MORE MUSINGS ON THE BAILOUT TO END ALL BAILOUTS

I've promised before to write more about the Grand Bargain for Greece agreed in late July - the latest bailout to end all bailouts. I'm still working on material for a new post but for now, here's one I prepared earlier.

What follows is an article I prepared for ACCA's Financial Services e-newsletter. It is written from a UK perspective but readers may still find it of interest.

Greece – can we look now?

Part I: The Exposure

On 21 July 2011, the leaders of the Eurozone nations announced to what must have felt like the entire world that they had reached a deal on a new rescue package for Greece, one that would reduce the country’s borrowing costs and outstanding debt, ensure its continued liquidity and hopefully set Greece back on the path of fiscal sustainability. They stressed that this is a one-off package, and that other embattled countries could not take it as granted that they would be offered the same.

What does this deal mean for the UK? The place to start answering this question is the exposure of UK banks to Greece. Now people tend to play with words when this question comes up, including in Parliament itself. For a start, it’s important to distinguish between exposure to Greek banks, exposure to Greek sovereign debt and claims on the Greek private sector, and then exposure to the much broader risk of contagion in the case of a Greek default. The good news is that there are definitive figures out there. The bad news is that they are dated and problematic in multiple ways.

Stashed away in the detailed tables of the latest Quarterly Review from the Bank of International Settlements is a detailed, if dated, answer to the question of direct exposure. As of December 2010, the UK banks’ total exposure to Greek public and private debt was $14bn. But less than half of this, around $6bn, was exposure to Greek government debt or Greek banks, where the risk of losses is greatest. Overall, UK banks appear to only carry about 2% of the total Greek exposure of European banks.

  

In fact, UK banks are nowhere to be seen on the list of top financial institutions by exposure to Greece, and what little they hold in terms of Greek bonds tends to be in shorter maturities. This is important because most bonds maturing after 2020 don’t seem to fall under the financing offer for Greece that was agreed by the banks through the Institute of International Finance (IIF) back in July. For what it’s worth, it appears that RBS is the most exposed UK bank, although it’s officially written down half of its £1.4bn worth of Greek bonds already.

This brings me to an important point. For the purposes of accounting profits and losses, the allocation of Greek bonds between the banks’ banking books and their trading books (which alone must be marked to market, leading to recognised losses when bonds lose their value) is crucial. Non-Greek banks typically hold about 31% of their Greek bonds by value to maturity, so most of their exposure is already marked to market – the banks will have recognised significant losses on them already. This is important because bonds bought at a deep discount may appear to be taking a haircut under a buyback scheme (the much-celebrated 21%) while in fact turning a profit for the banks participating in the swap. Coming back to RBS, for instance, the bank would recognise a profit of ca. £275m on this transaction. As a Greek, I feel a little cheated, but as a UK taxpayer... ka-ching!

By the way, if you’re thinking this impairments business might present a headache for auditors, you’re right. Especially given the wide variety of conflicting practices banks are likely to adopt. Further reading for the intrepid auditor here.

Now for the wider question of contagion and what it might mean for UK banks. To be fair, the contagion is already happening, so this is pretty much a moot point. But it’s easy to dismiss this as mere panic, an irrational response. That’s until one realises just how interconnected the European banking system is, and how exposed the UK is, through various different routes, to the contagion seeping out of Greece.

According to the BIS data I cited above, UK banks have a $22.8bn exposure to Irish banks and the Irish sovereign; another $20bn to banks and sovereign debt in Italy; another $6.8bn in Portugal; and a whopping $30.7bn in Spain. And the $80bn this adds up to are just the obvious risks, the black sheep of the European financial family. Given that the European stress tests earlier this year estimated the Core Tier 1 capital of the major UK banks for 2011 at about $300bn even in an adverse scenario, a substantial impairment of assets in the most troubled Eurozone countries would cause significant problems for them although it wouldn’t wipe out their capital. Still, there is no telling where the contagion would stop and indeed which other sovereigns and banks might follow should the PIIGS go.

This is why we must turn to the bigger picture.

Part II: Is the Eurozone insolvent?

Throughout the various stages of the European debt crisis, the argument has been made that, if only the Eurozone could co-ordinate fiscal policy and issue debt collectively, for instance via Eurobonds, it would put an end to all this drama of speculation and contagion – Europe would become a borrowing superpower and no one would ever dream of doubting its creditworthiness.

The idea that a fiscally unified Europe would be undeniably creditworthy is wrong on many levels. Superpower status, fiscal union, and indeed fully-fledged federalism, didn’t stop S&P from downgrading the US to AA+ earlier this summer. Perhaps more importantly, given who buys US debt nowadays, it didn’t stop the Chinese rating agency, Dagong, from downgrading the US to A with a negative outlook. Some might say that these downgrades reflect the mechanics, not the fundamentals, of US debt, and that’s fair enough. But even if Eurozone members can somehow be coerced into fiscal union (and they may well be in the following months) the delays and horse-trading involved in drawing up a collective Budget for the Eurozone will make the debt ceiling negotiations in the US seem like an elegant costume drama ball.

But it is the fundamentals, not the mechanics, of debt that truly worry the markets. In the Eurozone as in the States, policymakers may not want to countenance the thought that the entire bloc might be collectively insolvent. Yet for over a year this question has been preying on commentators’ minds. The IMF even did the math on this in a fascinating report last year that went largely unnoticed. They found that the Eurozone, mighty Germany included, is not, in fact, solvent in the long term. According to the IMF calculations, the only long-term solvent countries in Europe were Hungary and Denmark. Bulgaria and Estonia were also strong candidates, but that was about it. The news for the UK were particularly grim.

