Sunday, 5 July 2015

A New Deal for Greece

It appears that the Greeks have given a bloody nose to the EU, turning in a resounding NO vote in Sunday's referendum. Though exactly what they have rejected is unclear. The ballot paper is, to say the least, complicated. The UK's Telegraph published this translation from Greek Analyst:




And the paper asked, "Does this make sense to you?"

No, frankly, it doesn't. Neither of the documents referred to are current. The EU negotiators withdrew the June 25th offer as soon as the referendum was announced, replacing it with a subtly altered version from the "institutions" and dangling the carrot of debt restructuring if Greeks vote to accept the terms. No doubt they thought that this would force the Greek government to cancel the referendum. They were wrong. But the entire bailout programme expired on June 30th anyway, rendering the June 25th offer obsolete.

So the Greeks have rejected an offer that no longer exists. Perhaps the No vote is best seen as a protest against seemingly unending depression, unemployment and misery. I have considerable sympathy for this, though it will undoubtedly annoy Greece's creditors. .

But there has been a much more interesting development in recent days. The second document referred to on the ballot paper is the fudged debt sustainability analysis that accompanied the June 25th offer. But this too has now been superseded. The day after the announcement, the IMF produced another, more comprehensive debt sustainability analysis. It wasn't published until July 2nd. Allegedly this was because European members of the IMF board objected to its publication prior to the referendum. And having read the IMF's new report, I'm not surprised. The report undermines the EU creditors' entire case.

On first reading, the report is highly critical of the current Greek government:
But significant changes in policies since then—not least, lower primary surpluses and a weak reform effort that will weigh on growth and privatization—are leading to substantial new financing needs. Coming on top of the very high existing debt, these new financing needs render the debt dynamics unsustainable. This conclusion holds whether one examines the stock of debt under the November 2012 framework or switches the focus to debt servicing or gross financing needs. 
But embedded in the text (p.4) is this admission that the programme was ALREADY off track before Syriza came to power:
 The 2014 primary fiscal balance fell short of the program target by 1.5 percent of GDP. 
That is a considerable shortfall. And this was on top of the slippage identified in the previous programme review:
Debt/GDP was projected to fall from 175 percent of GDP at end–2013 to about 128 percent of GDP in 2020 and further to 117 percent of GDP in 2022. These were above the thresholds agreed to in November 2012, of debt coming down to 124 percent of GDP in 2020 and to “substantially below” 110 percent of GDP in 2022. 
In fact these charts from the IMF's report show that the programme had failed to meet targets from the start:


In 2013 the growth target was missed by a mile on the downside and the primary balance was also slightly below target. This programme has NEVER met its targets. Nor did the previous one.

Blaming the present government entirely for the failure to meet programme targets is thus unjustified. True, Greece's economic performance has significantly declined under the present government, mostly due to the uncertainty caused by its attempt to renegotiate the terms of the current programme. But if I were running this programme - and I am, among other things, a qualified and highly experienced project manager - I would have questioned the scope and assumptions long ago. A programme that is unable to meet any of its targets right from the start is not fit for purpose.

The slippage has principally been blamed on the Greeks not implementing the agreed reforms. There is some truth in this. But inadequate reforms do not fully explain Greece's terrible growth performance. Nor do they explain the deflation shown in the right-hand chart. Both of these are actually symptomatic of a severe demand squeeze caused by sharply falling real incomes. Or, if you like, by monetary tightness caused by very high real interest rates and no monetary offset from the ECB. It amounts to the same thing. The continuing fall in GDP makes the debt burden bigger, while deflation makes it more difficult to pay off. Yanis Varoufakis says Greece is in "debt deflation". These charts prove that he is right.

And as Irving Fisher reminds us, austerity is not the right medicine for a debt deflation. On the contrary, it makes matters worse.

Written at the height of the US Great Depression, Fisher's short paper "The Debt Deflation Theory of Great Depressions" describes how a debt crisis - be it sovereign or private - becomes an economic disaster. Fisher says that it is the combination of high debt with deflation that is particularly toxic. By itself, deflation need not be a problem at all, and a debt crisis may be quickly resolved. But when over-indebtedness is combined with deflation, a toxic spiral develops. Fisher describes it thus: "The more the debtors pay, the more they owe". And he explains how devastating the effects can be:


What we have seen in Greece in recent years is a fine example of this. Greece's economy has experienced a collapse on a similar scale to that in the US in 1929-32:


 And in Greece today, as in the US's Great Depression, debt deflation is accompanied by bankruptcies, unemployment and starvation.

The 2012 programme makes no attempt to restore the Greek economy. Rather, it is narrowly focused on achieving debt sustainability. To achieve this, it envisaged Greece running primary surpluses of over 4% of GDP for many years from 2016 onwards and achieving the highest TFP growth in the Euro area. This, for an economy as deeply depressed as Greece, is economically illiterate. It was never remotely achievable and I think the worse of both the IMF and the previous Greek government for agreeing to such targets.

Unsurprisingly, the first objective of the present Greek government was to get the primary surplus targets reduced. And it succeeded in this aim, But crucially, it did not manage to persuade the creditors to consider further debt relief. For this the IMF must bear much of the blame. Had it supported the Greek government in its efforts to bring debt sustainability to the negotiating table, we might not now be in this dreadful situation.

The IMF has now now admitted that watering down the primary surplus targets makes the debt unsustainable:
 In particular, if primary surpluses or growth were lowered as per the new policy package—primary surpluses of 3.5 percent of GDP, real GDP growth of 1½ percent in steady state, and more realistic privatization proceeds of about €½ billion annually—debt servicing would rise and debt/GDP would plateau at very high levels (see Figure 4i). For still lower primary surpluses or growth, debt servicing and debt/GDP rises unsustainably. The debt dynamics are unsustainable because as mentioned above, over time, costly market financing is replacing highly subsidized official sector financing, and the primary surpluses are insufficient to offset the difference. 
As FT Alphaville's Joseph Cotterill puts it, this means that the private sector really doesn't want the Greek debt it unloaded on to the public sector back any time soon. Or indeed ever.

But even these new policy targets are unrealistic. For a sovereign to run a substantial primary surplus AND achieve positive growth, either the external sector or the private sector must be in deficit. This implies that either Greece must also run a substantial trade surplus or Greek households and businesses must take on debt. The second of these is highly unlikely: real incomes for Greek households are falling sharply, Greek businesses are understandably unwilling to borrow to invest and Greek banks have high and rising proportions of non-performing loans on their balance sheets. Greece must therefore run a substantial trade surplus to have any chance at all of meeting these targets. Frankly, given Greece's long-standing competitiveness problem, the damage to Greece's already weak supply side in recent years, and the fact that it is locked into the Euro at far too high a real exchange rate, the chances of this are very low.

