Questions and Answers on the October 23 summit for the Euro Crisis

2011-10-19

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Lately I have been receiving many questions from my readers regarding various issues related to the next steps European leaders are about to make in the upcoming summit on October 23. I have found many of these questions worth answering in public. Below is a list of the questions I will be answering:

1. What are the main parameters of the new plan for Europe?
2. Greece will have its debt restructured. What does that imply?
3. What does it mean for the ordinary taxpayer to recapitalize banks?
4. The region’s bailout fund, the EFSF, will be ‘leveraged’ to expand its funding capacity. What about it?
5. Will Greece exit the euro?
6. Can Europe solve its problems?

1. What are the main parameters of the new plan for Europe?
The details remain to be announced after the summit. From the available information the new plan will be established on three pillars. First there will be a restructuring of the Greek debt. The so-called haircuts on private investors might reach as high as 50%. If this is a real debt reduction and not a rollover of the debt in the future it means that the debt of Greece will be cut in half. This is fundamentally different from what was the case of the July 21 summit’s decision for Greece. In that case the Private Sector Involvement (PSI) would ostensibly result in a 21% “haircut” for private creditors, when in fact it was an exchange of current bonds for bonds with longer maturities and the 21% was the discount in present value – in practice part of the debt would pass on to the future effectively not reducing the amount of the Greek sovereign debt. Now they are not talking about a rollover of current debt to the future, they are talking about reducing the total amount of debt by accepting that part of it will never be paid back.

The second pillar is a plan to recapitalize private banks. The exact form that plan will take remains to be seen. From what information is currently available it seems that it will be quite technical in the sense that it will first expect from national authorities to carry the task and if those are unable to do so, then the EFSF would step in to provide the necessary funds. Banks need to be recapitalized for two reasons. Namely to consolidated at least temporarily their troubled finances, second because a Greek debt restructuring will lead to considerable loses for many banks and will create a shock wave that needs to be contained to avoid unpleasant consequences.

Third is the expansion of the funding capacity of the EFSF, the region’s bail out fund. This will be done through a very technical process called ‘leverage’ that need not be explained here. The gist is that the EFSF will guarantee a portion of the debts of troubled countries (for now its main focus is Italy and Spain).

**2. Greece will have its debt restructured. What does that imply? **
There are two dimensions to the matter. The first is the purely national and has to do with what are the implications for Greece, while the second is the European and relates to the impact this will have on the rest of the eurozone. To a large extend those two overlap, yet for the sake of explanation will be treated separately.

The dimension of Greece first. If the restructuring is about reducing the total amount of Greece’s debt, then this means that the burdens will be reduced and future generations of Greeks will not have to bear the current immense costs. Of course this must not be seen as a gift to the Greek people, since it will be accompanied by draconian austerity and radical reforms in the economy that will aim to dismantle what is seen as a nexus of internal market rigidities. The debt reduction will come with immense pain for the people of the country so those local political powers who are deluded that the debt restructuring is only good news should think twice.

Now the European dimension. A restructuring of the Greek debt implies that private creditors, who are in their vast majority European banks, will have to accept loses which in many cases are unable to endure. In practical terms this suggests that many banks will run short of capital and will face the threat of closing operations. The case of Dexia is just the tip of the iceberg since the whole European banking system is deep in the hole, with many banks being in a zombie-like condition for years. That is partially why the plan will be accompanied by bank recapitalizations.

3. What does it mean for the ordinary taxpayer to recapitalize banks?
It means that governments will use taxpayer money to prevent banks from collapsing. For most people this is outrageous yet even though I also hate to say so, it is more than necessary since if banks are allowed to collapse then all the savings of everyday people who have been working hard for all their lives will be lost – and if savings are lost the resulting misery and the agony will be many times greater and much harder to bear.

