The not-so-original sin of finding others to pay for it.

Paul Krugman talks about the causes of the current sovereign default crisis in terms of what economists call "the original sin". The concept was developed to describe situations in which a country borrows in someone else's currency. When faced with a crisis, large devaluations of their exchange rates make the value of debt increase, which leads to default and possibly a deeper crisis. Krugman argues that a similar logic applies to Euro countries today: Italy has borrowed in a currency (Euro) that they do not control and this is a problem. If Italy had borrowed in their own currency they will always be a way out of a high debt situation: printing more Italian Liras.

Let me take a step back before I comment on how the "original sin" applies to Europe. What is a government default? Government debt is a result of spending decisions that have not been financed with tax revenues. If government debt is to be paid back it simply means that some future tax payers will pay for the spending done in previous years. If debt is not paid back and government defaults, it is simply a shift in the burden of paying for the debt from current and future tax payers to someone else (bond holders). In that sense, default of a government has nothing to do with default of a company where we tend to think about a failure of a business model. It is simply about finding someone else to pay for our spending, not tax payers.

But who else will pay for it? In a closed economy (no international trade or capital flows, think about the world), it is not obvious to find "others" who will pay for our spending. You can shift the burden from tax payers to bond holders but in a closed economy both are citizens of your country, in some cases they are the same individuals. No economy is closed but some do not look far from this example. Below is a chart comparing Greece and Japan in terms of who holds their government debt (domestic versus foreign investors).

In the case of Japan, most of the Japanese government debt is held by Japanese citizens. If the government of Japan defaults it is equivalent to sending a tax bill to only bond holders. But they are Japanese tax payers so there is very little difference between default and taxes, there is no choice! I am, of course, simplifying what is a more complex situation: not every tax payer in Japan has an amount of government bonds which is proportional to their income and Japan is an open economy but to a large extent we are talking about a redistribution decision. The comparison to Greece is a good way to understand that the trade offs and consequences of a decision to default are not the same for Greece. Greece can potentially pass the burden to others (foreigners) who are currently holding its debt.

Back to the "original sin" discussion. When a government borrows in its own currency, there is a third alternative to taxes and default: printing money. Conceptually, it not different from the other two: you need to grab someone else's resources. Printing money leads to seignorage via inflation and  this is an alternative source of income that can be seen as a tax on those whose assets are denominated in nominal terms. Some of these individuals are also tax payers, some are the ones who are currently holding your bonds, so you might be passing the bill to the same people but in different proportions (as in the Japanese example).

At the end of the day, default, taxes or seignorage are three ways to pay for the spending governments have already done. They are not that different conceptually. In a closed system there is no way to avoid grabbing resources from your own citizens - in some sense deciding between the three choices is simply a redistribution decision. In an open economy you might be able to grab resources from other countries by defaulting on debt held by foreigners. Although conceptually similar, each of the three methods differ in terms of the political consequences or even feasibility. Passing the bill to foreigners will tend to be easier from a political point of view although it will have more damaging effects in terms of credibility. In some countries raising taxes is more feasible than creating inflation. In other cases it will be the other way around. From an economic point of view it might be that the same individuals end up paying the bill but sending them a bill in a different format or color just happens to be easier.

Antonio Fatás

Italy: not good but we have seen this before

It is hard to find much optimism by looking at the Italian economy today: Low growth, high government debt, limited confidence of financial markets and no government. Pick a random newspaper or economics blog today and the tone will be on a range from mildly pessimistic to catastrophic. I will not repeat their arguments and instead I will do my best to be a contrarian and argue that maybe it is not as bad as it looks. Or maybe it is, but Italy has managed to live with such a bad situation for years so there is some hope. This might not be enough to turn you into an optimistic but at least it provides a perspective to how similar episodes ended.

Below is the Italian government debt expressed as % of GDP. There are two lines, the gross and net values of government debt. Net debt is a more appropriate measure as it takes into account some of the financial assets that the Italian government owns and it is equivalent to what is referred to in the US as "government debt held by the public". I include gross debt as well because the "net" measure is noisy and some times unreliable so some prefer to focus on gross debt. 

When we look at gross debt we see that Italy is now back to where it was in 1994. If we focus on net debt the current level of debt is significantly below what it was in 1994. So Italy has seen similar or higher levels of debt before.

We can then argue that those times were different, that Italy had its own currency (although it was heading towards the Euro) and that a combination of high inflation and fast growth allowed them to stabilize that high level of debt.

Certainly it was not growth what saved them. GDP growth in Italy has been low during this period of time: the average growth rate for the period 1994-2007 was 1.6%, clearly below the growth in other Euro countries (France grew at 2.6% and Spain at 3.6% during the same period of time).