The IMF concedes that these targets are unachievable in practice. And this is where the fun starts. The IMF's Q&A on alternative scenarios is revealing. First, on growth:
What if growth were lower—closer to the historical pattern of about 1 percent per year? .....Real GDP growth of about 1 percent would still require strong assumptions about labor market dynamics and structural reforms that yield TFP growth at the average of euro area countries. In such a scenario, Greece’s debt would remain above 100 percent of GDP for the next three decades. Doubling the maturity and grace on existing EU loans and offering similar concessional terms on new borrowing, as specified above, would be vital to preserve gross financing needs within a safe range—the average GFN during 2015-2045 would be 11¼ percent of GDP.
Crikey. So even real GDP growth of 1% per annum is a tall order. And it wouldn't make much of a dent in Greece's debt/gdp anyway.

Now, about that primary surplus:
What if primary surplus targets could not exceed 3 percent of GDP over the medium term? In that case, the provision of concessional financing for a prolonged period (10 years) would keep the GFN stable and below the 15-percent threshold over the next three decades. The decline in the debt-to-GDP ratio, nevertheless, would be very gradual. 
So unless Eurozone creditors agree to a huge extension of existing maturities and concessions on interest payments, debt would still be unsustainable even with a persistent primary surplus of 3% of GDP for decades. And if primary surpluses were much lower than this, then in addition to concessions and rescheduling there would have to be actual losses for Eurozone governments who made the mistake of bailing Greece out in 2010:
However, lowering the primary surplus target even further in this lower growth environment would imply unsustainable debt dynamics. If the medium-term primary surplus target were to be reduced to 2½ percent of GDP, say because this is all that the Greek authorities could credibly commit to, then the debt-to-GDP trajectory would be unsustainable even with the 10-year concessional financing assumed in the previous scenario. Gross financing needs and debt-to-GDP would surge owing to the need to pay for the fiscal relaxation of 1 percent of GDP per year with new borrowing at market terms. Thus, any substantial deviation from the package of reforms under consideration—in the form of lower primary surpluses and weaker reforms—would require substantially more financing and debt relief..... 
In such a case, a haircut would be needed, along with extended concessional financing with fixed interest rates locked at current levels. A lower medium-term primary surplus of 2½ percent of GDP and lower real GDP growth of 1 percent per year would require not only concessional financing with fixed interest rates through 2020 to cover gaps as well as doubling of grace and maturities on existing debt but also a significant haircut of debt, for instance, full write-off of the stock outstanding in the GLF facility (€53.1 billion) or any other similar operation. The debt-to-GDP ratio would decline immediately, but “flattens” afterwards amid low economic growth and reduced primary surpluses. The stock and flow treatment, nevertheless, are able to bring the GFN-to-GDP trajectory back to safe ranges for the next three decades.  
To make matters worse, the IMF suggests that as Greece's debt is nearly all held by the official sector, there is no systemic risk and hence no reason for the IMF to involve itself any further in a programme which has no chance whatsoever of returning Greece's debt/GDP to a sustainable level.

The message from the IMF to the EU negotiators is clear: "We've had enough of this. Restructure this debt NOW or we are out."

The result of the Greek referendum gives democratic legitimacy to the Greek government's demands for debt restructuring and relaxation of programme targets. But in reality, the Greek government had already won, thanks to the IMF belatedly applying its own rules. In the end, debt that can't be paid won't be, and attempts to make it payable through harsh austerity only make matters worse. If Greece's creditors don't restructure the debt and refocus the programme on restoring growth, they face large losses in the not too distant future. Indeed, given the damage done to the Greek economy by the bank closure and capital controls, that future may be closer than they think.

In their own interests, Greece's official creditors must now construct a New Deal for Greece.


Related reading:

How we would have restructured Greece's debt - FT Alphaville

















Tuesday, 30 June 2015

Never mind Greece, look at China

While all eyes are focused on Greece, there is a potentially far more important crash going on.

Via Sober Look comes this pair of charts:





















China's stock market is crashing. It's very evidently a bubble bursting. The question is, what will be the knock-on effect to the Chinese economy, and indeed to the whole of South East Asia, Brutal sell-offs of this kind are rarely without economic cost, especially when the bubble is debt financed (as this one is). I can't see this ending well.

Related reading:

China stocks are battered anew - WSJ


Friday, 26 June 2015

Morality in the Greek crisis

I know I keep saying that economics is not a morality play. But when it comes to Greece, I can find no other satisfactory explanation for what is going on. 

The harsh treatment meted out to Greece over the last five years makes no economic sense whatsover. It has driven Greece into a deep depression that not only makes its government budget unsustainable but renders its debt unpayable: it has not only caused poverty and distress among Greece's population, but it has driven businesses into bankruptcy and done serious damage to the supply side of Greece's economy. And yet creditors want more.

I might agree that reforms to pensions are a good idea. I might also agree with widening the tax base. But not, emphatically not, in an economy as depressed as this. What is needed is debt relief, FIRST. Then real reforms, and help to restore the wanton destruction caused to the economy through ill-considered and frankly vindictive austerity measures.

But debt relief is not on the agenda. The IMF has previously expressed concern about the sustainability of Greece's debt: but now, returning to the fray after a brief absence, it has compromised its own objectives in order to present a united front with the EU. The Greek side is still asking for debt relief, though not for debt reduction. But its pleas are falling on deaf ears. The reunited Troika continues to insist on austerity measures as a condition of releasing the bailout funds previously agreed.

I've reminded everyone before about Irving Fisher's famous observation: "The more the debtors pay, the more they owe". In 2012, Michael Hudson developed this idea further. "Debts that can't be paid, won't be", he said. And he went on:
Today’s financial trend threatens to reverse this pro-debtor reform tendency. Without acknowledging the economic and social consequences, the “business as usual” approach is a euphemism for sacrificing economies to creditors. It seeks to legitimize the disproportionate gains of banks and their rentier partners who have monopolized the past generation’s surplus...... The aim in practice is to impose austerity and economic shrinkage on the private sector, while the public sector sells off its assets in a voluntary pre-bankruptcy.
The internal contradiction in this policy is that austerity makes the debts even harder to pay. A shrinking economy yields less tax revenue and has less ability to create a surplus out of which to pay creditors. Debt repayment is not available for spending on current goods and services. So markets shrink more.
If what you want is debts paid back, austerity is bad medicine.

But I said this was a morality play. The standard story goes that lazy, ne'er-do-well Greeks borrowed and spent excessively to support a lavish lifestyle well beyond their means. And to make matters worse they lied about their true financial position in order to gain admission to the Euro club. Unsuspecting German and French banks lent to them believing they were financially in better shape than they actually were. And when the Greeks finally admitted they couldn't actually pay the money back, hard-working thrifty Germans had to bail them out. Now the Greeks are complaining about the reforms that the virtuous Germans and saintly official creditors are requiring of them. But they are only pretending to do reforms, In reality they are still shirking. No wonder the creditors' patience has run out. The Greeks just can't be trusted.

I hear this story a lot. But it's not true.  And even if it were, it would not be helpful. It could equally be argued that Greece was sold a lie by the promoters of the Euro, since it was led to believe that Euro membership was the path to future prosperity. How was it to know that the abject failure of France, Germany and the UK to control their banks meant that naive Greeks would be at the mercy of predatory lenders? See, it looks different framed like that, doesn't it? And it is a bit rich to regard the official creditors as "saintly", too. They lent foolishly, in contravention of their own rules, to banks that had lent profligately and gained disproportionately. In so doing, they became what Hudson describes as "rentier partners" to those banks. Why should they not now take the losses that they should have inflicted on the banks in 2010?

