Can the Eurozone Survive the Economic Challenges of Greece and Italy?

[John Creighto]

"3)their will be about 5% deflation per year."

3) I think you mean inflation? My guess is that inflation is probably the worst which can happen;

I did mean deflation. But I meant asset deflation through deleveraging not CPI deflation. The money has to to go somewhere, and if all assets are losing value than cash may be a safe place to keep ones savings. However, after rethinking it why not just stock pile cash if deflation is a fear? So perhaps the nominal risk free rate of return can't fall below zero percent. However, hording currency is illegal and one could still be robbed so perhaps even hording currency isn't risk free.

So even though deflation can help favor currency valued assets like low risk debt it is also true that inflation can reduce real debt. However, unless people have a way of making more than inflation on their investments, assets which yield less then inflation will not be attractive. Banks find government debt attractive at low yields only because they are able to borrow at cheaper then inflation and able to borrow at many multiples of their net worth. They are able to do this because of both governments insures depositors and central banks providing liquidity when needed. This is effectively a subsidy of the banking system.

 

[John Creighto]

I always find the currency argument a bit silly. When it comes to government debt, there is no difference between a haircut, and devaluation of sovereign issued money. There is also no difference between lowering (government) wages and deflation of a currency.

This is true in some sense but one approach is much more gradual and politically palatable. There are also some technical differences which I'll discuss elsewhere.

All in all, it doesn't matter. Most of the news about breaking up the Euro therefor is completely nonsensical. It'll only blow up a southern economy since they then need to invest in new IT, don't have access to the European market, and don't have access to European development funds.

Is there sort of a prisoners dilemma going on here. Everyone knows they can benefit from the European Union but everyone is looking for the most advantageous terms.

 

[MarcoD]

Is there sort of a prisoners dilemma going on here. Everyone knows they can benefit from the European Union but everyone is looking for the most advantageous terms.

I think it's the growing pains of a union. Personally, I am not even that opposed to the current debacle, it forces the weak economies to restructure, and the debt position overall of Europe certainly doesn't seem worse in comparison to the US's.

I don't even like the idea of European bonds. I mean, to do what with them? Raise the overall government debt to 100%? A system in which debt is locally held, and in check with market forces, seems more robust in the long term.

The risk, of course, is that the whole of Europe may blow up... But I am gambling on the fact that there still is loads of money going round in most of northern Europe.

 

[MarcoD]

I did mean deflation.

Hmm, this is the difference between historical financial fears of the US and Germany right? The US fear deflation, and the Germans fear inflation. The current rate of inflation in Europe was, last I heard, still in the 2%-3% range. I doubt deflation will be a problem anytime soon, but I may be mistaken.

(Anyway, wouldn't people buy government debt -certainly if it goes at 7%- if deflation is a problem?

To be honest, I am not an economist, and not from the US. I don't even understand the problems of deflation that well, seems it just isn't in my historical genes. Weird uh?)

 

[MarcoD]

What about the Italian government debt credit default swaps?

Numbers are by http://www.bloomberg.com/news/2011-11-16/jpmorgan-joins-goldman-keeping-investors-in-dark-on-italy-derivatives-risk.html" , well, kind off.

 

[Vanadium 50]

I always find the currency argument a bit silly. When it comes to government debt, there is no difference between a haircut, and devaluation of sovereign issued money.

Of course there is. A default affects those people who are holding bonds. A devaluation affects those people who are holding (or will be holding) cash.

 

[MarcoD]

Of course there is. A default affects those people who are holding bonds. A devaluation affects those people who are holding (or will be holding) cash.

Yeah, that's true, which is why I said: "When it comes to government debt, ...".

(Anyway, let's say Greece or Italy step out of the Euro. There is little to no chance that their external debt will be redefined it lires or drachmes - all creditors will want it in Euros. So leaving the Euro is hardly an option for them: they'll have external debt which will grow if they devalue their currency, their own assets evaporate, and the only good thing is that devaluing would help their export position but they'll have less export to Europe since their currency will be deemed unstable. There really doesn't seem any benefit to either the creditor or the debtor.)

