The free fall of Greece and the broken credit line

2012-07-23

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On July 17, 2012 the prolific economist Dr Yanis Varoufakis published an article with the ominous title “It is now official: The Eurozone’s monetary transmission system is broken”. Though the title itself conveys the message, I recommend reading his post to update your knowledge on the crippled European financial system.

After reading his article I left the following comment, which I shall hereby take the task of developing further:

Good reading. Given that the ongoing crisis has always been in part a financial crisis, it is no surprise that (extraordinary) monetary policy does not produce the desired effects. What we have witnessed in the course of this crisis, is that the ECB may only obfuscate the fact that an existential crisis has gripped the euro, by means of extra liquidity, which can only buy some additional time in the short-term. The point is that for as long as there is no determined response from EU leaders to stick by the euro, there is little the ECB can do on its own accord.</p>

As for interest rates, we must also bear in mind that they are at exorbitantly high levels for the individuals, because banks prefer the safer alternative of channeling any extra funds they have to perceived safe havens, i.e. core eurozone government bonds (e.g. German). Let alone the fact that “top quality” bonds are considered good collateral for the stress tests for capital adequacy they are now conducting…

With the confidence crisis in place, any monetary measure may only strengthen the downward pressure on the rates of core Eurozone economies, as banks will continue to rash to the perceived safe havens. This is a regime for further disintegration as the core countries have even less pressure to carry on with system-wide measures (why should they if they borrow at negative rates?), while the periphery continues to suffer from a dearth of liquidity which destroys the real economy.

A solution, if possible after all, will come from audacious political decisions (an implementation of the Modest Proposal perhaps), not from the ECB/Eurosystem…

Concerning the usurious interest rates that private banks are asking to furnish credit to individuals, I may say that it is not at all coincidental, as it is the outcome of a complex, interweaving web of causes. Three are, in my view, the primary causal sources of this phenomenon; all of which are directly related to the fact that Greek banks in particular have been severely hit from the ongoing depression in Greece, as they were the largest holders of Greek public debt.

1. The unbalanced Greek debt restructuring

The much-vaunted “haircut” on the Greek debt via the PSI programme, effectively wiped out 75% of the net present value of the amount held by private investors. Given that most private holders were in their majority domestic investors, i.e. Greek banks and pension funds, the disintegrating pressures on the Greek financial system have mounted ever since March 2012 when the restructuring was completed. The already undercapitalized banks saw their assets (bonds) lose their value even further in an unbalanced debt restructuring that protected among others the ECB from taking any losses, despite the fact that it had no seniority status in prior.

A bank without assets, or with assets of dubious quality, is practically bankrupt, especially when the economy in which it operates cannot accumulate any real savings that could otherwise provide a backstop.

In addition a private bank may only gain access to liquidity from the ECB/Eurosystem only after putting up some good quality collateral, which in practice means to present some “good quality” government bond. Alas, Greek bonds are nothing but junk paper and the ECB does not accept them as a safe asset any longer. The ECB has denied access to Greek banks forcing them to resort to the Greek National Central Bank instead, in order to draw liquidity at a higher price from the Emergency Liquidity Assistance (ELA).

Apart from the economic aspect, this entails a clear political message to the Greek government: to implement the memorandum they agreed upon or to continue laboring under extreme duress.

Politics aside, FT Alphaville notes the following on the ELA:

The Greek NCB – as well as other NCBs with ELAs – does not disclose which banks receive ELA funding, the cost of the facility or the exact amount provided. It also does not communicate its collateral requirements for tapping the facility, while the Eurosystem does not communicate the overall ceiling allocated to each country. This relative secrecy is widely criticised, but the ECB has mentioned that greater transparency could increase nervousness and further fuel market panic (which could reverberate on its own balance sheet‟s risk.)

What we should draw out of this quote, is that once a bank resorts to the ELA it has in effect admitted its stressful condition, which on its own account is a major source of concern for investors.