The constant presentation of Greeks as intrinsically untrustworthy is profoundly damaging to the social cohesion of Europe. Unpayable debts do not arise from moral defect: Greeks are no more untrustworthy than anyone else. I do wish Germans would remember their own history. It is not so long since Germans were regarded in much the same way as Greeks are now. This is Keynes describing the attitude of the French statesman Clemenceau to Germans:
He was a foremost believer in the view of German psychology that the German understands and can understand nothing but intimidation, that he is without generosity or remorse in negotiation, that there is no advantage he will not take of you, and no extent to which he will not demean himself for profit, that he is without honour, pride or mercy. Therefore you must never negotiate with a German, or conciliate him; you must dictate to him. On no other terms will he respect you, or will you prevent him from cheating you.
The Economic Consequences of the Peace, III.7 
Germany was loaded with unpayable reparations after World War I partly because of attitudes like these...... and we all know where that led, don't we?

Brian Lucey reminds us that after World War II, Germany was forgiven the majority of its debt. It also received aid from the US to restore its economy - the Marshall plan. Yet now it refuses to consider further debt relief for Greece, let alone aid. Instead, it insists on harsh austerity measures, even though they make it even less likely that Greece will pay its debts. This, coupled with the disparaging language that is routinely used about Greeks and the wilful ignoring of their terrible economic plight, smacks of a desire to inflict punishment rather than any genuine interest in reform.

But punishing people - or nations - for running up unpayable debts actually doesn't sit well with a moral stance, particularly one that is supposedly founded on Christian values. Jesus has quite a bit to say on unpayable debts:
The kingdom of heaven is like a king who wanted to settle accounts with his servants. As he began the settlement, a man who owed him ten thousand bags of gold was brought to him. Since he was not able to pay, the master ordered that he and his wife and his children and all that he had be sold to repay the debt. At this the servant fell on his knees before him. 'Be patient with me,' he begged, 'and I will pay back everything.' The servant's master took pity on him, cancelled the debt and let him go.
But when that servant went out, he found one of his fellow servants who owed him a hundred silver coins. He grabbed him and began to choke him. 'Pay back what you owe me!' he demanded. His fellow servant fell to his knees and begged him, 'Be patient with me, and I will pay it back.' But he refused. Instead, he had the man thrown into prison until he could pay the debt. 
When the other servants saw what had happened, they were outraged. They went and told their master everything that had happened. Then the master called the servant in. 'You wicked servant,' he said. 'I cancelled all that debt of yours because you begged me to. Shouldn't you have had mercy on your fellow servant just as I had on you?' In anger his master handed him over to the jailers to be tortured, until he should pay back all he owed.
Matthew 18:21-35, NIV 
 I'm not at all sure what Jesus would have to say about the treatment of Greece by its creditors. Whatever happened to forgiveness?


Thursday, 18 June 2015

Mario Draghi and the Holy Grail



In a reply to a comment on my recent post about Target2 and ELA, I said this:
There are no "Greek euros" or "German euros". There are only European euros. So the ECB is not exchanging Greek and German euros at par. Both countries are using the same currency, which is produced by the Eurosystem. The NCBs are not autonomous entities, they are part of the Eurosystem. They do not create their own currencies : collectively, they create the single currency.
This is how a single currency works. If there are multiple "central banks" within a single currency area - as there are in the United States, for example - they do not produce their own currencies. St. Louis Federal Reserve does not produce St. Louis Dollars. It produces United States dollars. As does the Minneapolis Fed, and the New York Fed, and the Atlanta Fed, and so on. The twelve Federal Reserve banks collectively produce one currency, the US dollar.

So the person who argued that Greek and German euros are exchanged at par by the ECB, which is the wrong price, is wrong, isn't he?

If the Euro were genuinely a single currency, he would be wrong. And that was the assumption I made in my answer.

But on reflection, something doesn't quite add up. The structure of the Eurosystem is not that of a single currency. No other currency area has individual "central banks" for every one of its member states. The US has twelve Federal Reserve banks, not fifty. The UK - probably the oldest and most stable currency union - has four "member states" but only one central bank, despite the fact that two of its member states produce their own banknotes. A single currency does not need a "central bank" for every member state. But a system of pegged exchange rates does. The Eurosystem is constructed as if the Eurozone were using a pegged exchange rate system, not a single currency.

For a single currency, where banknotes are issued is irrelevant. The US does not mark its banknotes with the identifier of the state where they were issued. In the UK, Scottish banknotes are different from sterling banknotes - but really they are a parallel currency that is pegged at par to sterling and fully reserved with physical sterling banknotes in a sort of currency board arrangement. But Euro banknotes are marked with their currency of origin. Again, this is not what we would expect for a genuine single currency.

The construction of Target2 reflects the Eurosystem structure. Target2 records credit and debit balances between Eurosystem "national central banks". It charges interest on debit balances, and pays interest on credit balances. This arrangement is frankly bizarre. The interest is created by one entity in the Eurosystem then transferred to another. It neither enters nor leaves the Eurosystem: it is simply creation and movement of reserves within the system. It is, in short, seigniorage. Eurosystem entities with debit balances create interest and pay it to the ECB: Eurosystem entities with credit balances receive interest from the ECB. Because debit and credit entries within a closed system have to balance, the net effect is that Eurosystem entities with debit balances create and transfer reserves to Eurosystem entities with credit balances. But it's all funny money. The "national central banks" in the Eurosystem are not independent, nor are they representatives of member states: they are simply branches of the Eurosystem. And within Target2, they aren't even real. They are just representations of the Eurosystem structure. The interest payments are symbolic. So are the balances.

But for Hans Werner Sinn, the Target2 balances are not symbolic. They are real debts between Eurozone member states. And the interest paid is real. So a country leaving the Eurozone must settle its Target2 balance with a real transfer of Euros obtained through taxation or sovereign borrowing.

Sinn's view is widely supported, even though it seriously undermines the concept of the Euro as a single currency. But there is an even bigger problem - and that was identified not by Sinn but by the person who probably has most to lose from a Euro collapse. Mario Draghi.

It took me a while to identify what was odd about this statement from a speech made by Draghi in Helsinki in November 2014 (my emphasis):
....if there are parts of the euro area that are worse off inside the Union, doubts may grow about whether they might ultimately have to leave. And if one country can potentially leave the monetary union, then this creates a replicable precedent for all countries. This in turn would undermine the fungibility of money, as bank deposits and other financial contracts in any country would bear a redenomination risk. 
This is not theory: we all have seen first-hand, and at considerable costs in terms of welfare and employment, how fears about euro exit and redenomination have fragmented our economies.
So it should be clear that the success of monetary union anywhere depends on its success everywhere. The euro is – and has to be – irrevocable in all its member states, not just because the Treaties say so, but because without this there cannot be a truly single money.
On the face of it, this looks like a call for commitment to the single currency. But wait. Draghi says, in effect, that a genuine single currency cannot accommodate membership changes. This is not true.