 

[AlephZero]

To be honest, I am not an economist, and not from the US. I don't even understand the problems of deflation that well, seems it just isn't in my historical genes. Weird uh?)

I'm still not quite sure what John Creighto means by "deflation", but the standard defintion is usually a good way to start a depression, because when prices are falling there is no incentive for anybody to buy stuff they don't actually need right now. Why buy something today for $100, if you know can buy it tomorrow for $99 or next year for $90?

 

[AlephZero]

Interesting math but while 3+1 doesn't equal 7 part of the interest on the debt is paid of course from tax revenue.

And in the long term, increased tax revenue comes from increased economic activity. QED.

Of course you can try to "screw the 1%" as a short term measure, but the likely result will be they just move themselves and their wealth to some place else.

 

[MarcoD]

I'm still not quite sure what John Creighto means by "deflation", but the standard defintion is usually a good way to start a depression, because when prices are falling there is no incentive for anybody to buy stuff they don't actually need right now. Why buy something today for $100, if you know can buy it tomorrow for $99 or next year for $90?

Yeah, I think I got it, and I think I understand the liquidity trap now. There doesn't seem to be a real danger for that, at the moment.

Back to that Bloomberg report. Anybody else got the feeling that this is a great time to be a banker, and -provided banks don't blow up- (inter-)national banks are soon swimming in GIIPS cash?

 

[AlephZero]

A summary of "who owes what to whom": http://www.bbc.co.uk/news/business-15748696

 

[MarcoD]

A summary of "who owes what to whom": http://www.bbc.co.uk/news/business-15748696

Either I am an idiot, or financial markets are. I mean seriously, Spain has an ok-ish public, and a large private debt, which is owned by the UK. That's probably mostly housing, which is worth exactly nada since their housing bubble collapsed. Who has the problem? If anyone is bankrupt, it's the UK's financial sector. But the Spanish are paying an enormous interest?

But I guess I am the idiot.

 

[DoggerDan]

Maybe but who decided that above 90% debt to GDP was a dangerous situation.

The 95% of countries who don't share in the miseries of the 5%?

 

[AlephZero]

If anyone is bankrupt, it's the UK's financial sector. But the Spanish are paying an enormous interest?

Spain not only has an economic depression caused by the property bubble collapse, but also some insanely protectionist employment laws. Employers are requred to give up to 5 years notice of redundancies, or keep paying people their full salary for doing nothing for that length of time.

The consequence is that no Spanish company has much interest in hiring new employees (hence youth unemployment is about 50%, and rising) and certainly no new startup company is going to base itself in Spain if there is an alternative option.

Financial markets work on the basis of predicting the future, not just on the current situation.

 

[MarcoD]

Financial markets work on the basis of predicting the future, not just on the current situation.

Yeah, I know that. Housing bubble, expensive healthcare, lots of workers protection rights, large (youth) unemployment.

But that doesn't change the fact that the public debt is low, and that the (bad) private debt is probably owned by the UK. The country itself shouldn't have a fiscal, liquidity or solvency problem but only a structural problem, and the way to deal with that is mostly a political issue.

I mean, this is a scenario where some small Spanish banks will topple, private debt will be restructured, both at the expense of the UK, and Spain will be left with low public debt and a slow economy. That's not a bad position to end up with.

I don't know the cost of bailing out (the clients of) bad banks though.

(I really have the feeling that in this case, high Spanish interest rates are the by product of bad financial news from the UK which wants its investments to pay off, moreover, also dominate the international financial media. I can understand that a US firm went bust on this one, Spanish debt is okay but media coverage is 'irrational' about the situation.)

 

[AlephZero]

But that doesn't change the fact that the public debt is low, and that the (bad) private debt is probably owned by the UK.