What about interest rates? Maybe the government of Italy did not face the high interest rates that they face today? Below is a chart of the 10-year interest rate for Italian government bonds.

As it is clear from the chart, financial conditions back in 1994-1995 were extremely difficult for the Italian government with nominal interest rates as high as 12%. Much higher than the current levels of 6-7% that look as unsustainable. Of course, what matters is not nominal rates but real rates (what really matters is the difference between interest rates and growth but I do not have that chart ready in my computer). Below is a chart with real rates that confirms that interest rates today remain low compared to the ones faced by Italy in 1994-95.

Here is what I learn from the previous three charts. To my surprise, and the surprise of many, Italy has managed to sustain a very high level of debt even when facing high interest rates by generating large enough primary surpluses. And it has done so with a political environment that has been volatile and in some cases driven by very poor choices. Does it mean that they can keep going like this forever? No, there might be a sense of fatigue and maybe the end of what it looks like an unstable model. But, at the same time, it is interesting to see when we look back at history that a similar episode did not automatically  lead to default even with poor economic policy choices. And if you want to be even more optimistic, there is some hope that this crisis is not wasted and the future Italian government finds an even better way to manage a very difficult situation.

Antonio Fatás

Europe versus the US: Fight!

Comparing economic performance in Europe and the US is always interesting and in some cases controversial, especially when politics enters the debate. European politicians blamed the US for causing the 2008-09 crisis and now it is the turn of the US politicians to blame the Europeans for their inability to handle the sovereign crisis.

Jeff Frankel has a nice blog entry comparing the performance of Europe and the US today under the title "Who is screwing up more: Europe or the US?". Not easy to make that call.

Some of the European economic problems come from the bad performance of politicians. Given that Italy is at the center of the crisis today, one wonders how a former G7 member and an economy of around 2 trillion dollars has been under the direction of Silvio Berlusconi for so many years...

But given that this post is about the competition between Europe and the US, we can check how some of the large US states (similar in size to Italy) compare in this respect: California (about 2 trillion dollars) has been led by Arnold Schwarzenegger for years; and the current governor of Texas (an economy of about 1.3 trillion dollars) is Rick Perry - the one who cannot remember the three government agencies that he plans to close if he becomes president. In case you have not seen the video, here it is:



But there is hope: Berlusconi is on his way out and it looks as if Rick Perry will not be the next US president.

Antonio Fatás

Plan B for Europe: Do not Stare Into the Abyss.

Everyone is running out of hope regarding a solution for the economic problems in Europe. A change in government in Greece, the possibility of Berlusconi stepping down are not enough to bring confidence to markets or the public. In the Econ Blogosphere we only see increasing pessimism: Mark Thoma, Barry Eichengreen, Paul Krugman, and many others.

Tim Duy makes the point that so far stock markets, in particular, Wall Street is ignoring the risks that are building in Europe. He draws an analogy to what was going on in 2007 when stock markets were still booming and ignoring the fact that we were literally looking into the abyss but we could not see it. He believes that today Europe is unable to see the abyss ahead of them and Wall Street is ignoring the problem assuming that it will not hit the US.

But what does the abyss looked like in 2007? In 2007 we had built a set of imbalances on asset prices, in particular housing prices that had supported a different imbalance, on spending and debt (private and or public). While some did not want to see the abyss, those who saw it were looking into a fall in asset prices, financial disruption and a sharp fall in economic activity. 

What does the abyss look like today for Europe? We know with certainty that there will be partial default in Greece, but as I have argued before this does not qualify as an abyss (for Europe). It is a bump on the road, maybe a big one but not large enough to justify a deep recession in the Euro area. The fear is about others following, in particular Italy and Spain. But here is where the 2011 abyss looks very different from the 2007 one: this time the crisis is much more linked to confidence. In 2007 the adjustment in asset prices was unavoidable. Today, we debate about whether the Italian government or the Spanish government are solvent and the answer is much less clear. Why? Because solvency depends on confidence and confidence depends on how we see solvency. If Italy keep losing the confidence of markets, as it is happening today, then they are insolvent, too big to fail but too big to be rescued. 

So if we keep staring at the abyss, we are just making it deeper. And the deeper the abyss is, the more we want to stare into it. 

So the solution is to stop staring into the abyss. Given where we are today there is only one way to do that, to have the ECB taking a very aggressive stance on how they are willing to support the governments of Italy or Spain if their interest rates keep increasing. Communication from European governments, over stretching the EFSF is not going to be enough anymore, you need the ECB to stand between us and the abyss so that we stop staring into it.