Apart from the economic aspect of the matter which relates to prevent the entire system from collapsing, with catastrophic ramifications for everyone, there is a moral issue as well, that is summed up in the following question: Why should everyday people pay for the loses and the gambling of a small minority of bankers? I agree that this is morally wrong and that states should not indirectly support reckless spending by bailing out banks. But I am afraid to say that at the point we currently find our selves in we have no alternative. To satisfy this moral argument bank recapitalizations should be done in exchange for shares which practically means partial (or total in some cases) nationalization of private banks. For me this is the most realistic approach, that prevents the system from falling apart and that partially satisfies the popular demand for justice since buying shares means that the current governing boards will be replaced by people appointed by governments, to at least gain some control.

4. The region’s bailout fund, the EFSF, will be ‘leveraged’ to expand its funding capacity. What about it?
This is a very technical issue. To put it simply the EFSF will be modeled like a financial derivative, like an insurance that will guarantee a portion of the debts of Italy and Spain (those two countries are the main focus now). This will allow its funding capacity to be increased up to five times. In theory the EFSF will be able to provide funding to Italy and Spain for approximately two years during which policy-makers will have to come up with something else to deal with the underlining malignancies of the system. In other words this can only buy some extra time but cannot possibly solve the crisis.

As a sentimental agent I say that it will work since I do not even want to imagine what will happen if it fails, but as a rational agent I am afraid to admit that an issue of over-leverage cannot be dealt with a leveraged mechanism and hence the whole plan will eventually fall into jeopardy, since markets will know how to attack it.

For a quite technical analysis on the matter you may visit this article on Zero hedge.

5. Will Greece exit the euro?
The answer is “no”. There is absolutely no chance that Greece will exit the euro for economic and political reasons. The economic part relates to the fact that this would be disastrous for the Greek economy and for the rest of the euro area, while the political part has to do with the fact that such a decision will become a very bad precedent that will have serious implications on everyday political life in Europe, by hindering the sense of integrity that now exists. Greece will only exit the euro if the single currency collapses. There is no other way. The analysis as to why is this true has been provided in previous articles of mine and I highly recommend you have a look at 1) Currency union and Greek Euro Exit and 2) Exit of Greece from the euro is nonsense.

**6. Can Europe solve its problems? **
Yes of course, since the crisis in Europe is above all political. The complexity of European politics is what has made the crisis so severe. In my latest article titled The current economic and political situation in the Euro Area I documented the following parameters of the current political situation in the Euro Area:

The political situation:</p>

• Regardless of how cynical this might sound, the crisis is seen as a unique opportunity to push for the most radical reforms in countries that have been unwilling to implement the necessary changes over the last years/decades (the shock therapy approach). In practical terms, the immense pressures that arise from the prospect of default in Greece first and then in Portugal, Ireland, Italy and Spain give the power to the rest of the eurozone countries to use their economic support as an incentive to demand much needed reforms.
• Germany, Netherlands, Austria and Finland possess immense bargaining power over the rest of the countries, because of their much more favorable economic position. On the other hand countries like Italy and Spain, despite the fact that they are the 3rd and 4th largest economies of the euro do not even dare to think of speaking their mind as that could easily produce adverse effects in the markets, leading interest rates to new heights, making their position even worse.
• Because of their inability to make propositions, these two countries are trapped in a position where they cannot have any practical impact on political decisions and on the other hand must implement austerity measures that further worsen their economic situation by contracting their economy. Austerity needs to be implemented for the sake of showing compliance to the hard line of the surplus countries and for appeasing the markets, since inaction would be conceived as a sign of inability to deal with fiscal issues, again leading to uncertainty and unrest which would affect interest rates on sovereign bonds (see The ECB captivity and the Italian, Spanish and Belgian prisoners).
• Greece is treated in a way that causes excruciating pain to its society. The harsh treatment is used as a detterant to any other country, sending a clear message that reforms must take place to avoid the suffering Greece is forced to endure. It is crystal clear that the demands of the ‘troika’ from Athens go against any economic reasoning and even though most can agree that reforms are more than necessary no sensible person would offer her consent to the sort of austerity policies the troika’s officials put forward. The malignancies of the Greek economy-society-state are deep seated and need to be addressed in their totality. Yet this must be done in a way that does not kill the patient.

Europe can solve its problems but must finally choose to do so. I hope the above have provided sufficient answers to the questions of many people out there and have offered food for further thought as to what we should expect from now on.