Markets also find it hard to think of sovereign nations as being insolvent; much of the world’s financial architecture rests on the assumption that there is a magic circle of ‘decent’ sovereigns that can never default, and this belief has persisted after the 2008-9 crisis despite ample historical evidence to the contrary. The only difference is the ever-retreating boundary of the magic circle, as each embattled sovereign puts pressure not only on those countries that are financially exposed to it, but also any country seen as equally or less ‘decent’. Right now, the magic circle includes very few countries beyond the small group of AAA-rated sovereigns, and the result is a AAA asset bubble that could pop with disastrous consequences.

European policymakers are increasingly testing the surface tension of this bubble. Consider the European Financial Stability Facility (EFSF). Caught up in their own rhetoric of being under attack by evil speculators, Europe’s politicians hailed it as a shield for the Eurozone. But market participants, still smarting from the experiences of 2007 and 2008, quickly identified it as no more than a massive Collateralised Debt Obligation (CDO) and treated it accordingly. The market tested first the junior, then the mezzanine, and finally the senior tranches (see also here and here) of this construct – the guarantees by France and Germany. The very existence of the EFSF prompts the market to do this, much like the very mention of fiscal integration prompts the question of the Eurozone’s collective solvency. This in turn explains the ever-diminishing half-lives of Eurozone initiatives to calm the markets.

Until the markets are convinced that Europe’s finances are sustainable, this drama will continue to play itself out regardless of what schemes are concocted by its leaders, and will claim ever more, ever more conspicuous victims. Long-term sustainability trends can be reversed more quickly than one would think – relatively small changes can add up to a lot over a 50-year horizon. But they do not reverse themselves.

ALL UR BAILOUTZ ARE BELONG TO GREECE!

*** IMPORTANT UPDATES COMING UP. PLEASE CHECK BACK FOR MORE LULZ***

Readers will have noted that I have refused to write anything on Thursday's Summit outcomes and the new Greek bailout. The fact of the matter is that the amount of information in the public domain is pitifully inadequate - and that's not just me saying this. I will try to update this post as new information comes out.

Greek readers can, for now, consider the very competent if politically charged discussion by Techie Chan on this matter. The gist of it, with which I completely agree, is that private creditors have taken far smaller losses than the 21% trumpeted by European leaders, and in fact will in some cases make a reasonable profit from this deal, that Greek debt is still unsustainably high, and that a large transfer of risk has taken place from Europe's banks to the European taxpayer. Stay tuned for my own discussion of this.

I am particularly disturbed by the triumphalism with which some news outlets aligned to the Greek government were reporting on the deal late last week, essentially calling doubters and naysayers out on their sour-faced skeptical remarks. They'd be shouting 'IN YOUR FAAAACE! IIIIN YOUR FACE!' if they could get away with it. Cue of course, a chorus of world-weary defaultniks lamenting the continued loss of sovereignty, decrying Shock Doctrine tactics (Naomi Klein's tedious political version of the Philosopher's Stone, which explains everything under the sun), denouncing the new interest rate as usurious and the like. Let them all talk.

I'd rather focus for now on a topic that fewer commentators are talking about back in Greece and for which the facts are actually out. This is the CDS market - remember the evil specuLOLtors that were supposedly betting on Greece going bust (some of whom were in fact Greek banks themselves)? Well they're pretty fxed now.

You see, the most important implication of Thursday's grand bargain was no outcome of the Summit talks themselves, but the earlier announcement by ISDA that such a deal would not constitute a credit event triggering CDS payouts. By confirming that politicians will use this loophole to its fullest extent, Thursday's announcements mean that CDS are now virtually a non-asset-class: they only ever pay out if Greece sticks two fingers up to our creditors a la #Debtocracy, or if some suit at the IMF forgets to put our welfare check in the mail. Neither of which will ever happen. Some back home may be cheering that CDS spreads are down but that's because the actual value of the CDS as a hedge is down, not because Greek debt is any safer. It's like police procurement chiefs cheering the savings created by the falling price of bulletproof vests, following test results that prove they can't stop bullets.

You may think this is something for teh EVIL specuLOLtors to sort out among themselves, but what it actually means is that Greek bonds are now going to become much more illiquid (and that's saying something considering how illiquid they are now), because investors can't hedge against losses. The same goes for Greek bank stocks: in the past, people might use a Greek bank + CDS combo to replicate a European bank portfolio and skim some of the arbitrage out of the market or use Greek CDS to hedge exposures in the Balkans and Eastern Europe. But worse, far worse, the same goes for other PIIG and European bonds, and their banks. The entire Eurozone's financial system has become less liquid overnight. Surely that can't be a good thing?

UPDATE: only a few hours after I wrote the few lines above, this happened. QED.

*** IMPORTANT UPDATES COMING UP. PLEASE CHECK BACK FOR MORE LULZ***

KILL MEEE... KILL MEEEEE... PART 4

BACKGROUND:

Kill me no. 4 is the sequel to the original 'Kill Me' post available here, which in turn is the sequel the Dog Ate my homework v. 2 post and of course the original 'Dog Ate my Homework' post. All of these posts are reactions to the IMF staff reviews of Greece's standby arrangement and the subsequent letters of intent from the Greek Government. 

Together the two sets of documents could explain how the Greek Government is from Venus and the IMF is from Mars, except of course everyone knows where the Greeks are originally from. 