2. The perverse capital adequacy criteria

The very concept of capital adequacy traces its roots to governmental edicts, that on a global level are fleshed out in the Basel Accords. In practice it is a concerted action of the world’s largest central banks and important states, to force private banks to buy and hold government bonds (for further reading I highly recommend this article of economist Manos Schizas).

Ever since the Basel Accords were first implemented, private banks have practically strengthened and deepened their symbiotic relationship with their regulators, as on one hand the state needs a steady supply of credit to finance, inter alia, its chronic and often unnecessary deficits, while on the other private banks are forced to supply that credit in exchange for government bonds, so as to comply with the capital adequacy criteria (the perversions and cronyism that derive from this relationship are indeed numerous and far-reaching). Given that the Basel Accords calculate capital adequacy in a manner that considers top-rated sovereign bonds as assets with zero risk, a bank that can buy such bonds effectively increases its capital adequacy by decreasing the perceived risk on its balance sheet.

In practical terms a bank would be on the safe side, as far as regulations were concerned, by investing in government bonds rather than by carrying out the proper function of a financial intermediary that loans money to individuals and enterprises. These perverse capital requirements effectively rewarded recklessness and over-speculation by encouraging banks to invest in Collateralized Debt Obligations, Special Purpose Vehicles and other financial derivatives that were on many occasions based on such “creditworthy” collateral as sovereign bonds, in their incessant struggle to diminish their perceived risk (to meet the capital requirements).

The decision over which bonds were the ones to be seen as “top-quality” rested in the hands of the established Credit Rating Agencies, the other state-sponsored oligopolies of the hypertrophied crony capitalism of our times (see analysis on the truth about Credit Rating Agencies).

Thus when on the October 26, 2011 European Council meeting, EU leaders agreed to ask from European banks to raise their capital ratio from 8% to 9%, by June 30, 2012; they effectively demanded from private banks to cause a credit crunch, since the only way to raise capital in the midst of an ongoing recession and an environment of generalized uncertainty, is to decrease perceived risk, i.e. cut the supply of credit to the riskier real economy. Or in other words they expected from private banks to prefer buying government bonds than issuing credit to the ordinary businesspeople, since the former are considered less risky, while the latter are thought as highly uncertain investments, especially when there is a recession; since firms fail but states, with their monopoly of compulsion (taxation) never cease to exist by means of going bankrupt.

In effect governments had/have exacerbated an already severe crisis, by depriving the real economy from much needed liquidity. Governments used this neat trick to artificially lower their borrowing costs so as to refinance their debts/deficits by “crowding out”, or rather by strangling the private sector, so as to perpetuate more or less the same set of policies that brought us -and can only keep us- in this human-made morass.

3. The ongoing uncertainty in Greece and capital flight

It is well known that Greece is among the most ill administered and sclerotic states in Europe (the world). For example the index of the World Bank on Doing Business, ranks Greece as the 100th economy, below countries like Yemen, Vietnam, Zambia etc. To put it in a better perspective, Ireland ranks 9th, Portugal 30th, Spain 44th, Italy that also has the mafia problem is 87th; while Germany is 19th, France 29th, the Netherlands 31st, Latvia 21st, Estonia 24th and so on (see all data here). While this is not the only index that one needs to consider before evaluating the condition of a country, it nevertheless offers a clear picture of the desperate need for reforms in Greece, to rationalize and modernize the economy so as to attract much-needed foreign investment (and to repatriate the capital and facilitate new domestic investments).

Instead of reforms, the Greek political system and society have remained deeply divided over who is to bear the brunt of the blame for the crisis and of who is to cling on to the excessive privileges that were distributed in the years prior to the (eventual) downfall. For instance the second bailout programme, with all its flaws, was never really implemented since soon after it was signed Greece entered in a prolonged election period. Eventually the programme has been derailed as many targets were lost.

On top of that, European partners have rightly so lost their patience with the incompetent Greek politicians, as they themselves cannot possibly go back to their national parliaments to ask for more bailouts for Greece, just because the Greek politicians do not want to abide by the memoranda they agreed upon (whether they should have signed them or not is another issue). Thus there has long now been a discussion whether Greece will be forced out of the eurozone; which only exacerbates the existing problems, as it increases the uncertainty and the negative expectations.

