subsidize their bankrupt borrowers forever (in fact in every case they came pouring back clamoring for the right to invest in the subsequent growth).

        The point of restructuring is to recognize the reality of insolvency and the create conditions for future growth. You seem to assume that a European restructuring cannot possibly to do the same but will only result in more wasted borrowing and foolish investment, but if it is so obvious that this will happen, why is it also so obvious to you that Germany will continue to lend them the money to do so?

  24. What we are witnessing here is the beginning of the end of the European social model. The 20th century witnessed the end of socialism-hard, the 21st century will see the death of socialism-lite as practised in Europe. The fundamental problem Eruope faces is that the ever shrinking productive class can no longer bear the burden of an ever growing parasite class. Or in other words, Europeans are running out of other people’s money. Given Europe’s terrible demographics and insutionalized hostility towards the productive class, those 1% at the top who create most wealth and the jobs, there is no way Europe can grow out of this mess. Today it the less efficient southerners who are brutally exposed. Eventually it will be the turn of the northern countries. No amount of leftist demagogury can save them.

    • You are right that several European countries have so far mistakenly pursued mutually incompatible policy objectives:

      1. Rise wages, and in particular the minimum wage corresponding to lowly qualified jobs, faster than productivity gains.

      2. Decrease weekly working hours and / or decrease legal retirement age at unchanged wage, thereby increasing unit labor cost.

      3. Extend the scope of public spending, thereby pushing taxation to too high levels.

      4. Engage their country in global free trade, including with countries that have 10 times lower wage level, social charges 2 times lower, working time 40% higher, taxation level 50% lower, without making sure that cross-exchange rates will be set at levels equilibrating trade balances and therefore to some extent jobs balance.

      5. Engage their country into the Euro, thereby giving up all possibilities to adjust via the exchange rate.

      6. Create jobs.

      It is immediately visible that 1-2-3 (which we might put together under the label of the European social model) is not compatible with 4 and not compatible with 5 if large Euro-area economies (eg. Germany) follow a different strategy or if the Euro-area is engaged into global free trade in the current exchange rate set-up.

      The inevitable result is that the political leaders of these countries have objectively worked against employment (against 6), against economic growth and against debt sustainability. Effectively, countries in this situation cumulate all the problems of a dysfunctional domestic set-up, a dysfunctional Euro area set-up devoid of any common economic policy and ruled by arbitrary public finance criteria and a dysfunctional world trade and monetary system set-up ruled by systematic arbitrage giving rise to large and persistent imbalances. These three handicaps compound each other to make the situation of these countries totally impossible. This is triple whammy for the people concerned and is likely to result in serious political tensions in the not too distant future if progress is not made at all three levels. So far, there are not many reasons to be impressed by the domestic and European leaderships who remain largely in denial of the need to clearly choose common and compatible priorities. Same comment for the G20 leadership on global issues. Hence no progress so far on any of the three levels.

    • Your comment is a well-spoken discourse on the stupidity of socialism. Of course, trying to convince socialists of their stupidity is a foolish endeavor.

      The biggest problem in Europe isn’t necessarily a lack of wealth in the top 1% as it is that they have a class of people (ex. useless bureaucrats) who never become poor. Instead of the American model, where the focus is mobility across the distribution with an emphasis on the incentives being aligned properly.

      Socialists have this stupid idea that everyone and everything should result in equal outcomes. I don’t think they’re able to recognize that different people have different skill sets. Socialism really fucked up India in the 40 years after independence before 1991, but people keep hailing socialism as this great thing.

      From my perspective, I view socialism as a tool to mobilize for warfare. This is why, I think, capital is viewed as a national asset in most of Europe.

      • The problem with socialism-lite is that there is so much emphasis on wealth redistribution that people forget about the wealth creation part. What’s not to like about 35 hr work weeks, long vacations, early retirements with generous pensions, free healtcare and education ? It wins votes. But eventually nations run out of money as people increasingly decide that it is much wiser to suck up to the government than toiling 12 hrs a day to sart a business. As a consequence, the continent that gave us the industrial revolution is basically a mute spectator to the information revolution (http://fortune.com/unicorns/xiaomi-1/). The only strategy the government knows is to desperately keep milking the old dying cows, those century old industrial age titans which are becoming increasingly uncompetitive. How many European companis/brands you can name which did not exist 20 yrs ago ? Not too many I can bet. That’s because there aren’t too many teenagers in Rome or Paris toiling away in their basements with their laptops trying to lay the foundation of the next google or facebook. They know it is not worth it.

        As for India, she wasted four decades after independence by adopting USSR as the sugar daddy. The daddy then died, but a lot of people still haven’t gotten over it. Hopefully the younger generation will be a bit more worldly wise than their parents so that things can get better.