Do you have any evidence for that assumption? (In any case, "Spanish private debt owned by the UK" seems a strange way of doing the accounting, even if you are talking about British nationals with second homes in Spain)

Some numbers from http://www.bbc.co.uk/news/business-15789385

Spain in 1989:
Government debt 39% GDP
Corporate debt 49%
Houshold debt 31%
Financial sector debt 14%
Aggregate 133%

Spain now:
Government 71%
Corporate 134%
Household 82%
Financial 76%
Aggregate 363%

Compare with Italy:
Government N/A in the link
Corporate 81%
Household 45%
Financial N/A in the link
Aggregate 313%

 

[MarcoD]

Do you have any evidence for that assumption? (In any case, "Spanish private debt owned by the UK" seems a strange way of doing the accounting, even if you are talking about British nationals with second homes in Spain)

I extrapolated that from the BBC reference you gave, I'll look it over again to see if I didn't get the charts wrong.

Oops: The arrows seemed to be contrary to my intuition, but the foreign UK debt could also be read as the collateral used for investment, and close UK/Spain ties. Hmm, I think I got that wrong to translate that to UK investment, apologies, it is French and German debt - not UK. (Apologies again. My original reasoning was that Germany and France hold Spanish debt, and the Spanish hold UK debt, therefor, the UK is 'working' to pay off the Spanish debt. I think I got the spread number wrong, though.)

Some numbers from http://www.bbc.co.uk/news/business-15789385

Spain in 1989:
Government debt 39% GDP
Corporate debt 49%
Houshold debt 31%
Financial sector debt 14%
Aggregate 133%

Spain now:
Government 71%
Corporate 134%
Household 82%
Financial 76%
Aggregate 363%

Compare with Italy:
Government N/A (I'll fill in 120% here)
Corporate 81%
Household 45%
Financial N/A in the link (which would mean 67%)
Aggregate 313%

But that's the problem with external debt, right? First, external debt sometimes is high whereas the numbers are meaningless, Luxembourg has around 3,400% GDP external debt.

Second, not all debt is bad. If companies invested in production capability by upgrading their machine park with cheap money, then that is a solid investment. Also, household debt is okay if invested in real-estate instead of consumed. So what to do with these numbers?

Third, there is the point that you can't add all these debt together. Sure it says something about an economy, but normally you wouldn't find, in a scenario where IBM has large debt and Apple none, IBM a healthy company, but you could claim that on average, the IT sector is doing okay. (And still you wouldn't know since IBM might be investing and therefor outpace Apple in a few years.)

It looks to me that Italy's government has far larger problems than their economy, and the Spanish government hardly has a problem with debt but solely with the economy, the youth unemployment. As long as they can service their debt, even with 50% youth unemployment, nothing is the matter.

 

[MarcoD]

Do you have any evidence for that assumption? (In any case, "Spanish private debt owned by the UK" seems a strange way of doing the accounting, even if you are talking about British nationals with second homes in Spain)

I am still in economy class 101, but puzzling a but further. First, it is odd that Spain would have invested that much in the UK, that doesn't really make sense, right? So there is something strange about the UK debt owned by the Spanish. I think I figured it out.

It has to do with the UK having its own currency.

Say investors in Spain want to sell to the UK. If they find an investor, he pays in British pounds, fine. So a Spanish bank ends up with pounds, doesn't know what to do with it, but it is worthless to have it laying around so the bank buys UK treasuries, and uses those as collateral to buy Euros, and the deal is finished.

So, yeah, the UK debt hold by Spain may well be British investment. Then again, it may also be the result of UK tourists buying sangria, or pensionistas buying homes. No idea.

No idea if this makes economic sense though.