Anyway dear readers, I know you've been waiting for this so here goes. 


Here are the quickest possible highlights of the Fourth Review by the IMF with only a little play by play from me.

Open discussions of Greece’s financing challenge and euro-zone countries’ insistence on private sector involvement to resolve this have convinced markets that Greece will restructure its debt (pg. 4)

[Translation: The market expects a default.]

The fiscal position has stalled (pg. 6)

[Translation: Current austerity measures aren’t working]

Wholesale funding markets remain closed, and exceptional ECB liquidity support has grown (pg. 5)

Banks’ combined market value of €13 billion falls well-short of their reported Tier I capital of €30 billion (pg. 6).

[Translation: The market says that the stuff regulators say your banks are OK to hold as capital is actually crap. Nice job everyone.]

First quarter 2011 targets were met, with the help of temporary factors (pg. 7)

[Translation: Q1 2011 targets were ONLY met with the help of temporary factors. Your coach is about to turn into a pumpkin]

GDP is now projected to contract by 3¾ instead of 3 percent in 2011 (an outlook broadly in line with that of other forecasters). (pg. 9)

[Translation: Everyone else’s forecasts haven’t changed; we should have listened to them]

Risks remain skewed to the downside in the near term (p.g. 9)

[Translation: You are more likely to miss your targets than meet them for the next few quarters]

The scope for shortfalls in policy implementation or in macroeconomic outcomes is limited […] stress testing shows that full and timely program implementation is absolutely critical: incomplete fiscal adjustment, privatization shortfalls, or delays in structural reform implementation (producing a considerably slower economic recovery and fiscal adjustment) would see debt remain at very high and likely unsustainable levels through 2020 (p.g. 10)

[This point is repeated in various different ways throughout the report. Translation: You mess this up one more time and it’s Good Morning Harare!]

The discussions focused on Greece’s deeper medium-term policy needs and identifying ways to replace the expected market financing that is now likely no longer available (pg. 10)

[Translation: you can’t borrow from the markets anytime soon.]

At the end point, Greece would be targeting a primary surplus in the range of 6½ percent of GDP (pg. 11)

[Translation: The adjustment programme only works if you achieve an impossible primary deficit target]

there is a good motivation to switch the headline program targets to focus on primary balances, namely to insulate the fiscal assessment from the potential variability in interest payments (pg. 11)

[Translation: In addition to the markets we also expect a default, which is why we’re not counting interest payments anymore]

The government has prepared a medium-term fiscal strategy (MTFS), which would […] reduce the size of the Greek state: overall spending would decline from 49.5 in 2010 to 43.1 percent of GDP by 2015 (pg. 12)

[Translation: The nightmarish small state we have in mind for you is the same size as Canada’s.]

All administratively complex programmes are massively back-loaded (this is not verbatim, but see Pg. 13)

[Translation: We’ve given up on administrative reform]

[T]o begin implementing the strategic plan for medium-term reforms, the authorities will begin […] a number of major institutional changes (creating a central directorate for debt collection, a large taxpayers unit, as well closing and merging several uneconomic and inefficient local tax offices). (pg. 14)

[Translation: You don’t have a large taxpayers’ unit or a debt recovery unit? WTF?!]

[T]he system will remain heavily reliant on ECB support […] peak support could top €130 billion. Greek banks cannot by themselves rapidly reduce their existing level of ECB exposure (pg. 16)

The authorities also committed to encourage banks to seek foreign merger partners (pg. 17)

[Translation: Someone has to bail out your banks. We’d rather it was other banks from abroad.]

The BoG […] may appoint a commissioner with managerial powers to run a troubled bank; it may withdraw a bank license and then put the bank into liquidation; and it can impose a moratorium on a bank's claims. However, the Greek legal framework lacks specific bank resolution tools towards lowering the cost of resolving banks. [T]here are no techniques to allow the continuity of banking operations, including sustained depositor access (pg. 18)

Reforms are also needed to ensure that the deposit insurance fund can be used to fund such techniques, and to establish depositor preference over unsecured creditors. (pg. 18)

[Translation: If you default before you fix this shit, your citizens will not be able to get their deposits back.]

[UPDATE: Since people are asking, this doesn't mean people will lose the deposits necessarily, and it could just be a scare tactic. But what it does mean is that in the event of a default, restoring people's access to their deposits will take time and the Greek government will have to negotiate the status of depositors' claims. Unless of course we sort out the legal framework first.]

The supervisor has thus requested that undercapitalized banks meet regulatory requirements or find appropriate merger partners by end-September. (pg. 18)

[Translation: Your banks need to put a fire sale together pronto.]

Still, for the timetable to hold, market demand must exist. This is a significant risk which the authorities can manage by ensuring that foreign investors can participate, and by establishing a track record of even-handed and timely execution of transactions (to demonstrate to bidders they have a real chance to acquire the assets). (pg. 20)

[Translation: Even if you hold a fire sale, who is going to buy this crap? They don’t even trust you to honour your end of the bargain]

firm-level collective agreements, introduced in late 2010, would allow for wage reductions below sectoral minima (to the nationally-agreed floor) within the formal bargaining framework, thus overcoming this rigidity, but had been used little to date. (pg. 23)

[Translation: Businesses aren’t using the one good labour market reform you managed to push through. Someone isn’t playing ball.]

the end-March indicative target on the accumulation of new domestic arrears by the general government was again missed in March. A waiver of applicability is being requested for end-June performance criteria (except concerning external arrears). (pg. 27)

[Translation: you’ve missed your targets but we’ll look the other way.]