In 1922, Southern Ireland left the United Kingdom, becoming first the Irish Free State and later the Republic of Ireland. It adopted its own currency, the Irish pound, in 1928. At no point did it ever occur to anyone that Ireland adopting its own currency would threaten the existence of sterling. Indeed, sterling continued to be used in the independent Ireland alongside its own currency.

Last year, Scotland held a referendum to decide whether to remain in the United Kingdom. It narrowly chose to remain. Sterling was indeed a contentious issue in the referendum, but not because Scotland leaving the union would threaten its existence. Even those who claimed that Scotland's departure would mean the end of the United Kingdom, and those who said that Scotland would inevitably be followed out of the union by Wales and Northern Ireland, did not argue that sterling would cease to exist. On the contrary. Passionate advocates of Scottish independence claimed sterling as their own and demanded to share it with the rest of the UK after independence. Unsurprisingly, since the rest of the UK had no voice in this referendum (and were highly sceptical of Eurozone-style currency union arrangements, with good reason), the demand was rejected by the UK government.

In the "velvet divorce" of the Czech Republic and Slovakia, both sides eventually chose a new currency. But this is unusual. More often, when currency areas break up, the dominant state retains the single currency: for example, the rouble - which was the currency of the Soviet Union - remains the currency of Russia. Genuine single currencies may change their allegiance, but they don't disappear. They are maintained through history, custom and above all by identity. The rouble has been the currency of Russia for a very long time: satellite states come and go, but the currency remains a mark of Russian identity.

In an interesting interview with Jacobin magazine, the Greek economist and MP Costas Lapavitsas - speaking about the Greek crisis - says that the currency of a country is intimately bound up with the identity of its people:
This crisis demonstrates beyond dispute that money is much more than an economic phenomenon. Fundamentally, of course, it is an economic phenomenon. But it’s much more than that. It has a lot of social dimensions and one dimension it has, which is critical, is that of identity.
Money, for reasons that are not for this moment but which I develop in my work, is associated with beliefs, customs, outlook, ideology, and identity. Money becomes identity more than capitalism. 
He adds that for periphery countries, Euro membership is about far more than just money. It is a mark of belonging - of being accepted as full members of a large, wealthy club called "Europe":
People have to appreciate that for Greeks, joining the monetary union and using the same money as the rest of Western Europe was also a leap in identity. In popular consciousness, and given the history of Greece, it allowed Greeks to think that they had become “real Europeans.” In a small country on the southern end of the Balkans, that had a very turbulent history, through the Ottoman period and what happened afterwards, this was a very, very important thing.
This attitude is not limited to Greece. When I wrote about Latvia recently, I was struck by how Euro membership was viewed as some sort of Holy Grail - a wonderful prize to be won through hardship and privations. For Latvians, like Greeks, Euro membership was a mark of being accepted into this wonderful club called Europe, leaving behind the terrible legacy of their Soviet past. That by accepting the Euro they have once again surrendered their sovereignty appears lost on them.

The tragedy is that the "European identity" that so appeals to Greeks and Latvians alike does not exist. True, it could develop - after all, America managed to forge a common identity from a warring collection of disparate states. But Europe has 3,000 years of conflict and bloodshed to overcome, including the two most terrible wars in the history of the planet and some of the greatest atrocities. Fear of another war is not sufficient to overcome the deeply rooted differences of culture, custom and identity between - and indeed within - the countries of Europe. And locking into an artificial currency that has no foundation in history or custom is not going to create a European identity. As we have seen all too frequently in recent years, when a crisis hits, European solidarity vanishes like the morning mist. European identity is a fair-weather friend.

The Euro is founded on lies. It claims to promote European unity, but it is set up to create and maintain fragmentation and distrust. It claims to preserve sovereignty, but to ensure its own survival it requires its member states to relinquish control of their economies and, increasingly, their politics. It claims to bring prosperity, but its legacy is depression.

And because it is founded on lies, it is fragile. Draghi is indeed correct that if one country leaves, others may follow, and that may result in the whole thing unwinding. But this is not because irrevocable membership is a necessary characteristic of a single currency. Clearly, it is not: in other currency unions, member states come and go, but the currency survives. No, irrevocable membership is necessary because the Euro is NOT a single currency. It lacks the underpinning of history, custom, identity and trust that characterises genuine single currencies. And its institutional construction is that of a pegged system of exchange rates, not a single currency. We saw in 1992 how pegged exchange rate systems can unravel when one member leaves.....

As I write, there is much discussion about whether Greece will leave the Euro. And as default draws closer and no deal is made, the fear spreads from Greece to other countries. If Greece defaults and leaves, what of Portugal? Spain? Italy?

We have played this scene before. It's called "contagion". We were told this would not happen again: the ECB has a battery of financial artillery to protect other Eurozone countries from the effects of a Greek disaster, and the banks have been fixed. It seems markets think otherwise. Stock markets are falling, bond yields in periphery countries spiking, business investment collapsing....Contagion is back, with a vengeance.

Draghi is widely credited with ending the market panic that threatened to destroy the Euro in 2012. "We will do whatever it takes", he said. Market participants interpreted this as meaning that the ECB would act as a proper lender of last resort, and this was backed up with the OMT programme. So why are markets panicking again now?

I do not think Draghi deserves as much credit as he is given for the calming of the 2012 panic. The real reason why markets calmed down was that no-one left the Euro. Greece was rescued. Again. And that was enough to reassure markets that the Euro would not unravel. But now, we are back where we were before the 2012 restructuring. Greek debt/gdp is 180% of GDP, its primary surplus is going up in smoke and it has an uncooperative and belligerent left-wing government that refuses to do what creditors want. Greek default and exit is once more on the agenda, and markets are increasingly doubtful that it will be rescued this time. If it leaves, others may well follow....

For my money, Greece should have left long ago - indeed it should never have joined. We know that Greece lied its way into the Euro. But equally, it was lied to. It was promised a golden future. Instead, it got destruction of competitiveness, unsustainable debt and a deep, prolonged depression. The trouble is that for such a damaged economy, leaving the Euro would now be very painful. And more importantly, at present the Greek people do not seem to want to leave. I can totally understand this, given the emotional charge that Euro membership appears to carry for periphery countries. Voluntarily leaving would be an admission of failure: being expelled would be even worse.

So although I think that in the longer term Greece would do better out of the Euro, I respect the desire of its people to hang on to their dream. Unilateral departure is not the solution - and nor is forcing Greece out, since that would just make the Euro unravel even faster (are you listening, Germany?). Winding up the Euro in an orderly fashion is the right thing to do.

But that won't happen while people continue to believe that it will bring them prosperity. Somehow, the Euro must be shorn of its faux glister. It is fool's gold.


Image from Monty Python and the Holy Grail, obviously. 

Wednesday, 10 June 2015

Goldilocks and the Griffin

The UK is forcing universal banks like HSBC to ring-fence their retail operations from their global and investment banking businesses – a sort of watered-down Glass-Steagall arrangement. The ring-fence will come into force in 2019, and banks are currently working out how to implement it.