 

[sfs01]

Some numbers from http://www.bbc.co.uk/news/business-15789385

Spain in 1989:
Government debt 39% GDP
Corporate debt 49%
Houshold debt 31%
Financial sector debt 14%
Aggregate 133%

Spain now:
Government 71%
Corporate 134%
Household 82%
Financial 76%
Aggregate 363%

Compare with Italy:
Government N/A in the link
Corporate 81%
Household 45%
Financial N/A in the link
Aggregate 313%

The glaring omission in that article is however the same statistic for the UK, with aggregate debt at 469%. Even after gratuitously subtracting the contribution of the London financial sector, it remains above that of Spain in the underlying source (http://www.mckinsey.com/mgi/.../debt.../debt_and_deleveraging_full_report.pdf)

 

[MarcoD]

I hope that the all of you are not too bored with the subject, but the situation is getting grim. Looks like they either solve it or maybe this, maybe next, year we will see countries defaulting and possibly banks topple over.

Interestingly, that means that maybe in a year I'll be standing in line for free food?

 

[John Creighto]

I hope that the all of you are not too bored with the subject, but the situation is getting grim. Looks like they either solve it or maybe this, maybe next, year we will see countries defaulting and possibly banks topple over.

Interestingly, that means that maybe in a year I'll be standing in line for free food?

It seems like there are lots of good plans in place. It is just a matter of getting the political will to follow them and then implementing them properly

 

[lisab]

I hope that the all of you are not too bored with the subject, but the situation is getting grim. Looks like they either solve it or maybe this, maybe next, year we will see countries defaulting and possibly banks topple over.

Boring? No way - I find it very interesting. Not interesting , more like interesting .

Interestingly, that means that maybe in a year I'll be standing in line for free food?

I surely hope not. If the Euro fails, it would be catastrophic for most large economies in the world.

http://www.reuters.com/article/2011/11/29/us-euro-zone-contingency-idUSTRE7AS0H020111129 (which is understandable - they have to manage risk). Problem is, such plans may make a breakup more likely. What a mess!

 

[Hlafordlaes]

Spain not only has an economic depression caused by the property bubble collapse, but also some insanely protectionist employment laws.

So far, correct.

Employers are requred to give up to 5 years notice of redundancies, or keep paying people their full salary for doing nothing for that length of time.

Wildly inaccurate. There are many forms of contract, but the standard and "fearsome" one is the full-time, tenured position. The employee can only be fired "legally" if caught with his/her hands in the till, or for verbally abusing the owner, or something glaring. So, after dismissal, most ex-employees will file a civil suit, declaring the firing "improper," and getting as a financial reward 45 days pay for every year worked, pro-rated. Less often, an employer can be ordered to restore the employee to his former position, although more often than not that is when the firing has been fishy or broke some other formal agreement.

Today, the average spend for firing is around 30 days per year worked, pro-rated. That's not 5 years pay, but it still is a good chunk and can force companies to hold onto less productive dolts and not hire someone better. Lotsa satisficing, iow.

Having been there and done that as both employer firing and employee getting let go, I can say that this is not the greatest of our problems here. What we all do now is give people temp contracts, and let them go when the law would force us to change them over to tenured positions (>3 years on the job). So, what labor law has wrought is tremendously precarious job positions, and poor human capital development.

The main problem is that labor contracts are negotiated by industrial sector and are currently applied nation-wide, so that a smaller, weaker company, or a fledgling start-up, finds itself required to not only follow salaries, but also work rules, that were designed for the largest and strongest in the industry. Ridiculous.

...

Lest you believe the Spanish are completely insane, this mess was created by Franco, the country's former fascist dictator. He granted all these rights and rules to labor in order to reduce strife and prevent wild cat strikes, while otoh absolutely prohibiting organized strikes, most unions, and free speech. Back then it was a good deal for employers, too, since judges and rulings were slanted in their favor. Along came democracy, and when unions were allowed to form freely, and the right to strike restored, someone forgot to eliminate the insane tenured position and mad sectorial contract rules.

 

[mheslep]

...
Ridiculous.

...

Lest you believe the Spanish are completely insane, this mess was created by Franco, the country's former fascist dictator...

Yes that's right, and US problems were created by King George III.

 

[Hlafordlaes]

Yes that's right, and US problems were created by King George III.

Actually, by Kings George I and II, as well and Ronald the Renowned, and all the magical thinking their counselors engaged in.