A tailored downside scenario exposes additional vulnerabilities. Debt would peak at 186

percent of GDP in 2015 and remain above 178 percent of GDP in 2020, a situation highly unlikely to allow continued market access. (pg. 70)

[Translation: You know how you keep missing targets? Well if you stay on that path you’re on track to owe fuckloads forever.]

ARE WE THERE YET? (UPDATE)

Apologies for the radio silence, dear readers - it's been a busy week.

Now that I've caught up with my sleep and the in-tray for the day job I feel ready for another post, and predictably it is a new batch of statporn, though I promise you haven't seen this before - not from me anyway.

I have strong but mixed feelings about Debt Clocks - here's one of ours, courtesy of the awkwardly transliterated Xrimanews.gr. In countries where government debt is not the number one issue on the agenda, a good deal of the population tends not to know just how much debt the state has picked up in their name. This is not too dissimilar to what individuals in too much debt do (a more academic treatment here and here) and the behavioural results are similar too. Such tools can give the people a sense of proportion. But while being able to visualise debt in this way tends to make people think, in practice it is not very actionable. By the time a country has a Debt clock built for itself, it is usually in too much debt already.

I was wondering, on the other hand, what kinds of clocks we could build for Greece that would mean something to the Greek people. If we're counting down to anything these days, it is surely D-Day, the day we get to default. And this is not a matter of time but of fiscal dynamics. Converting these into time variables is not straightforward.

As it happens, there are three sets of figures we can use that do sort of suggest timings.

PART 1: JUMPING

The first is the primary deficit, which counts down the distance left to run until we can secure an orderly default. I should point out that, unlike the Greek ministry of finance and some defaultniks, I'm counting public investment against the primary deficit. The reason is simple: public investment is the most productive part of government spending, as we've discussed here, here and in Greek here. In the event of default, it should be among the last budget items to go.

So how is that primary deficit coming along? Below is a graph of our monthly primary deficits, collated by yours truly from the monthly budget execution bulletins available here. Please note this is the Central Government budget as opposed to the General Government budget, where the data take much longer to produce and are much less reliable. Even with these caveats, I can only go as far back as Jan 2009 and can only follow the data up to May 2011 - but I will update as more data come in.

[Correction: The Y axis on this graph previously read 'surplus'. This was of course wrong. Many thanks to @ggementzis for spotting this. The hollow datapoints are my own naive forecasts, read on for details on how these were calculated.]

The bottom line here is that the 2011 budget isn't really working out. While 2010 was an improvement over 2009 in nearly every month, 2011 hasn't been an outright improvement on 2010 so far - only two out of five months have returned a smaller deficit or larger surplus. If the above graph doesn't really speak to you, maybe this one does: it would suggest austerity as currently pursued depends hugely on political timing and is producing diminishing returns.

Actually, this graph is a little scarier than that, because it's actually very easy to describe the trend involved. It's essentially a negative sine with a linear trend thrown in, or at least that's what it behaves like. Crucially, the trend points upwards.

[UPDATE] My longtime reader Chris Voltaire has pointed out over Twitter that running a regression with 15 observations is risky. He is too kind, of course. It is stupid and pointless. However, my purpose is not really to derive a forecast (even though I do). I only want to show what the trend has been so far and because of the seasonal variation involved I can only do this by deriving a forecast of sorts. Apologies.

If you run these figures forward, the forecast is for a primary deficit of EUR5.893bn, against EUR6.231bn last year. So we're only really on track to shave EUR338m off the primary deficit this year and at this rate it will take us 17 years to be able to default. Not good. It is probably this realisation that underlies our latest batch of austerity measures, which I've seen fellow libertarians criticise quite strongly. I will return with more commentary there. For now I should point out that there's more than one way of delivering a primary surplus, and I'm on the record as saying that taxation isn't a very effective one, for reasons to do with administration and equality.

Chris also points out that the Greek state is looking forward to some extraordinary income from property tax arrears in 2011, which readers would do well to take note of. Now in my days of trying to scrape by on £5 a day in London so I could afford my rent and the occasional drink, I used to have a rule: there is no truly extraordinary income and no extraordinary expenses. Better to assume that every month £100 will get spent that you can't plan for, and £20 will come in that you don't expect. It's a similar case here. The Greek state had extraordinary revenue in 2010 from the 2009 business levy, then more extraordinary revenue with the tax amnesty, and probably more that I can't keep track of. My point is that these 'extraordinary' income drives are driven by cyclical revenue figures rather than vice versa, so in one sense it doesn't really matter what income we're looking forward to.

But this is dodging Chris' argument. The real answer is that I can only keep monitoring the data - when that money comes in, I'll check again to see whether it's shifted the trend. That's all anyone can do really. For instance, just today (11 July) the preliminary figures for June came in - indicating a primary deficit of EUR1.356bn for the month. This in turn is consistent with a EUR7.1bn primary deficit for the year, taking us way off course.

Incidentally, the first graph I've presented here also reveals one more useful thing: that the most fiscally positive months for Greece are January, July and October in that order. This will be important to anyone trying to time a Greek default while we're still still running a primary deficit.

PART 2: BEING PUSHED

The second way of timing a default is to look at the exposure of European (in particular French and German) banks to Greece, particularly the Greek sovereign and Greek banks. The only reason we are in this state of suspended animation, from a foreigner's point of view, is in order to prevent massive losses to European banks and the associated contagion. If they could magically remove their exposure to Greece overnight, we would be forced to default at once, whether we liked it or not. This begs the question of how far along they are in dumping Greek assets.