HSBC is creating a completely separate UK retail entity with its own capital, management and head office. As part of this process, it conducted a review of possible locations for the unit's new head office, and concluded that London was not ideal. In March, it announced that the new UK retail bank head office would be in Birmingham, to the delight of local politicians and media. The announcement sparked approving remarks about the UK retail bank going “back to its roots”: HSBC’s UK retail arm was formerly Midland Bank.

Prior to its acquisition by HSBC, Midland Bank had a long and at times colourful history. It was founded in 1836 as the “Midland & Birmingham Bank”, and originally served businesses and households in the Midlands region. But it had larger ambitions. From the 1880s onwards it grew rapidly, acquiring a string of smaller banks. By the end of the century it had expanded far beyond local banking in the Midlands. It became a clearing bank in 1891 through acquiring the Central Bank of London, renaming itself the “London and Midland Bank”, and in 1898 it merged with City Bank, which gave it a London head office. It continued its acquisition spree throughout the early 1900s. By the end of WWI it was one of the world’s largest banks by assets. 

After the war, the acquisition spree ended, but the bank continued to develop its UK branch network, becoming the largest deposit bank in the world by 1934, a position it held for some time. It shortened its name to Midland Bank in 1923.

But Midland Bank wanted to be much more than just a UK retail bank. It developed an extensive global presence very early. HSBC’s association with the Midland (as it became known) goes back to 1907, when the then Hong Kong & Shanghai Bank became one of the Midland’s network of 650 correspondent banks. And it was the Midland’s overseas business, not UK retail banking, that was responsible for its decline and eventual failure.

By the 1950s Midland Bank had lost its leading position in international banking. It had developed its global business through correspondent banking, while other banks had established a more direct overseas presence through branches and subsidiaries. Anxious to catch up, in 1967 Midland Bank acquired a stake in the British merchant bank Samuel Montagu & Co., becoming sole owner in 1974. And it followed this up with a series of international acquisitions. One of the banks it bought was Crocker Bank of California, which Midland Bank hoped would give it a significant position in the important US marketplace. Briefly, Midland Bank became the tenth largest bank in the world.

But it didn’t last long. Almost immediately after the acquisition, Crocker Bank started to post enormous losses: in 1984 it lost $324m, a huge amount by the standards of the time. It turned out that Crocker Bank was riddled with bad real estate loans and toxic Latin American debt. Midland itself also had substantial portfolios of Third World debt: the two combined to knock a huge hole in Midland’s profits. Midland divested Crocker in 1986, but the damage had been done. In 1987 Midland posted an operating loss of £505m. From that moment on, Midland Bank was doomed.

The eventual takeover by HSBC in 1992 was presented to the world as a friendly merger, but those (including me) who worked for Midland Bank at that time know better. There is no such thing as “friendly” when a merger is the only alternative to collapse. We all knew this was a takeover. The disappearance of the familiar “griffin” logo from UK high streets inevitably followed in 1997.

(image: Daily Telegraph)

But now, HSBC seems to be on the verge of reversing this decision. It has announced that its UK retail banking operations will not only be ring-fenced with a new head office in Birmingham, they will be given a different name. The red-and-white HSBC logo will disappear from British high streets, to be replaced by…..well, we don’t know what, yet. HSBC says it intends to “consult with staff and customers”. But there is already speculation that the Griffin is about to stage a comeback. After all, if Lloyds can spin off a resurgent TSB, and RBS can re-create the almost forgotten Williams &Glyn Bank, what could possibly be better than for HSBC to bring back the familiar name and logo of Midland Bank?

To be sure, there are alternatives. HSBC’s First Direct online bank is popular and highly-rated: it was originally created by Midland Bank as an ancillary to its high street brand, not to replace it, but as all banks are becoming online banks now, perhaps the time is right for an online brand to become a premier High Street bank. But I don’t know. First Direct’s stark black-and-white branding works well for its marketplace, but would it translate to a high street environment where the principal customers are elderly people, families and local businesses? The Griffin is a lot cuddlier, and has a nostalgic appeal that First Direct probably lacks.

Personally, I would like to see the return of the Griffin. Midland Bank was the first bank that I worked for: the disappearance of the Midland brand was a loss to me even though I left HSBC not long after the takeover. 

The re-branding announcement has increased speculation about HSBC’s intentions regarding its UK presence. Is HSBC – which was originally based in Hong Kong - planning to spin off its UK retail arm and move back to the Far East? I think this is unlikely, at least at the moment, though HSBC is currently conducting a review into the best location for its head office and will announce its decision at the end of the year. But if bringing back the Griffin means that HSBC eventually leaves these shores, so be it. The UK will continue to be a premier financial centre even if it is no longer home to a giant bank whose main business is on the other side of the world. And it would be far better for the UK if its own banks were smaller. There aren't many of them - the UK has a pretty concentrated financial marketplace - and yet their combined assets are four and a half times the UK's GDP. That is far too high.  

I am no fan of small banks, and I don't want to see the UK attempt to replicate the overladen, expensive and technologically outdated German retail bank network. For me, it is the disappearance of what we might call the “middle layer” from the UK marketplace that is the real tragedy. We bail out large banks because we daren't let them fail, and we rescue smaller banks by merging them with large ones. I include building societies in this: Nationwide, now the UK's fifth largest lender, took over three smaller building societies in the aftermath of the financial crisis. The result is that a small number of banks become ever larger and more powerful, crowding out the rest, and we gradually lose our distinctive middle-sized high street banks and building societies. 

The EU has done us a favour by forcing the spin-off of TSB and Williams & Glyns. And we have new challengers such as Metrobank. But we need more. So let’s have Midland Bank back, not as it became in its latter days – a huge, sprawling conglomerate with no clear identity – but as it was in its salad days, a middle-sized retail bank centred in the Midlands and providing services to households and commercial businesses in England & Wales. Goldilocks had the right idea. Bring back banks that are neither too large nor too small, but just right for the UK. 

Related reading (courtesy of Daniela Gabor):

On being the right size - Haldane, Bank of England, 2012

Wednesday, 3 June 2015

Oh dear, Professor Sinn......

Hans Werner Sinn has a post on Project Syndicate which purports to explain why the plans of Greek finance minister Yanis Varoufakis are much cleverer than anyone has realised. I don’t disagree that Mr. Varoufakis’s plans are clever: indeed I have written several posts on Forbes explaining just how clever they are. But Professor Sinn’s explanation, sadly, is very wide of the mark.

Here is Professor Sinn’s description of Mr. Varofakis’s strategy:
Plan B comprises two key elements. First, there is simple provocation, aimed at riling up Greek citizens and thus escalating tensions between the country and its creditors. Greece’s citizens must believe that they are escaping grave injustice if they are to continue to trust their government during the difficult period that would follow an exit from the eurozone.
Second, the Greek government is driving up the costs of Plan B for the other side, by allowing capital flight by its citizens. If it so chose, the government could contain this trend with a more conciliatory approach, or stop it outright with the introduction of capital controls. But doing so would weaken its negotiating position, and that is not an option.
So Mr. Varoufakis’s strategy, apparently, is Grexit, for which he is preparing by stoking antagonism between Greece and its creditors while asset-stripping the rest of the EU. This is despite Mr. Varoufakis’s repeated statements of support for the EU and indeed for the Euro, which long pre-date his appointment as finance minister. What kind of turncoat does Professor Sinn think he is?