        • I blame Marx for much of this. When you have the idea that you can fix all the structural problems of society by covering the sky red from the blood of the revolution, you’re just a sucker. Only idiotic societies take maniacs like that seriously. You can loot and pillage the productive/financial classes to take their money, but it won’t make you wealthier. Once the loot is used up, what else is there? It’s the same underlying problem in Europe.

          What kind of maniacs are drawn to the idea that guns and revolution are the solutions to the world’s ills? What kind of sucker thinks that good ruling and serving the populace of your country/city/state/whatever is by destruction and violence? Unfortunately, many countries in Europe have, in their DNA and thought processes, embedded these ideas that cannot be easily removed.

          I’ve been attacking Marx a lot, but I really think he’s a major part of the problem. You can’t take ideas like him seriously and expect to have a well-functioning society. The more I read him, the more angry and furious I get and the more I hate him. I’ve been reading him quite a bit and he brings out my rage better than virtually anyone else. Marx has changed the way the world thinks, and the world, for the worse, moreso than virtually anyone else (including Hitler who was highly influenced by Marx BTW).

          In reality, the liberals and their arguments against Marx were correct. I’ll quote Keynes to end this post.
          “How can I accept a doctrine which sets up as its bible, above and beyond criticism, an obsolete economic textbook which I know to be not only scientifically erroneous but without interest or application for the modern world? How can I adopt a creed which, preferring the mud to the fish, exalts the boorish proletariat above the bourgeois and the intelligentsia who, with whatever faults, are the quality in life and surely carry the seeds of all human advancement? Even if we need a religion, how can we find it in the turbid rubbish of the Red bookshops? It is hard for an educated, decent, intelligent son of Western Europe to find his ideals here, unless he has first suffered some strange and horrid process of conversion which has changed all his values.”

          • Watch Brasil. Going to start flushing the Red’s down the toilet. This weekend should be very interesting. Complete loss of control down here. Gov’t has no control of the military – Thank GOD!! Very interesting.

      • I think you far too easily assume the dismissal of a group, as a class or category, that is far too wide, to have meaning or substance, but……your notion on the assumption of equality is interesting, and the old point of political philosophy, there is no liberty in equality and no equality in liberty, necessarily, and definitionally, in their absolute senses…..problem is,most will realize this, but the range of the common sense (boundedly rational, or satisficed) moderated absolute is where the contention ranges. Of course no absolute, but my ideal has the equality or liberty extending this far, mine this. This is appropriate to this discussion, because those who come with a set of financial and economic beliefs do the same thing, Fukuyama this week discussed Putnam’s new book, where he talked of the blinders of Libertarians, but inevitably we all have them, all the more so the more we are convicted of a truth we assume (Taleb, Islamic Traditionalists, Russian neo-Imperialists, Century of Humiliation Xenophobes, etc). Necessarily our truths are made operant in our beliefs, in our sense-making, our model constructions, worldviews and bleed out into the larger zeitgeist. Why we can not let the most assumptive rule the day, rather rue their ignorance.

        • If anything, my dismissal of socialism doesn’t go far enough. Ideas like equality are inherently retarded. People aren’t equal and suckers should have no say in anything. Socialism always leads to governments and large corporations uniting for political goals in the name of “equality” or the “will of the people” combined with other garbage.

          My notion of equality is more than just interesting; it’s correct. The only way to ensure equality is by holding a gun to people’s heads and effectively loot them. This is the kind of thing socialists pride themselves in doing. The idiot Karl Marx is the quintessential example.

  25. I do not see how your arguments apply to Greece. Greece does not borrow from the markets at low rates because of the ECB put. Greece is financed by long term loans (average > 20years) at very low rates, owed to eurozone governments. There was also an agreement with the Greek government in November 2012 to further extend loans to 50yrs and a potential further decrease in rates. So can we pls agree that Greek debt has been restructured?

    Given that Greece has had current account deficits for over 30 years (well before Germany had huge surpluses) I would say that this restructuring is actually better than a nominal haircut. As it ensures that Greece’s populist politicians cannot saddle the state with more debt over the next 10 years – as they have been doing consistently since 1980.

  26. Can someone please explain to me the concept of discount rates?

    • Since no one has answered, I’ll give you my understanding, but I’m an engineer, not an economist. Maybe one of these smart guys will correct me.

      A discount rate is the method for figuring out the present value of a sum to be paid in the future. If someone owes you $100 next year and the discount rate is 8% the present value is 0.92*100=$92. If he owes you $100 in two years the present value at 8% is 0.92*0.92*100 = $84.64. The formula is Present Value = Future value * (1- discount rate) ^ number of periods (usually interest per year and number of years).

      PV = FV*(1-i)^n

  27. The main interest of reports on global debt like the recent McKinsey referenced in this article is in the compilation of data that are long and sometimes difficult to find for many countries. We need to say a big thank you to the juniors at McKinsey who spend long evenings and nights doing a fastidious but necessary work of data extraction and number crunching.