I should note at this point that the markets for most Greek assets are currently very illiquid, so banks are very worried about dumping them as they are unlikely to get a good price. Moreover, when they sell banks have to record losses, whereas a rapidly depreciating bond can be held to maturity without showing a loss. All of this makes it difficult for foreign banks to dump Greek bonds.

You can review the latest data on exposures to Greece with commentary from yours truly here. But what is the trend? Well here we have a problem because the Bank of International Settlements (BIS), the source of all such statistics, has only started providing data with a sector x country breakdown in Q4 2010. Further back, we can only look at aggregates, which are much less useful. But let's see what we can find. The graph below outlines the exposure of banks in Europe, France and Germany to Greece (that's total exposure, including the Greek sovereign, Greek banks and the Greek non-bank private sector:

These data suggest that since the Greek crisis began in late 2009, French and German bank exposure is falling at a rate of 2% every month, or about EUR2bn per month. At this rate, it will take 44 months, or until August 2014, for them to reduce their exposure to zero.

Realistically, French and German banks will never manage this, and even if they could or wanted to, they don't need to wait that long, as they only need to cut their exposure enough so that they can remain capitalised when we default. Also recall that this is total exposure to the country, and although it makes sense to dump Greek banks alongside Greek bonds, it probably doesn't make sense to dump all Greek assets altogether.

But this is the general direction of travel.The query in question can be replicated by trying this link.

More to come, as I've still got data to crunch. For now the verdict is that we're more likely to be pushed than to jump unless we can come up with a real show-stopper. Somehow I doubt we will.

PART 3: GOING APESHIT

There is of course a third clock ticking away. Every quarter I watch the labour market statistics for clues of rising stress. My favourite index is of course the share of the unemployed that turned down job offers in the last quarter; the rationale is that once the fat has gone out of the land and people are forced to take whatever crappy job comes along or drop out of the labour force altogether the result is very angry people in the workplace or on the streets. Regular readers should not need any reminder but the graph as of Q1 2011 is as follows:

A naive extrapolation suggests that we will run out of unemployed people turning down  job offers by Q4 2013. This suggests to me that the apeshit scenario is approaching us faster even than the being pushed scenario. Everyone buckle up.

U CAN HAZ HAIRCUTS!

One of my favourite things about the UK is that occasionally, not often mind you, people collectively turn around and say 'wait, this is getting a bit confusing. Does anyone have the facts?'

The product of this mentality is the brilliant @fullfact, an independent fact-checking service which undertakes to clarify what the facts are in heated public debates. One day, when Greece has emerged on the other side of this LOLery, I hope we will have our own version of FullFact. I'll work for them for free while they get up and running and that is a promise.

Earlier today I gave them a few hints on the issue of the UK's exposure to Greek debt - their factcheck can be found here. Basically I relied on the latest figures from the Bank of International Settlements, which break down Greek debt into private and public and then into the countries it is owed to. A composite table of this looks as follows. (Source: BIS Quarterly Review Detailed Tables pg. 103 onwards)

All figures are current as of Dec 2010 (so quite dated), and expressed in US Dollars. Please note this is only banks' exposures to Greece, not those of other states or of course the ECB and IMF.

And are you wondering which banks are most exposed to Greece? From Barclays Capital, via FT Alphaville, who are now back in my good books:

WE NO DOES MODESTY AT LOLGREECE!

A couple of days ago I logged onto LOLGreece's Twitter account to an unusual comment:

Now my first instinct was to ignore Dimitris' question. I wrote back to say that I wasn't aware this was a comply-or-explain issue; a needlessly dismissive response which I regret. I am if anything grateful that he brought this to my attention.

The true answer would have been: I'm way behind on the day job; I'm helping my ex move house; I've got to help put a microfinance conference together in Nairobi. And I can't figure out who this Varoufakis fellow is supposed to be. He doesn't sound like the kind of high-profile MUPPET I would spend time ridiculing on this blog.

However, on the DLR to Stratford that is part of my new daily commute I got a brief chance to look Yanis Varoufakis (that's Professor Varoufakis of Athens Uni) and his Modest Proposal up and it turned out I of course did know the man and some of his thinking; though to my regret I can't honestly say I'd heard of this idea of his before and could not put a name to the face without help from Google. This is my omission; not only am I out of touch with Athens' admittedly small Policy circle but as I said I mostly focus on stupid things that are worth ridiculing.

For those of you with the appetite for a little light Eurodrama reading, the most up-to-date version of the Modest Proposal can be found here. It is in reality far from modest, a fairly technical proposal for simultaneously addressing the banking and sovereign crises (in the understanding that one sector will drag the other down perpetually if we don't), by establishing a surplus redistribution mechanism within the Eurosystem, courtesy of the ECB and EFSF. It is meant to be fiscally neutral and hinges on robust stress tests and haircuts for Europe's banks.

Prof. Varoufakis himself is a cool guy, with a brilliant recording voice and a calm discursive manner. The last time I had heard him mentioned by name was while chasing up on the Weisbrot hoax, during which time I was directed by one blog to this Greek TV show excerpt which explained, in a vulgar manner for the most part, the collapse of the Greek economy.  His was one of the few coherent, well-argued and instructive contributions (though I suspected at the time that our politics don't quite match, which they don't). It's worth watching this show for.