People know, or expect, that an exit from the euro will wipe out the last vestiges of their savings, thus the “Grexit” rumors and scenaria have sustained a (silent) bank run which compounds the crisis in the already quasi-bankrupt banking system I mentioned earlier; while it simultaneously creates a self-fulfilling prophecy towards the exit from the euro zone.

At this point I must stress that if we were to blame the people for withdrawing their savings, or the banks for remaining reluctant to supply credit at affordable rates, we would be committing an egregious error, as we would be confusing cause and effect; while in the meantime we would be expounding on uneconomic, moralistic and atavistic concepts about the “patriotism” or other metaphysical attributes of individuals, or more so, the chimera of a “just” level of interest.

None of this would be correct. The reason this is happening is because of the incompetence of Greek politicians and the inability or unwillingness of EU leaders to provide a solid response to the ongoing existential crisis of the euro. In a nutshell the uncertainty in Greece is directly related to the overall sustainability of the single currency; and the euro will only be viable in the medium-term if the euro area evolves into a genuine federation, featuring a banking, fiscal and a political union (whether this will or can actually be achieved shall not be discussed within the context of this article).

Concluding remarks on the broken credit line and high interest rates

Due to the above three reasons interest rates in Greece remain exorbitantly high. If we understand that the interest rate reflects (1) the expectations and perceived risk, (2) the condition of the banks and the overall economy, (3) the time-preference of individuals; then we already know that what is happening in Greece is the expected outcome of the overall conditions, though it is indeed lamentable.

Moreover, because many macroeconomists might suggest that the remedy in such cases is for expansionary monetary policy or for the more subtle yet still fallacious claim of “higher inflation in Germany to ease the pressure on Greece”; I may rephrase what I noted in previous articles and in my comment to Dr Varoufakis’ post, that unless the overall institutional framework changes dramatically an increase in liquidity will only channel more funds to the perceived safe havens, such as Germany. This is a policy for total disaster over the medium-term as it will invigorate the dynamic of divergence between core and peripheral countries and will further strengthen the disincentives for reform by keeping interest rates for government bonds in the North at artificially low (negative) interest rates, at the expense of increased duress in the financial system of the South. All this will be reflected in even greater Target2 imbalances which will greatly increase the risk and costs of a euro breakup. The euro zone needs thoroughgoing reforms, not the dubious nostrums of macroeconomists who provide exhortations aloof from the fray.

Unless political leaders in the euro area agree on moving drastically towards a system-wide reformation of the euro zone, the ad hoc half-measures may only postpone the inevitable breakup at the cost of compounding the risks involved while providing the ideal excuse to propagandists and nationalists of various sorts.

It ultimately comes down to politicians in the North making fiscal transfers politically acceptable, while politicians in the South agreeing on stricter fiscal, banking and political rules that will effectively reduce their sovereignty. Tough decisions indeed.

In the meantime I regret to say that Greece has become largely irrelevant in the big picture because of internal and external factors, meaning that while an exit remains a suboptimal choice for everyone involved, it will no longer trigger the kind of chain reaction we would expect, say two years ago. For their part Greek politicians must strive for their best and must hope that their European partners can pull their selves together in a final and determined solution to the crisis, that will also benefit Greece.

I am not saying that all this will happen, but I am convinced that unless it does happen sooner rather than later, the euro will continue to disintegrate until there is nothing left but the empty shell of the laudable idea of a United Europe. I am of the view that the political costs for the federalization of the eurozone are significantly less than the costs of a breakup, since a disintegration of the euro area in present time will lead with mathematical accuracy to currency wars, protectionist measures, stringent migration policies etc. while it will most probably engender the “we-they” syndromes of those misanthropes who will seek to put the brunt of the blame on “the foreigners” just as they did in the 1930s’.

Picture Credit: Wikipedia