    However, as far as the analysis is concerned, it is rather light and disappointing. Nothing on the primary engines that make global debt run faster than global production and income for over 30 years. It is a pity after spending so much time on trying to quantify the issue. I mean, you have to love this apparently innocent question on page 20: “This raises fundamental questions about why modern economies seem to require increasing amounts of debt to support GDP growth and how growth can be sustained”. Seriously, did it take McKinsey 30 years only to formulate the question? Because, of course, no answer. Do we have to wait another 30 years for it?

    Of course, McKinsey is unlikely to dwell on the real causes of the global debt balloon. The commercial risk of upsetting some clients among multinational companies, large financial institutions or governments that are advisory clients of McKinsey is too material. You can’t reasonably expect McKinsey to shoot itself in the foot. It is already good – and probably the most they can do – that they raise awareness about the issue with reports like this.

    Nevertheless, it forces them to stay at the level of obvious observations. Global debt continues to increase faster than global GDP: +17pt since the already problematic level of 2007. What a surprise! The solution that worked well when only very few small countries like Sweden or Finland needed to deleverage – to devalue the currency and export to countries who don’t need to deleverage – no longer works now that everybody in the world needs to deleverage at the same time. No joke? Well, it is now a bit late to think about that, may be in 2009 after the system was backstopped it would still have been possible to move towards coordinated rebalancing instead of reloading the system with yet more debt for one more of these destructive credit easing iterations.

    And so, not being able to formulate the structural solution addressing the root causes for lack of a correct diagnostic, the report resorts to a list of solutions aimed at treating the symptoms: innovative mortgage contracts ; better debt restructuring mechanism including for sovereign ; better macro-prudential supervision ; reduce tax incentives for debt (only for households apparently, we don’t know why not for corporates, though we may suspect commercial reasons) ; improve data collection on debt (necessary but insufficient condition as we saw in the US in the precious cycle where the data was plainly visible for anyone who cared, which was nobody) ; create the right mix of banks and non-banks credit institutions ; promote financial development in developing countries. No sustained relative deleveraging with that i’m afraid.

    The root causes of the global debt snowball in the past 30 years lie in the fact that trade globalization has taken place within a global exchange rate system that has allowed the development of large and persistent current account imbalances resulting in a duplication of credit in both deficit and surplus countries on a worldwide basis. As long as this is not clearly stated, recognised, accepted and remedied in a coordinated manner, it is vain to expect any progress on global deleveraging. Reports like the McKinsey or the Geneva Reports on the World Economy no.16 will simply continue to register new highs in global debt-to-GDP and to propose largely inadequate solutions. The G20 will continue to be innefective.

  28. In my view this has been the most interesting entry I have read in your blog. Being spanish I understand this is one of the most important political issues these years. I have recently been studying corporate financing and I am aware of the importance of aligning interests between creditors, investors, managers, owners, workers etc.

    First of all, thanks a lot! Your post provides an excellent framework for discussion. Your text raises so many questions that I prefer to comment. It seems to me that the debt problems in Europe, originated basically with private contracts thereafter transferred to the public domain will linger precisely because political resolution is slow. As you say they haven’t been recognized properly and it is dificult when debt is framed in terms of cultural differences instead of real economic incentives.

    Sadly, I will have to wait until uncertainty returns with vengeance to see any real attempt to address the problem. According to official data public deficit in Spain will amount for about 5,5% of GDP in 2014, down from 6,3% in 2013 (the data changes somehow depending on who reports). While GDP groth has been estimated at 1,4% in 2014. Another year of rising debt. The spanish government is optimistic and estimates that in 2015, the economy will reach “cruising speed” and grow above 2% while the deficit will be reduced to 4,5% of GDP.

    Brussels shares this optimism and foresees that employment will grow at 1,8% in 2015 (0,8% in 2014) and internal demand will be the main growth driver (although salaries would drop further). According to these projections in 2017 or 2018 we could see debt stabilisation at about 105%GDP. If these projections prove correct, Spain could muddle through the debt crisis provided the ECB maintains the credibility of Draghi’s put, or provided that germans don’t put a stop to it before 2018, provided there aren’t sharp political changes in Spain or other countries. Particularly troubling for this scenario is France where the nationalistic FN leads the polls and Presidential elections are scheduled next march. S&P says that public debt would take a hit if Le Pen wins the elections.

    Political risks apart I feel that, again, those projections do not account for the problems you mention derived from financial distress, misalignments, external shocks etc. Have you identified the main limitation that would prevent growth in Spain?

  29. “When do we decide that Europe must restructure much of its debt?”

    When do we decide that the US must restructure much of its debt?