I don't agree with a lot of the Modest Proposal (though not the 90% I hastily told Dimitris over Twitter), and I'll explain why. Most of this is due to my politics; the arguments I offer are as good as I can come up with but as with most argumentation they are only a front for my gut reaction. I am happy to be proven wrong though so comments are welcome. Please make sure you've read the Proposal first.

First of all, here's what we can agree on.

I agree with the MP that the Sovereign crisis in Europe requires a comprehensive solution that includes dealing with the undercapitalised banks. I hint at this here, noting also that European leaders will put this off until sovereign jitters reach a hardcore Eurozone member such as France. France is to the sovereign debt crisis what iron is to solar death; the point past which the shit can't be packed any tighter and the whole thing goes supernova. Hopefully I'll be proven wrong and a solution will be given much sooner than that but stupidity is endemic in the corridors of power.

I agree that any solution that does not involve a) serious stress tests (see here) and b) serious haircuts is untenable, even in the fairly short term. Serious stress tests involve the banking book as well as the trading book and in fact I'd like a stress test that simply takes Greek default for granted. How will the markets argue with that?

I agree that netting off bank-sovereign exposures is particularly important as the endless bank-sovereign loop creates incredible potential for contagion. (Trading probably exacerbates this; just think: you can approximate a portfolio of German bank shares with one of Greek bank shares and Greek sovereign CDS and vice versa). I would support netting off even if no other part of the MP is considered.

I agree that Eurozone members should not be asked to provide further bailouts out of taxpayer funds because this will strain whatever goodwill is left towards deficit countries, and that bond buybacks by the ECB will not work. [For some reason this post was deleted; I don't know what happened there but I've now got it back on the blog with the right time and date, too. What would I do without Google Cache?]

I also agree that any good solution must ultimately destroy money. And if it must, then it's best to destroy the original impaired assets than to spare them and transfer the losses to some poor bastard who is not systemically important, i.e. the taxpayer. The MP proposes that, in return for tapping the ECB for liquidity without eligible collateral (under the old rules I take it?) the banks should be required to tear up some of the bonds that they hold. This means that the money supply is reduced, but not by very much since the bonds are heavily discounted by the market already. The only difference is that the bank needs to show a loss, which it might as well.

Now for the bits where I disagree with the Modest Proposal.

First, I think it overlooks just how easy it is for the banks to force the ECB to shelf the idea of bond-tearups or 'haircuts-for-liquidity'. Banks don't want to recognise losses; their optimal endgame is a massive global guarantee that keeps the nominal value of their assets constant for the 7 or so years it will take for the world economy to grow into its balance sheet. It is the easiest thing in the world for them to collude together and decide to resist the ECB's charms just long enough to get it to change its rules - the equivalent of a child holding her breath after being refused a treat. The precedent of the ECB refraining from a scheduled tightening of its collateral rules in the wake of the Greek debt crisis will no doubt reinforce their intentions.

Worse, governments would be powerless to prevent this because a decrease in ECB funding tends to be seen as a victory for their banking systems and thus for themselves. Thus the politicians would not be able to rally public opinion quickly enough and would simply have to hammer out yet another seedy deal with the banks behind closed doors.

Second, I think it overlooks the damage it will do to the ECB's credibility and the damage that will in turn do to the European economy, even before we examine its effects on the ECB balance sheet. Central banks can MAKE MONEY OUT OF THIN AIR. This is the kind of power that needs to be held in check by chains and manacles of steel and probably a magical pentagram or force field of some sort. Why? Because the moment investors suspect that the central bank is pursuing an agenda other than the one prescribed by its charter, inflation expectations go through the roof. And inflation, my friends, causes riots. If the ECB comes under the kind of fire that the Fed is getting in the States the European member states will not back it up or take the blame; they will bury it and dance the Zimbabwean rain dance on its grave.

[LOL. Zimbabwean rain dance? That's racist. And ignorant.]

Third, the proposal that the ECB buy all Maastricht compliant debt off member states overlooks the damage this will do to the ECB's balance sheet, which is already bloated with, frankly, junk. The ECB has already had to tap member state central banks for capital since the crisis, and will have to do so again if its balance sheet expands further or if it is forced to recognise losses on all of this worthless paper. Current assets run to an amazing EUR1,940bn, nearly EUR2tn. The MP furthermore exposes the ECB to enormous interest rate risk as interest rates are bound to go up and thus its holdings of periphery debt at ultra-long maturities are going to take a serious pounding.

Similar arguments for the EFSF. The markets aren't stupid; they know who underwrites the EFSF and will therefore simply do a calculation of the entire Eurozone's solvency and proceed accordingly. The MP should really face up to the fact that the entire bloc may collectively be insolvent. Why won't anyone at least consider this?

Fourth, the MP overlooks the fact that most of the liabilities of member states are not actually captured by securities. Some contingent and implied liabilities can I suppose become explicit but not without all member states tapping the capital markets at once, which will cause chaos, but what of the liabilities implied by pensions or national insurance systems? What of the liabilities that have yet to arise, but which are nonetheless weighing on investor sentiment? If these are factored in, as this study shows, much of the Old Continent is insolvent even if the ECB and EFSF make the debt on its books disappear.

Incidentally, the MP makes no mention of what will happen to creditors that also *happen* to be crucially important pension funds. If this is not dealt with, the implications for social unrest could be substantial.

Fifth, the MP overlooks the fact that its solution will simply make investors wary of the EFSF's own bonds. If the member states don't mind this extreme alchemy to make their own debt go away, will they even think twice before doing the same ot the EFSF's creditors?