 

[MarcoD]

http://www.reuters.com/article/2011/11/29/us-euro-zone-contingency-idUSTRE7AS0H020111129 (which is understandable - they have to manage risk). Problem is, such plans may make a breakup more likely. What a mess!

I doubt the Euro will break up, even if banks and governments topple over, it's near impossible to return to the previous situation. Just imagine Greece would leave, or kicked out of, the Eurozone. We have free transfer of money in the EU. It would take them a year to implement the Drachme, and meanwhile all Greeks would transfer their money to northern Europe, most of the Greek banks would fall since that's equivalent to a bank run, you'ld end up with a shadow Euro economy and the Drachme would be completely worthless and Greece's government would be unable to borrow any money. It would end up akin to a third world nation where everybody prefers to pay in dollars instead of its own currency. Completely impossible.

Meanwhile, if Germany and France would start their own currency, they might impose this scenario on the south, and their loans would be worthless, and their economies a lot weaker.

Everybody keeps on talking about the Euro, but really, the currency is irrelevant. It's a government debt and bank leverage problem, nothing else.

 

[MarcoD]

The main problem is that labor contracts are negotiated by industrial sector and are currently applied nation-wide, so that a smaller, weaker company, or a fledgling start-up, finds itself required to not only follow salaries, but also work rules, that were designed for the largest and strongest in the industry. Ridiculous.

Which is why I think Spain is not that badly off. Implement some structural change and the economy will be boosted by foreign investment, and the government debt would be relatively low. The deflated property bubble is pretty bad though (but if I am right, this debt is mostly owned by UK banks, so it's not Spain, but the UK which has problems.)

 

[LaurieAG]

I wondered about the attached NYT cartoon until I noticed that Angela Merkel had a PHD in Physics.
http://www.dw-world.de/dw/article/0,,4580585,00.html

 

[AlephZero]

I wondered about the attached NYT cartoon until I noticed that Angela Merkel had a PHD in Physics.]

I don't know about the PhD. I think it's a German translation of Zeno's paradox.

 

[russ_watters]

Looks like an English version to me...and I'm not going to have to explain irony to you, am I...?

 

[AlephZero]

Looks like an English version to me...and I'm not going to have to explain irony to you, am I...?

Well, he's got a Bavarian hat and beer stein ...

I don't do irony, I send my shirts to the laundry.
-- Scott Adams.

 

[lisab]

France and 8 other European nations saw their credit ratings downgraded today -

http://money.cnn.com/2012/01/13/markets/sandp_europe_downgrade/index.htm?iid=Lead

I think this news was expected and already build into the markets. But that's just my WAG - anyone think otherwise?

 

[JonDE]

France and 8 other European nations saw their credit ratings downgraded today -

http://money.cnn.com/2012/01/13/markets/sandp_europe_downgrade/index.htm?iid=Lead

I think this news was expected and already build into the markets. But that's just my WAG - anyone think otherwise?

I agree that most of it was built in. I do feel however that some may have been surprised by France's downgrade. I had heard before (a few months ago) that it was possible, but I doubted they would actually do it, because France's debt really isn't that high. France's total debt actually went down in the third quarter (I don't believe fourth quarter has been announced yet).
I think the reason they downgraded France's rating was because they probably think that Europe is going to go into another recession, if it isn't already in one.

 

[MarcoD]

I also think it was built in. Moreover, I agree with the downgrades. The short term problems have been addressed, so now people are pooped off in Europe by the downgrades, but the long term solutions are not in place yet. Europe needs a manner, apart from financial markets, to pump money around. I.e., some process to stimulate the weaker economies, except for free trade, and not in the manner of financial abundance we did it before.

The above is more based on 'feeling' than actually studying the economic data, btw.

 

[AlephZero]

The thing that probably isn't "built in" to the markets is the fact that the Greek debt restructuring still isn't done and dusted. That time bomb is still ticking away with the deadline to defuse it about 3 months off.