But let us assume for a minute that Professor Sinn is correct about Mr. Varoufakis’s intentions. Yes, Mr. Varoufakis’s statements have been inflammatory, and the effect has been to increase tension between Greece and its creditors. But what of Professor Sinn’s second statement – that Greece is deliberately encouraging capital flight in order to increase the costs of Grexit for the rest of Europe.  How does this work?

Professor Sinn explains it thus:
Capital flight does not mean that capital is moving abroad in net terms, but rather that private capital is being turned into public capital. Basically, Greek citizens take out loans from local banks, funded largely by the Greek central bank, which acquires funds through the European Central Bank’s emergency liquidity assistance (ELA) scheme. They then transfer the money to other countries to purchase foreign assets (or redeem their debts), draining liquidity from their country’s banks.
Other eurozone central banks are thus forced to create new money to fulfill the payment orders for the Greek citizens, effectively giving the Greek central bank an overdraft credit, as measured by the so-called TARGET liabilities. In January and February, Greece’s TARGET debts increased by almost €1 billion ($1.1 billion) per day, owing to capital flight by Greek citizens and foreign investors. At the end of April, those debts amounted to €99 billion.
A Greek exit would not damage the accounts that its citizens have set up in other eurozone countries – let alone cause Greeks to lose the assets they have purchased with those accounts. But it would leave those countries’ central banks stuck with Greek citizens’ euro-denominated TARGET claims vis-à-vis Greece’s central bank, which would have assets denominated only in a restored drachma. Given the new currency’s inevitable devaluation, together with the fact that the Greek government does not have to backstop its central bank’s debt, a default depriving the other central banks of their claims would be all but certain.
A similar situation arises when Greek citizens withdraw cash from their accounts and hoard it in suitcases or take it abroad. If Greece abandoned the euro, a substantial share of these funds – which totaled €43 billion at the end of April – would flow into the rest of the eurozone, both to purchase goods and assets and to pay off debts, resulting in a net loss for the monetary union’s remaining members.
This is an extraordinarily confused piece of writing.

Firstly, Professor Sinn asserts that Greeks are borrowing from Greek banks in order to transfer Euros out of Greece. On exit and redenomination the loans would be converted to drachma, which would promptly devalue leaving the Greek borrowers in possession of stashes of Euros for which they would now pay much less. It’s a plausible strategy, I suppose. There is only one problem with it. It isn’t happening.

Private sector borrowing in Greece has actually been falling since 2010:


There was a tiny uptick in borrowing towards the end of 2014, no doubt because the prospects for the Greek economy looked brighter then. But the economy is now back in recession and lending has tailed off. The Bank of Greece’s figures show that private sector loans decreased by 1.2bn EUR in April. If there is capital flight going on, it isn’t funded by borrowing.

Professor Sinn also outlines an alternative: Greeks removing funds from banks and stashing them as physical cash. This is actually true. Demand for Euro notes & coins in Greece has soared and Greek mattresses have never been so stuffed. But why are Greeks doing this? After all, if they really want to move money out of Greece, by far the easiest way to do so is to open an account in, say, an Italian or Slovenian bank and electronically transfer the money there. Why are they removing funds from banks completely?

The answer has nothing to do with ELA, Target2 or the Greeks’ understandable desire to stiff the Germans. It is far simpler. Greece is very close to Cyprus, and the Greeks have not forgotten what happened there two years ago. They fear losing their deposits in order to bail out banks that are bankrupted by sudden removal of ELA. It is the ECB’s stranglehold on Greek bank liquidity that is driving their excessive demand for notes & coins.

In addition to conversion of deposits to physical cash, there has been a continual flow of deposits out of Greece since the beginning of the year. These are electronic transfers and they are almost certainly due to redenomination fears. For some reason Professor Sinn ignores these. Could it be that he does not understand - or chooses to deny – the purpose of the single currency? Or does he simply not understand modern electronic payments systems?

I suspect it is both. Let’s look at each in turn.

Firstly, the single currency. Free movement of capital within the EU is enshrined in treaty directives. Yes, capital controls were imposed in Cyprus to prevent capital flight after the banking system collapsed. But that was to ensure that the freeze on deposits in Cyprus’s broken banks held. Greek banks are wobbly, but they are still standing. Professor Sinn wishes Greece to impose capital controls not because its banks are broken, but simply because of the way the single currency works. Capital flight is supposed to happen in a monetary union: ordinary people and legitimate businesses should be able to move funds wherever they like and whenever they like within the union. Routinely interfering with this destroys the single currency.

Secondly, the payments mechanism. This is quite technical and I will have to do some accounting to explain how it all works. Basically, though, Sinn has confused the funding of banks with the movement of private sector deposits.

When a private sector agent makes a payment from a deposit account – whether that be to purchase goods or assets, withdraw physical cash or transfer funds elsewhere – the bank’s reserves reduce. To show this, let’s imagine that the customer is withdrawing physical cash. The accounting entries for the customer and his bank are as follows.

Customer:       CR deposit account (asset)
                        DR back pocket (asset)

Bank:               DR customer deposit account (liability)           
                        CR reserves (asset)

For non-accountants, please note that a CR to an asset reduces it: DR increases it. I have preserved this convention even for customer cash movements where it is perhaps counter-intuitive, as in the example above. It will be very important to remember this as we go through the Target2 accounting later on. 


The customer has simply exchanged one asset for another. But the bank actually has less money. This shows up as a reduction in reserves. Reserves are a form of “money” used only by banks among themselves. Their sole purpose is to facilitate movements in and out of customer deposit accounts. They are, in a word, “liquidity”.

If a lot of customers withdraw physical cash, or transfer funds to other banks, the bank can run out of reserves. Banks can borrow reserves from other banks by pledging assets as collateral, typically government debt. But if the bank can’t borrow reserves from other banks – and not many commercial banks will lend to Greek banks now, because who is going to accept Greek government debt as collateral? - it turns to its central bank.


Explaining ELA

Central banks will lend reserves to banks against a range of collateral, subject to haircuts and conditions. In the Eurosystem, provision of “emergency liquidity assistance” (ELA) is the responsibility of national central banks, though it requires ECB approval.

ELA is provided to Greek banks by the Hellenic Central Bank, which bears all the risks associated with it. Professor Sinn’s assertion that the risks of lending rebound to other central banks in the Eurosystem is flatly contradicted by the ECB:
ELA means the provision by a Eurosystem national central bank (NCB) of:

(a) central bank money and/or

 (b) any other assistance that may lead to an increase in central bank money to a solvent financial institution, or group of solvent financial institutions, that is facing temporary liquidity problems, without such operation being part of the single monetary policy. Responsibility for the provision of ELA lies with the NCB(s) concerned. This means that any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB.
In the event of Greek default, the Hellenic National Bank would become technically insolvent because of all the Greek sovereign debt that has been pledged to it by Greek banks. But it would be the responsibility of the Greek sovereign to recapitalise it, not other central banks.