Finally, the MP does not address moral hazard. There is nothing in this proposal that will force Europe to consider the sustainability of its debt. In fact, we'll all pat each other on the back for outsmarting "the markets" and go on as before. Already in Greece the expectation (as I argue here) is forming that once we get rid of the Troika straitjacket all of the measures we've had to adopt so far to correct our structural government and current account deficits will just be revoked. I will concede to Prof. Varoufakis that individual public deficits will not matter with a deficit recycling mechanism in place. But it's worth noting that the aggregate deficit of the 'deficit countries' is not cancelled out by the aggregate surplus of the 'surplus countries'. The entire bloc is in (fiscal) deficit, and with record-low interest rates (if the MP succeeds) the bloc's collective debt will continue to grow, until the next crisis blows the whole sorry mess right back to the stone age.

People often grow tired of me as I explain this point, but perhaps I can interest you in another way. The following graph (source) shows that in the US indicators of man-made climate change are more closely correlated to total leverage in the economy (public and private) than they are to greenhouse gas concentrations. Debt is not just a financial obligation; it's indicative of our willingness to waste, to live beyond our (and the planet's) means; our willingness to kick the can down the road, to live large and send our grandkids the bill. Climate change is one consequence of this attitude; the fiscal crisis is another; ultimately until we learn better than this we will run into ever-bigger crises of one sort or another. Don't tempt fate by trying to invent free lunches. They tend to explode in your face like a Smurfs prank cake.

A solution that would get my vote would rely on bail-ins, not bailouts. In a bail-in, creditors who have lent to an insolvent borrower are forced to accept an equity stake in return for their debt holdings - they become part-owners, which means they now share the risk the earstwhile debtors have taken on. This too destroys money but does not force creditors to immediately recognise any losses as the nominal value of the equity is equal to that of the debt they gave up. Here's the catch for me: the sovereigns come into this as well, temporarily; in the great big roundtable of the great European Final Solution, it will briefly be possible for a bank to take an equity stake in a sovereign nation. Having converted all debt to creditors' equity, the netting off begins until there's only two types of stakes left: sovereigns' stakes in creditors and creditors' stakes in sovereigns.

The catch is that creditors cannot be allowed actual equity stakes in sovereigns at the end of the reshuffle. (Since people are asking, the reason is simple: the sovereign -the power of the state- can only be owned by the people. It's legally impossible for somebody, for instance, to buy the right to pass laws, levy tax and sanction the use of force in Greece). The EFSF comes in, swapping sovereigns' claims on itself against the banks' claims on sovereigns, so that it ends up being partly owned by those banks that were net creditors of sovereigns. The sovereigns are once again free of private sector ownership but do end up owning some banks (the ones that, after all debt has been netted and written off, are still undercapitalised), alongside the banks' erstwhile net creditors.

This doesn't provide a surplus recycling mechanism but then I don't actually want one. The member states never wanted one in past treaties, which is why they famously forbade the taking on of one member state's debt by another. We've now got around this but what could the intention of this proscription have been apart from the banning of bailouts?

Now the Federalists among us (don't know whether Varoufakis is one, to be fair, but many people encouraged by his views probably are) want to take advantage of the member states' desperation for cash in order to remake Europe as the superpower they were once promised they would be part of - a no-brainer if one grew up watching too much Voltron but otherwise one that deserves some scepticism and at the very least a referendum.

Don't worry; like Ireland you can ask us again and again, until we give you the 'right' answer, which will then of course be considered binding forever.

IF I WAZ A SAFE BET... PART TWO

I think the IMF is trying to give Ireland a hint. Or perhaps Greece. Or maybe their staff have too much time on their hands.

Remember about a month ago when I wrote about the effects of the 'investment-grade' premium on our spreads? The idea back then was that regaining the investment-grade glamour would push our spreads back down to barely-viable levels, although of course this was never going to happen.

More dedicated readers might also remember this analysis which I did a propos the Stiglitz "Leave Britney Greece alone!" article in the Guardian. (Readers less up to date with the cultural reference will probably have to read this).

As these readers will recall, I believe that the Stiglitz intervention marked the end of our sovereign period by rallying Greek pundits around the idea of a 'mild adjustment' and thus convincing the rest of the world that we were never going to get serious about the debt situation. Thanks MUPPET. I'll send you the bill in spilt guts.

Well this argument has now been made far more formally by the IMF's researchers, in a recently published analysis of what is called 'debt dilution'. Debt dilution basically works like this: if Greece owes say 100% of GDP and is running a huge deficit, a new creditor knows that the chances of being paid, let alone being paid out first, are diluted by the fact that there's going to be a long, growing queue of people waiting to be paid too, some of them our own citizens, and some nominally senior creditors like the IMF and the EU.

The authors simulate what would happen if we were to throw in a guarantee to compensate bondholders for any losses they suffer as a result of our bonds losing value due to dilution. This will of course never happen but it helps isolate the effects of dilution.

It turns out that, for the average sovereign, dilution accounts for 36% of the amount of nominal debt issued (because undilutable debt would be issued at better prices/lower yields) and an amazing 92% of the average spread. Let me put this another way. This would mean that Greece would pay an amazing 4.21% on its debt based on these spread figures. Btw the implied 74bp spread is not entirely fictitious; it is actually more than what we used to pay between 2002 and 2007 (although note these are spreads v. bunds, not T-bills as in the calculation above).