  30. Prof Pettis,

    Many thanks for this insightful analysis of the European debt problem; it is always a pleasure reading your analysis and very helpful in understanding the current market environment. I had two questions regarding this paper and would love to get your input them:

    1/ Your concept of “inverted balance sheet” is very interesting and is IMO an element which is missing in our modern theory of economics. However, how would you quantify the “invertedness” of a balance sheet and would you be able to compare, on a relative basis, different balance sheets in order to rank them? My initial guess would be to analyse the convexity of each company/country’s balance sheet, would that be correct?

    2/ Though you mention the Draghi put, which is still very present in the minds of investors, I did not see any mention about the current environment of negative rates, which is taking the concept of financial repression to another stage. Indeed, I believe that with the European QE which will start this month, one of the ECB’s goals is to guide yield seeking investors towards Eurozone periphery countries by depressing even more current yields in countries like Germany and France (courtesy of the folks at FTalphaville and RBS : http://ftalphaville.ft.com/2015/03/03/2120770/this-is-nuts-where-have-all-the-bonds-gone/). The results would be lower borrowing costs for peripheral countries (including Greece) and, using your concept of inverted balance sheet, would help bring the growth rate of those countries above their “natural” level. This gasp of air would help most of the countries in the Eurozone by giving them a bit more time to implement those critical structural reforms.

    Many thanks for your thoughts on this!

  31. This post is so good ! Unfortunately too good to be understood by the members of the Eurogroup and by “debt-doesn’t-count” Paul Krugman.

  32. @To Probato,

    “So can we pls agree that Greek debt has been restructured.” I am afraid that it has not been restructured because I do not believe that Greece will accept unemployment at >25% say for 30 years or more.

  33. I am so glad your site came back! God bless you Michael.

  34. @Csteven,

    That video (the link in the comment that no longer exists) was dope. This is my comment to your question on why I think the current political structure (primarily the nation-states of Europe) developed for warfare.

    The essence of the wars in Europe in the pre-Cold War era was because Germany and France were competing for the same trade network (the North European Plain). The area is easy to develop economically, all of the rivers go into the North Sea, trading costs are cheap, and infrastructure is very easy to build and develop. The problem is not so much France as it is Germany. I don’t think anyone here would be surprised if I said that Europe’s economic problem is German excess capacity. This isn’t a new problem BTW. It’s a problem that’s existed since the unification of Germany and has geographical roots. When you have a large productive capacity without the ability or institutions to develop a domestic consumer base, what’s the most useful thing you can do? The most obvious and productive thing to do from a domestic perspective is to use the entire savings of your middle class, your extra infrastructure, and excess manufacturing capacity to build guns, weapons, and other things of the sort. Germany’s entire location makes it so that it has Russia to the East and France to the West. From the German perspective, Germany is in a very tough spot geopolitically and has been forced to develop institutions that can handle that problem and it has. It’s done so by unifying it’s population structures in a highly unnatural way and creating a system that has a lot of excess capacity which can be mobilized very quickly.

    I know I said mainly Germany, but even France had issues. A few hundred years ago, hundreds of languages existed in France. Now, only one language is spoken. Few of the states in Europe today were even united in their current form until a few hundred years ago. Now, we also have deep water navigation, which means the UK, Northern France, Northern Germany, and Denmark can all trade with one another very easily.

    Now think about how much more sense it makes for Southern Europe to be involved in a trade alliance with Northern Africa as well? Why couldn’t you use the natural resources in North Africa and allow them to be used by the more populous and more wealthy countries in Southern Europe? What if you were to line the deserts in North Africa with solar panels and build infrastructure that allows much of Europe to access that energy? From a defense perspective or an economic perspective, does it make more sense for Italy to be concerned with what goes on Tunisia or Tripoli vs Berlin or Poland?

    Is it easier for places like Naples and Athens to be wealthy if they traded with Egypt, Cyprus, Israel, and others or if they were in an alliance with Berlin? The answer should be obvious. It’s easier for Valencia, Barcelona, Naples, Rome, Florence, Algiers, Marseilles, Tunis, Tripoli, Benghazi, Athens, etc. to trade with one another than it is for them to trade with Berlin. I really think all of those places can become very rich and wealthy if they were in there were institutions developed to encourage trade and commerce with one another, but maybe I’m batshit insane and don’t know what I’m talking about.

    I think many of these areas that’re poor could become very wealthy and boom if they were in a new (or extremely old) trade alliance provided that they had institutions to encourage the (re)development of these networks. I really, really do.

    • Med Union

      Provided they had the institutions, and a better frame of what is going on in their country, in the region, and around the world. Were they to have the education, maturity and similar. This is one reason, I harp on assumptions, to diffuse the ideologue who impedes progress.