If Greece defaulted and left the Euro, the Hellenic National Bank would acquire the right to create the new national currency – a right it does not currently possess. Greek government debt, we assume, would be redenominated in the new currency (lex monetae). Grexit, therefore, would resolve the Hellenic National Bank’s “insolvency”. However, that would create a problem. What would it do with the Euro-denominated reserves on its balance sheet?

The simple answer is that it would also convert those to drachma. Greek banks would then be unable to meet demands for Euro deposit account withdrawals. Greece would have no choice but to impose capital controls and a bank holiday to avoid bankrupting the banks.

But the conversion of both Euro-denominated reserves and their collateral (Greek sovereign debt) to drachma would have no effect whatsoever on other central banks. There would be no losses anywhere else in the Eurozone. Sinn is simply wrong about ELA.


But what about Target2?

The question of Target2 balances is somewhat more complex. Target2 is the Eurosystem’s real-time gross settlement (RTGS) system. All Western central banks have RTGS systems: they are the core of the electronic payments systems upon which Westerners have come to depend. Target2 is a little more complex than the RTGS of a single country such as the UK.

But only a little more complex. It is in reality far more straightforward than a lot of the rubbish that is written about it suggests.

Example 1: How asymmetric trade flows cause Target2 imbalances

The Bank of England’s RTGS system can settle payments between people in London and people in Manchester. If people in Manchester make lots of purchases from companies based in London, funds flow from Manchester to London. But we use double entry accounting to record all movements of funds. So a net flow of say £1m private sector funds from Manchester to London through the Bank of England’s RTGS system looks like this:

Manchester private sector       CR cash at bank                 £1,000,000 (asset)                                                                                             DR e.g. fixed assets            £1,000,000  (asset)       

Manchester banks                   DR customer deposits        £1,000,000  (liability)                                                                                          CR reserves                        £1,000,000  (asset)

London banks                         CR customer deposits        £1,000,000 (liability)                                                                                            DR reserves                       £1,000,000  (asset)

London private sector             DR cash at bank                 £1,000,000  (asset)                                                                                            CR inventory                      £1,000,000  (asset)

This is what is known as “quadruple accounting”, where double entries are recorded for all four participants. You can see that there has been a movement of goods (fixed assets) from London to Manchester. You can also see that there has been a movement of cash from banks in Manchester to banks in London, which is recorded both as a change in “cash at bank” on the customer side and as a change in “customer deposits” at the banks. This is NOT two lots of money: it is the same money, recorded as an asset & liability pair (customer asset, bank liability). You can also see that there has been a movement of reserves from banks in Manchester to banks in London (remember CR to a bank’s reserve account reduces the balance).

Now let’s add in the central bank’s reserve accounts. Remember that reserves are assets for commercial banks. The corresponding liabilities are held at the central bank. We can think of reserve accounts at the central bank as similar to a bank customer’s transaction account: it contains a small amount of moving funds. So when there is a net flow of funds from Manchester to London, the reserve movements look like this:

Bank reserve accounts (assets):   
              Manchester banks    CR £1,000,000
              London banks          DR £1,000,000

Central bank reserve accounts (liabilities):
             Manchester                DR £1,000,000
             London                      CR £1,000,000

So at the central bank there is a reserve imbalance between Manchester and London. Manchester is in “deficit” and London is in “surplus”. Or, putting it another way, Manchester has a net liability to the central bank and London has a net claim on it. As the entries balance, we could ignore the central bank completely and say that London has a net claim on Manchester.

But this is silly. London’s private sector has already received cash. All the reserve entries show is that there has been a net flow of funds from Manchester to London. In this case it is balanced by a net flow of goods in the other direction. What this is showing, therefore, is that London has a trade surplus and Manchester a trade deficit. In no sense does Manchester “owe” London anything. It has already paid.

Now, using the above example, replace Manchester with Greece, London with Germany, and the Bank of England with the ECB. All Target2 does is facilitate and record these movements of funds. It is a gross misunderstanding of RTGS settlement accounting to describe the imbalances arising from these movements as “debts”, as Professor Sinn does.

So we can see clearly how Target2 records the trade imbalance between Germany and Greece. But there was a large trade imbalance between Germany and Greece before the financial crisis. Why did this not show up as a Target2 imbalance?

The reason is that prior to the financial crisis, Greece’s trade deficit with Germany was funded by borrowing from German banks. Let me show you how this works.

Example 2: How foreign financing of trade deficits eliminates Target2 imbalances

Greek customer takes out a loan of 1,000,000m EUR from a German bank (in practice this was often mercantile credit, i.e. importer borrowed from exporter who in turn borrowed from his own local bank, but let’s not complicate things). The loan accounting entries are as follows:

Greek customer                      CR German bank loan                         1,000,000 (liability)                                                 DR cash at German bank                    1,000,000 (asset)

German bank                          DR Greek customer loan account       1,000,000 (asset)                                                 CR Greek customer deposit account  1,000,000 (liability)

The Greek customer pays the money to the German exporter.  The accounting entries are as follows:

Greek customer                      DR goods & services received            1,000,000 (asset)                                                 CR cash at German bank                    1,000,000 (asset)

German exporter                    CR inventory                                       1,000,000 (asset)                                                 DR cash at bank                                  1,000,000 (asset)

German banks (aggregate)    DR Greek customer deposit account  1,000,000 (liability)
                                                CR German exporter deposit acct      1,000,000 (liability)

RTGS reserve accounts (liability):
            DR Germany   1,000,000
            CR Germany   1,000,000          

In other words, although the customer is Greek, the financial transaction in effect takes place entirely within Germany. This is why there were no Target2 imbalances even though Greece had a large trade deficit with Germany.

When the Greek crisis hit, German banks stopped financing German exports to Greece. Greek customers were forced to borrow from Greek banks instead (you can see this clearly as a spike in Greek bank lending in early 2010 in the chart above). The result was a large Target2 imbalance.

But as the Greek economy faltered, imports to Greece fell massively. Trade stopped being the main cause of the Target2 imbalance. What replaced it was capital flight. And it is capital flight, not trade, that is currently causing the Target2 imbalance to grow.

Example 3: How capital flight exacerbates Target2 imbalances

Suppose we have a Greek who has £1mEUR of cash deposits at Greek banks. Fearing capital controls, redenomination and seizure of his deposits, he decides to move his money to safety in Germany. So he opens a deposit account at a German bank and transfers his money electronically from his Greek bank deposits to the German bank. The accounting entries look like this.

Greek customer          CR Greek bank deposits          1,000,000 (asset)
                                    DR German bank deposit        1,000,000 (asset)

Greek bank                  DR customer deposits             1,000,000 (liability)                                     
                                    CR reserves                             1,000,000 (asset)

German bank              CR customer deposits              1,000,000 (liability)                                    
                                    DR reserves                             1,000,000 (liability)

RTGS reserve accounts (liability):
              Greece            DR 1,000,000
              Germany         CR 1,000,000

The Greek customer’s decision to move his money to safety widens the Target2 imbalance.