This should really serve to remind people of how stupid investors were back in those days. But it should also explain just why the balance in favour of default can tip so quickly. In our present state, where investors know not only that their chances of getting paid decrease with each penny we borrow but also that we would be genuinely better off defaulting, is it any surprise that the only people buying Greek debt are the ones who have no choice?

KILL... ME... KILL... MEEEEE...

The latest review of our stand-by arrangement by the IMF staff has come out and it is apocalyptically hilarious. The IMF still refuses to publicly accept its mission for what it is: to act as administrator as we negotiate our default. The suits introduce the show with the following remark:

“The economy has been evolving broadly as projected.”

Translation: Our original GDP forecast was only off by about one eighth. The Greek economy contracted by 4.5% in 2010 or 6.6% minus seasonal adjustments, against initial expectations of a 4% drop.  And we’ve reached our 2011 unemployment ‘target’ already, a year early.  

In their headline figures, the IMF have somehow managed to maintain the fiction of Greek debt/GDP stabilising by 2012. Riiiight. As always the background figures tell the unmassaged truth. Expressed as a percentage of government revenues (a more accurate measure of sustainability), debt will now peak at 392% in 2014, not at 343% in 2012 as previously believed.

With no additional measures put in place, the IMF expect our debt to simply never come down, exceeding 211% of GDP in their forecast scenario. Even better, with key variables at their long-term averages, debt will stick to 141% of GDP and pretty much stay there.

Not bad enough for you? Even with the current measures in place, the IMF concedes that if we consistently miss its growth targets by 1 percentage point, as shown below, Greece’s debt will never return to a downward trajectory. Last year, the IMF overestimated growth by .6 percentage points so things are on a knife’s edge; a statistically insignificant misstep away from oblivion, even with a perpetual IMF loan facility. Weisbrot reports that the IMF typically gets it wrong by much more than that. Almost half of all adjustment programme reports make adjustments of 3% or more. 

Another way of looking at this is to consider that 2010 GDP growth (-4.5%) came in at the very end of the range of estimates. This year’s lowest estimate is -4.1% (courtesy of the Economist Intelligence Unit, although Pireaus comes close at -4%, for those of you who don’t trust foreigners). The IMF’s projection is [drumroll] -3%. Checkmate.

Appropriately, the IMF makes some allowances for error in its scenarios. Under one of these, our debt will have exploded to 250% of GDP by 2019. Importantly, these downside risks (recognition of implicit liabilities, bank recapitalisation, lower growth, failure of reform, low inflation) are strongly correlated, so the combined adverse shock scenario is hardly an outlier. 

Even more amazing: the interest cost projections of the IMF assume a spread of 500bp against German bunds. This may be twice what the original plan projected but it’s almost half the actual figure. [Ed: ZOMFG this is the most PWNED figure in the history of IMF and Greek Gov’t muppetry. WTF?????] That such a crucial figure is so far wrong in black and white can only mean one thing – the IMF have given up and are just cooking the books.

Now I must concede that even with moderate success the Memorandum should bring spreads down somewhat. How far down though? As I explain here, we've lost the glamour of a safe bet, so our spreads can't go back to where they were before the crisis. With the same fundamentals they should be about one third higher at the very least. And we're insolvent, so unless we can perpetually find investors willing to flip our short-term debt to others and pray the musical chairs don't stop while they're still in the game, insolvency will at some point mean illiquidity.  

Actually I’ve got a theory about this stupid number. It’s the average of two states. State 1 is Greece as an independent but mostly bankrupt country, with spreads of 1000bps. State 2 is Greece as a German protectorate, without debt of its own, and therefore a spread of 0. Like one of the twisted souvlaki vendors of old, the IMF is serving us Schrödinger’s cat on a skewer. More to the point, it's entirely likely that with EFSF intervention our spreads could fall because German bonds will start to become junkier. The IMF will get their wish but we won't get cheaper debt. 

[Cue trivia point: everyone please look at the title of this paper]

But incredibly this LOLfest gets better.

‘In the banking system, deposit outflows have continued at a modest pace, and credit has begun to contract, but financial system stability has been preserved with the assistance of exceptional liquidity support from the ECB’

Translation: None of our banks would survive one day without the ECB, which provides 19.5% of the system’s funding. In fact in net terms the system can’t even lend any money. It only takes one badly written note allegedly forwarded by 10 nobodies to get deposits out of the system at the ‘modest pace’ of EUR200m in a couple of hours. Things are so bad that even the merger of two of our major banks cannot produce one creditworthy institution. And here’s the belly laugh : the IMF’s new projections anticipate EUR4bn less in bank recapitalisations over the next three years than the original plan! F*ck knows why, perhaps more wonder mergers like the Alpha NBG deal are meant to materialise somehow.

So when do we get to default? Under the IMF’s projections, our primary deficit is still on track to reach zero in 2012. Better start working on that debt audit.

All of this hot stuff comes hot on the heels of our latest Labour Force Survey (LFS) data, revealing that unemployment has rocketed to 14.2%. My favourite LFS metric is actually the % of the unemployed who received a job offer but turned it down. Because it’s not a headline unemployment figure there is very little incentive to game it and it’s indicative of much more than just labour supply and demand – including growth expectations and public sector jobs growth, as I explain here.

This figure is now 7.4%, less than half what it used to be in the good days of 2006 but still some way to go from zero. The closer it gets there, the more desperate the people will become. Other highlights include 17.4% unemployment in our worst-performing border region, and near-record differences in unemployment rates between graduates and school leavers as well as Greeks and foreigners. This kind of bifurcation bodes ill for everyone concerned.

Happy end of the world everyone!!!