      But frankly they don’t, prior to Arab Spring, which destroyed any possibility for what you mentioned, it had been discussed seriously; but then need to constantly clean solar panels in desert because, dust everywhere. If you have ever lived in the Middle East, you know, even with the windows always closed, every few days, everything (even walls) has to be wiped, because, even on the seventh floor, there is so much dust in the air, that it even gets in your apartment, and leaves a thin haze, fine sand on everything. Panels, would be constantly throughout the day.

      • So let’s forget about solar panels. What about wind? I don’t see why you couldn’t use the wind in the desert to power stuff. Italy, Spain, and Southern France are already hooked to North African gas (which has actually worked out pretty well IMO).

        Another issue is instability in places like Libya and Tunisia. Southern France, Spain, and Italy have the most to lose by instability in North Africa. At some point, it’ll be more valuable for them to come in and stabilize those regions if those regions become any more unstable. Otherwise, you risk all sorts of other issues, not the least of which could be unwanted immigration via unskilled labor that could potentially have a different view of society.

  35. Although I like with your traditional, history-based trading route idea, Suvvy, I’m at I’m at a loss when it comes to imagining what North Africa has to offer in trade that could sustain economies of the South of Europe? Spices? Slaves? Grain? Technical/medical/math expertise and innovative philosophy, like perhaps in the Middle Ages? Uh, not going there with that one. Tourism? Well, that could work but now they have a significant terror problem. I’m no expert but it seems to me that the Middle East and North Africa did okay when it played the middleman between East and Europe and between Central Africa and Europe. Indeed perhaps Southern Europe did better back when it played an upstream middleman between Africa/Middle East and Northern Europe, and in the process created great banking dynasties. (Venice, Amalfi.) I believe the history of exploration, colonialism, and most recently airline travel, is a lot about Europe expending great energy to cut out these middlemen. Just saying. Anyway I’m always engaged and interested in your comments. Sincerely willing to stand corrected about viable trade and economic development in North Africa and, beyond oil, the Middle East. (Turkey, as always, a very interesting exception.)

    • North African energy? There’s a reason why countries like Spain and Italy don’t run off Russian natural resources like Eastern and Central Europe. It’s because they use North African energy. Think about how useful it’d be to run solar panels across the North African deserts while linking up infrastructure to send that power to Southern Europe. To get that same power to Northern Europe, you’d have to build links across the Alps or the Pyrenees which would be a pain in the ass.

  36. Csteven,

    I don’t know if you’ve seen this, but check out these maps. The first is a Russian population density map, the second is a map of the total fertility rate across Russia, and the third is a ethnicity distribution across Russia. Make whatever conclusions you will, but these are the facts.
    http://www.mapsofworld.com/russia/maps/population-density-map.jpg
    https://jaymans.files.wordpress.com/2012/09/russia-fertility-map-2008.png?w=595
    http://www.mapsofworld.com/russia/maps/russia-ethnic-groups-map.jpg

  37. Larry Summers echoing Michael Pettis (and/or vice versa):

    “If there are more countries tending to have excess saving than there are tending towards excess investment, there will be a global shortage of demand. In this case countries able to devalue their currencies will benefit from generating more demand. Global mechanisms that concentrate on causing borrowing countries to adjust without seeking to shrink the surplus of surplus countries will tend to push the global economy towards contraction.”

    http://larrysummers.com/2015/04/01/on-secular-stagnation-a-response-to-bernanke/#more-4045

    • How can more countries tend to have excess savings over excess investment? Savings and investment must be, by definition, equal. Since the world is a closed economy, Y=C+I=C+S implies S=I.

      I don’t think this is what Prof. Pettis is saying nor is it anywhere close. What Prof. Pettis is saying (I think) is that when everyone tries to push up their savings rate all at once, there are basically 4 optoins:
      1. a drop in consumption and higher unemployment to accommodate the higher savings rate
      2. debt-fueled consumption to prevent higher unemployment to prevent the savings rate from increasing
      3. a rise in unsustainable investment to accommodate the higher savings rate
      4. a rise in sustainable investment to accommodate the higher savings rate
      5ish. A country can export its savings, but the world cannot

      In a world of excess capacity and production, option (4) isn’t really possible for the world as a whole and the previous 3 all either destroy capital or increase unemployment or both.

      From the same post you cited earlier, this is what Summers says.
      “The essence of secular stagnation is a chronic excess of saving over investment. The natural question for an economist to ask is how can such a chronic excess exist in flexible markets? In particular, shouldn’t interest rates adjust to equate saving and investment at full employment? The most obvious answer is that short term interest rates can’t fall below zero (or some bound close to zero) and this inhibits full adjustment.”

      I don’t think this is what Prof. Pettis is saying. Summers is using an IS/LM framework to argue that interest rates aren’t low enough to equalize savings and investment by arguing rates can’t go below zero. All this shows is an incompetent understanding of finance by arguing some BS framework that’s “Keynesian” even though Keynes explicitly stated it wasn’t his framework several times.