Because Professor Sinn believes that Target2 “deficits” are actual debts, and Greece is already very highly indebted, he thinks that Greece should take steps to stop the Target2 imbalances increasing. Greece should therefore impose capital controls so that our Greek customer can’t move his money to safety outside Greece. Presumably Professor Sinn also thinks that Greece should eliminate its trade deficit, though he doesn’t say this.

Central banks do not allow banks to run persistent reserve account deficits. Greek banks experiencing capital flight therefore have to borrow reserves to top up their reserve accounts. At present, because no-one else will lend to them, they borrow reserves from the Hellenic Central Bank, as I explained above. The Hellenic Central Bank’s balance sheet is therefore expanding by an amount corresponding to the growth of Greece’s Target2 deficit. But that does not mean they are the same thing. Professor Sinn unfortunately confuses them.


How would Grexit affect Target2?

Much time and energy has been spent discussing what the effect on Target2 – and, by extension, the ECB – would be if Greece left the Euro. Unfortunately most of the explanations are wrong.

Currently, Greece is running a Target2 deficit which is entirely covered, as far as Greek banks are concerned, by ELA from the Hellenic Central Bank. Suppose that Greece defaults, creates a new currency and redenominates all sovereign debt and all bank reserves into drachma, including reserves created through ELA. What does this do to Target2?

Nothing. Nothing at all. Zilch. Nada. Nix.

The Target2 “deficit” would remain as a notional liability of the newly-independent Greek state. It would still be denominated in Euros, since Greece would have no power to redenominate it. It would be frozen, since Greek capital controls and suspension of external trade in Euros would mean no further Target2 transactions. It would not need to be settled, paid, reallocated or otherwise disposed of. It could simply be ignored.

“But”, I hear you say, “surely there’s a catch?”

There is no catch. The existing Target2 deficit for Greece is entirely balanced by payments already made from Greek banks to banks elsewhere in the Eurozone. No-one is going to lose any money if Greece stops using Target2 because it ditches the Euro.

I admit, it has taken me quite a while to "get" this, despite the promptings of my good friend Beate Reszat who has always insisted that Target2 is simply a "black box" computer system and has nothing whatsoever to do with national accounting. But having now worked through the accounting, I am sure of my ground. The whole Target2 imbalances issue is a complete red herring.

If someone felt like being tidy, they could simply eliminate Greece’s notional Target2 deficit by proportionately reducing the Target2 surpluses of its Eurozone trade partners. In fact as the balancing reserves in Greek banks would already have been redenominated into drachma, this would technically be the correct thing to do. The Hellenic Central Bank leaving the Eurosystem and redenominating Greek bank reserves into drachma would reduce the aggregate quantity of Euro-denominated reserves in the Eurosystem. Bringing Target2 into line with this would preserve the consistency of Target2 balances with Eurosystem reserves. But it isn’t strictly necessary.

Nor is Greek redenomination potentially inflationary for the rest of the Eurozone, as some have suggested. Rather the reverse, actually. Capital flight can be inflationary for “safe haven” countries. If Greece left the Eurozone, capital flight would stop due to capital controls. This would be deflationary for the rest of the Eurozone, not inflationary.

Once the dust had settled, of course, Greece would want to lift capital controls and start trading with the Eurozone again. Most trade would probably be in Euros and settled via Target2.  But that is true for any non-Eurozone country trading in Euros with the Eurozone. The Euro would be a foreign currency for Greece. It would have to earn euros through trade. And because of this, it would need to run a substantial trade surplus, helped by inevitable devaluation of the drachma. So if it were not “tidied up”, Greece’s Target2 deficit would shrink over time.

To sum up, Professor Sinn’s piece is wrong from beginning to end. Sadly, because there is so little general understanding of what is a pretty technical subject, and he is one of the few people paying attention to Target2, he is widely believed. Even Wolfgang Munchau, who should know better, was convinced. I despair, I really do.

Monday, 1 June 2015

An anthem for Europe



The final paragraphs of Greek prime minister Alexis Tsipras's op-ed in Le Monde read thus:
Europe, therefore, is at a crossroads. Following the serious concessions made by the Greek government, the decision is now not in the hands of the institutions, which in any case – with the exception of the European Commission- are not elected and are not accountable to the people, but rather in the hands of Europe’s leaders.
Which strategy will prevail? The one that calls for a Europe of solidarity, equality and democracy, or the one that calls for rupture and division?
If some, however, think or want to believe that this decision concerns only Greece, they are making a grave mistake. I would suggest that they re-read Hemingway’s masterpiece, “For Whom the Bell Tolls”.
Hemingway's book is set in the Spanish Civil War. It graphically describes the ugly fight between those he describes as "fascists" - the Nationalists, who were supported by (among others) Italy's Fascists and Germany's Nazis - and the Republicans. The reference will not be lost on Spain's Podemos.

Nor indeed will the placing of this op-ed in a French paper. France is the mother of revolutions. "Solidarity, equality and democracy" are not unlike "Liberty, equality and fraternity", the slogan of the first French revolution.

In a way, Tsipras is calling for revolution in Europe. A revolution that would overthrow the "technocrats" whose aim is:
the complete abolition of democracy in Europe, the end of every pretext of democracy, and the beginning of disintegration and of an unacceptable division of United Europe.....the beginning of the creation of a technocratic monstrosity that will lead to a Europe entirely alien to its founding principles.
Tsipras's concern about the destruction of democracy in Europe is well founded. Europe seems to be splitting along quasi-feudal lines, with weak periphery states becoming subservient to a strong, austerity-minded core. Overturning the dictatorship of creditor states and ending harsh punishment for failing to comply with creditor demands is essential if the EU is to remain true to its founding principles. At present, arguably it is betraying them.

But revolutions are ugly. And they seldom deliver what they promise. France's revolution created the Terror and led ultimately to the rise of Napoleon. Russia's revolution re-created the feudal Russian empire under a new name and an even worse dictator. Both betrayed their founding principles. Neither created the prosperity that they promised.

And revolutions can fail. Hemingway's book does not say this, but the sacrifice of those who lost their lives fighting to preserve the Spanish republic was ultimately in vain. Spain's civil war ended with victory for the Nationalists and nearly forty years of dictatorship under General Franco.

Setting this piece in the context of Hemingway's violent, death-obsessed masterpiece is inflammatory. And it could have disastrous results. The suffering of the Greek people is considerable, but it is far less than that experienced by the victims of war. We do not - yet - have conflict in the Eurozone. Tsipras's op-ed is a call for political change. It must not be seen as a call to arms.

The title of Hemingway's book comes from this paragraph in the English mystic John Donne's Meditation XVII.
No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend's or of thine own were: any man's death diminishes me, because I am involved in mankind, and therefore never send to know for whom the bells tolls; it tolls for thee.
Solidarity, indeed. Europe needs all its peoples. Those calling for Grexit (in various forms) seem unaware that loss of one diminishes all.

This, not Hemingway's book, should be Europe's anthem.

Related reading:

The broken Euro
False Dawn