      Then, Summers goes on to say:
      “In situations where target saving is important, reductions in rates may increase rather than decrease saving, exacerbating imbalances.”
      Now this comment makes some sense, but the key factor isn’t interest rates, but the difference between interest rates and NGDP growth. If you drop interest rates, but NGDP growth drops by a larger margin, then the savings rate will drop.

      It also seems to me like Summers is, in some sense, arguing higher short term interest rates. I don’t think that he gets how much pressure this would place on the financial system. If that’s what he’s arguing, he’s arguing for an inverted yield curve in a world that’s in depression. That sounds like a horrible idea. In a world where debt levels are this high, a rise in short term interest rates could risk a blow-up of the entire system. Just think about the kinda pressure that could put on the payments system and the financial system. It sounds like disaster to me because debt servicing costs would spike.

      To be honest, Summers seems kinda like a part of the problem. Personally, he doesn’t seem to understand the real problem and argues expansionary fiscal policy as the clear solution, but when he was in the White House as an adviser, he specifically advised more fiscal policy all financed on a short term basis. This makes rising short term interest rates more disastrous, not less.

      In fact, Summers is completely blind to the real problem: the screwed up international monetary system. He’s using a bogus framework that’s what I was taught in intermediate macro (and is still taught in intermediate macro) while seemingly refusing to look at balance sheets. In my opinion, we need to throw advisers like him out and replace them with people who have actual solutions rather than doubling down and claiming that they’re right.

      When you have a set of guys that blow up the system, you don’t respond by placing them in charge again. You throw them out and replace them with more sensible guys. What we need isn’t more deficit spending (which is all Summers has been saying for decades). What we need is a new monetary system.

      • New International Monetary System…..

        And we would get that, after the deficit spending, and the blow-up, not currently when so many, outside of your popular US bogeyman, globally, in nations around the world, are so horridly confused. I think you misread Summers, because of your obvious distaste for him. Regardless, if new monetary system is needed, and such recalcitrance exists globally to more maturity and cooperation in the present one, what would more fiscal deficit spending matter, perhaps only lead the switch you desire, no. You have way too much a focus, on a linear action, effect. Far too simplistic, no wonder you feel passionately about it, if they just did this, then that, but they don’t because they are incompetent or something. Like with your, France and Italy and Spain, should just stabilize North Africa. If you can so easily imagine such a process, you would be far better writing screenplays than doing useful analysis.

        • The problem isn’t right or wrong or who did what. The problem is the thinking process, which Summer hasn’t done anything to fix. Doubling down is not a good risk management strategy.

          You can say you were wrong about whatever stuff you did, but that doesn’t mean you even made the right or wrong decision. You’re talking about nonlinear effects, but in complex systems with nonlinear responses, the most important part isn’t about being right or wrong, but the impact of the event. This is a concept Summers still doesn’t seem to grasp (see his focus on right and wrong). The problem with Summers is his underlying thought process, which takes decades to fix.

          For God’s sake, Summers specifically says that there’s excess savings over investment for the world as a whole. How the hell is that possible? Apparently, we must be exporting goods to Mars or Venus. Then, he says the reason they’re not equal is because short term interest rates aren’t low enough to equalize savings and investment because he’s “Keynesian” even though Keynes explicitly stated that it was the level of income, not the interest rate, that equalize savings and investment. Then, he makes some BS argument to invert the yield curve. Do you realize how crazy that is?! This is a world in depression and he’s arguing for what effectively amounts to a yield curve inversion?! That’s nuts. So yes, I do passionately want Summers to call it quits, but I’m surprised you don’t.

          You’re arguing for maturity and cooperation, but that doesn’t mean you take suckers and retards seriously. Instead, you short them on the way down, laugh at them when they begin to run the system into the ground, then come in with other sensible people to reset the system. I’m making some implications about Summers, but I’ll leave it to you about what those implications are.

          BTW, I never said France, Spain, and Italy should stabilize North Africa. I said I think they will (eventually) stabilize North Africa. They already all have energy connections into North Africa while the French are already rebuilding their old empire by starting in Africa. In Libya, any risk of political or social unrest could result in major issues for European countries in the Mediterranean

        • It looks like I didn’t have to wait long at all in order for Summers to prove my point. Did you see this stupid article he wrote? He’s saying that it’s the end of American economic dominance and that China’s gonna take over the US because of the AIIB. This piece is riddled with errors.
          http://larrysummers.com/2015/04/05/time-us-leadership-woke-up-to-new-economic-era/

          “We cannot expect to maintain the dollar’s primary role in the international system if we are too aggressive about limiting its use in pursuit of particular security objectives.”

          The problem is the dollar’s role in the international system. The development of the AIIB and (hopefully) the development of an alternative reserve currency is a wonderful thing.

          He also says:
          “With China’s economic size rivalling America’s and emerging markets accounting for at least half of world output, the global economic architecture needs substantial adjustment. Political pressures from all sides in the US have rendered it increasingly dysfunctional.”

          Ah yes, emerging markets are doing so well and clearly they’ve all decoupled. Of course, China’s growth rates are completely sustainable too and they’ll keep growing at this rate for the rest of eternity or at least until they catch up to US in terms of GDP. Clearly, China is becoming the world’s economic power and it must be stopped by keeping the USD in place so we can weaken the industrial and middle classes of the US in order to strengthen them as he clearly goes on to say.

          “Second, in global as well as domestic politics, the middle class counts the most. It sometimes seems that the prevailing global agenda combines elite concerns about matters such as intellectual property, investment protection and regulatory harmonisation with moral concerns about global poverty and posterity, while offering little to those in the middle. Approaches that do not serve the working class in industrial countries (and rising urban populations in developing ones) are unlikely to work out well in the long run.”

          The reason middle classes don’t exist in most of the world is, in large part, because of structural issues, policy issues, and the leading ideas of much of the world. We cannot fix issues of massive corruption or issues of political instability in much of the world. Without institutions to protect intellectual property, investment protection, the protection of property rights, and other key issues, you’re preventing capital formation and the development of a middle class. These issues that the “elite” talk about are issues necessary to the development of a middle class, as ironic as that may be. Improper incentive structures do not promote capital formation, which is necessary to the development of a middle class.

          This article shows he thinks he knows what he’s talking about with things all of us barely understand. I don’t understand how you like this guy.

          • Well as to security implication, he is not advising course, but stating the reality, the US has allowed the dollare to be used because it has been in its interest, even perceived security interests, where that changes, so will the usefulness of allowing the dollar to be used as it has. The funny thing is, how people have been running around for years (Jon the Russian on Gold, Some people on Builderburgers, others as Paul on the FED, etc and so forth), but yes the post WWII era, and security implications and system, and yes, were it to change, then we could change, would change, necessarily would find it less useful, as I have said for years on this blog.

            the reason that inequality exists as it does in the developed world, is because of the developed world allowing itself to be used for the purpose of rationalizing developing world export oriented investment, and thus growth and such is why recent run up in Central Bank holdings as MNC’s and Central Banks in the developing world have beggared each other, and used developed world citizens, while not taking steps to transit the middle income curse, and creating consumption driven economies, as if the have genetically dominant blinders attached to their eyes as if they were fruit flies, well….it will break, meander or find more cooperation. even meander will lead to break, because the structures, inter-relations and impacts are far too large at present, and everyone becomes more aware of income inequality within countries.

    • Among the pyromaniac firefighting brigade formed by Rubin, Summers and Greenspan, who put powerful financial fuel to the fire of global economic imbalances in the freely floating exchange rates regime when in office by repealing the Glass Steagall Act and deregulating OTC securities and derivatives, only Rubin gained a practical experience of the consequences when he found himself in the cockpit when Citigroup crashed to bankruptcy. Summers and Greenspan didn’t gain such practical understanding and consequently still don’t get it. Their desperate and vain efforts to safeguard their tarnished reputation is pathetic. Like many of the junk securities they helped create, they have been fully written off. Good ridance.

      • Well said (much better than how I stated it).

      • I think Greenspan and Summers have been quite forthcoming about how much they got wrong and how much they didn’t know, we still don’t know. And view your pop-cultural, they just don’t get it, if they weren’t just academic policy-makers and actually ran corporations then they would be able to blah, blah, blah is just popular non-sense, and always, undermines, your rather more prescient analysis otherwise, and more generally, and I often, reflect, as unfortunately.

        • Yes, they have good PR.

          No, my comment has – unfortunately – nothing to do with pop culture. In the early 1990’s, Maurice Allais – who had laid out very clearly the problems with the system of international free trade and free movements of capital as set up and as pushed by guys like Larry Summers and Alan Greenspan – had an expression for guys like them: “you don’t make the blind see, nor the deaf hear”. Things have been spelled out to them very clearly and things have happened exactly as warned. It’s not that they didn’t know, they simply didn’t want to listen, they didn’t want to see, they went ahead with their mistaken agenda and it was indeed mistaken.

          Please don’t alter my comment with things I didn’t say. Just elementary intellectual honesty. Thank you.

          • There’s more to Greenspan and Summers than just that. The Chairwoman of the FTC at the time stood up to Greenspan and Summers and called them out about how backroom deals on certain derivatives (particularly CDS) were becoming an issue. Of course, Greenspan and Summers completely ignored her because they thought they knew better. Oops. Fortunately for them, their wallets and bank accounts still got bigger. Unfortunately for me and my friends, we’re paying (and gonna pay) for their mistakes. How just?

  38. Csteven,

    I think you may like this post by Cullen Roche with regards to a sovereign currency issuer. I think it’s pretty good.
    http://www.pragcap.com/can-a-sovereign-currency-issuer-default

    On another note, I remember you saying that many of the world’s problems stem from the underlying ethos of social democracy (and I agree). I just wanna know why you think that social democracy is the problem. Is it similar or the same as the reasons why I think it’s retarded?

    • can’t say I do or you do, or we do, as to social democracy. And there is nothing wrong with it, per se, but is rather meant more for the choosing, because of the very very real structural issues associated with SD. While I enjoy a secular society, it is not my new religion. While I like difference, I don’t even celebrate similarity, why should I be cajoled elsewise. It seems that to expect an entity to do something, divorces ourselves from dong it, while we can complain, and not hold such a responsibility ourselves, some non-descript other does that. So, i can feel good, about what should be, while having no skin in the game, to speak your speak.

      Social Democracy with and of responsibility by and for the people, with no overarching ever expanding, mere notional, rather than person action oriented. zeiteist is fine, when it expands, and we can give nothing but supposed acquiesent support, or need to alter to the duplicity of some managed crowd, well, then, I must say it can be horrid. Some places with nearly all children born outside marriage, well, as secular, or right, or better, as single parenthood might be in a case, does not make for a better trend, much less one that sounds good, because Oprah would give a quick nod, along you can do it girl type affirmation.

      So lazy ethos, not SD, when it is chosen and acted upon by free people, continuously.

      • I just looked at divorce rates across the world and, my God, they’re horrible in many parts of the world including the US. I think there’re institutional frameworks that discourage men from marriage. What incentive do I have to get married if I’m a regular guy with a job and when I get a wife, a house, and all the other stuff to raise a family and the woman I married decides she’s “unhappy” and takes half of what I got, the kids, half my paycheck, and completely ruins my life. All of this is supported under “democracy”, “equality”, and “will of the people” is bullshit. You’re right.

        If you’re extremely wealthy, really smart, or elite in different senses of the word, you’ll excel and get everything you please. However, if you’re just a regular middle-class guy, you’re running the risk of getting completely fucked–especially if you’re a sucker. You end up getting volatility suppression and repression, possibly on a large scale. People then turn to ideologies like nationalism or some other nonsense. This is actively dangerous, destructive, and leads to blowups.

        The only thing about high divorce rates is that they usually come from people who divorce, remarry, and get divorced again. So again, we have to look at the divorce distributions across the population, not just the rates. Some sort of tradition can fix this problem, but having a completely secular society that allows this kind of behavior is unsustainable.

  39. The Greek Government should prime the Greek people for the necessity of Greece leaving the Eurozone. Greece’s debts are toxic and unpayble, and the beneficiaries of servicing this debt are financial interests, not the people of Greece. I believe that Greece should leave the Eurozone, issue its own currency, re-denominate all debts into the new currency, and spend heavily on public sector job creation, social services, and public infrastructure. It would be better to face difficult times with full monetary and fiscal sovereignty than to submit to continued powerlessness.

  40. I’d like to offer a belated “thank you for this post” to the author. Enjoying re-reading it in light of recent developments.

  41. It’s NOT Germany (only) that’s fed up with Greece. Smaller & poorer countries like Portugal, Slovenia, Slovakia & Latvia have contributed to the rescue package for Greece. Had to cut down on spending. These countries have pressured Germany to NOT give in to more greek demands any more.

    • It’s because those countries are stupid. If Greece exits, we’ll see Greece go in on an alliance with Russia. All this will happen while Portugal, Italy, and Spain will also probably exit because their debts cannot be paid. Germany, in this case, would suffer a depression and Europe could easily be at war again.

      I’m starting to wonder if there was a rift between Varoufakis and the rest of the Greek government. In a letter to the EU, this is what a portion of the letter said:
      “Greece is committed to honor its financial obligations to all of its creditors in a full and timely manner.”

      This is the link where you can read the whole letter.
      http://www.bloomberg.com/news/articles/2015-07-08/greece-commits-to-repay-imf-tones-down-debt-relief-rhetoric

      • Greece wanted to have financial support from Russia but Greece was turned there down as well.

        • It’s cuz Russia has major financial difficulties. but that doesn’t mean there can’t be trade between them that doesn’t use the FX mechanism as a way to have Greece import massive amounts of capital.

      • Contrary to common belief, the biggest enemy to Europe is NOT Russia but the US. Although european politicians won’t admit it publicly, helping to foment more unrest in the Ukraine, North Africa & the Middle East has actually a detrimental impact on Europe. And has backfired on Europe.

        • Europe doesn’t have a common interest or a common fate. Some European countries are pro-US (ex. the Netherlands, UK) and some are anti-US (ex. France, Russia). Europe is not unified. Spain and Germany do not have united interests and until then, a united Europe or treating Europe as a united entity is foolish.

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