Antonio Fatás

It is not Greece, it is Fear.

I made this point before when I discussed the exposure of a French bank (Societe Generale) to Greek debt  in comparison to other losses such as the loss that a single trader (Jerome Kerviel) caused to that bank back in January 2008.

Today I see that Societe Generale released the results of the third quarter of 2011 and that comparison has become even more interesting. In a balance sheet of about EUR 650 bn, exposure to Greek government debt is as low as EUR 575m. Exposure to the government debt of Ireland, Portugal, Spain, Greece and Italy combined is "only" EUR 3.4bn. This combined amount remains below the loss caused by Kerviel back in 2008 (about EUR 4.9 bn).

(Note: there is nothing specific about Societe Generale in this analysis. I just picked it up as an example of a large French bank. I assume that others look similar.)

Antonio Fatás

Politics: the beginning and the end of the Euro

As much as economists have been wondering for years about the economic benefits and costs of sharing a currency, such as the Euro, the decision to create the Euro area and to be one of its members has always been a political one. As an academic, I have written about the costs and benefits of sharing a currency and my work has led me to the belief that, in the case of the Euro, the benefits outweigh the costs. When I have had an occasion to present my work in this area to those in charge of making the decision (politicians) I always realized that economic arguments matter very little when there are political constraints.

As an anecdote, back in January 2010 I wrote a chapter for a book about the 10 year anniversary of the Euro and the lessons for countries such as Sweden that stayed out of the Euro area. Anders Borg (Swedish Finance Minister) was in charge of commenting on our book and he made it very clear that from the point of view of economics there was no doubt that Sweden belongs in the Euro area but that we need to wait for the "right timing" (a similar position, although less explicit, is held by the UK government with their entry tests). And the right timing is decided on political grounds and not so much on economics. Given the current Euro crisis, it is likely that the timing of entry of any of these countries has just moved into the very distant future...

The countries that are part of the Euro area joined under different political agendas. There is the core (France, Germany) who has been driving European integration through the years (for reasons linked to the end of WWII). There is the periphery (Greece, Spain) who wanted to be like the core. With relatively low income per capita, their societies aspired to converge not only in terms of development but also from an institutional point of view to the levels of the rich Euro partners. And this was the reason why these countries supported every step of European integration, including membership to the Euro area.

And now are looking at the possibility of exit. In the last months, when I have been asked whether Euro exit was a possibility I have always said that it would be economic suicide for any country to leave the Euro area. But economic and political incentives are not always aligned and I have also argued that I could imagine a country leaving the Euro area if the political dynamics of the country produce a potential referendum where the question of Euro membership is simply read as "us versus them". In that environment you could imagine a country leaving the Euro area simply because its citizens have lost faith in the European project and the other countries are seen as enemies not allies. This has happened in recent times in Europe, where a referendum (about the Maastricht Treaty or the European constitution) was turned down in several countries and the only thing the European politicians could do is to repeat the referendum over and over again until it was approved...

Today the Greek government has surprised other Euro members and financial markets announcing a referendum on the last Euro bailout plan. This can be the end of the Euro, at least in some countries. Given the difficult economic situation in Greece and Europe, a "No" vote is not just possible but very likely. And while the vote will be just on the details of the plan, it will be seen as a referendum on the Euro. And this time there will be no second chance to repeat the vote if we do not like the outcome. And my fear is that just the announcement of a vote and the anticipation of that scenario might lead to a crisis months before the referendum takes place.

Antonio Fatás

Being pessimistic to build optimism

The new European plan to deal with the potential of sovereign default and the increasing doubts about solvency of financial institutions was announced two days ago. Financial markets so far seem to like the plan. The plan did not provide many surprises, it was very much what was expected. Maybe the surprise, to some, is that there was an agreement on the plan.

One issue that was debated in the preparation of the plan is how to account for potential losses derived from default on sovereign debt when doing stress tests on banks.

But here is a problem: European governments want to send two messages:

1. No default will ever take place in Italy or Spain.

2. Financial institutions are safe, they have enough capital.

But how do you build a capital buffer for banks that convinces markets? By being pessimistic and consider scenarios where things really go wrong. When doing this exercise there is a big difference between losses on sovereign debt and losses on other loans. For other loans one can imagine different macroeconomic scenarios where housing prices or GDP are more or less affected and this leads to a certain % of loans going bad. The disagreement can be on how pessimistic you want to be but conceptually we all understand how the different scenarios are being built.

When it comes to sovereign debt, there is something much more problematic. Will governments default? According to market prices there is a significant probability of default by several European governments. According to European governments this will never happen. But we heard that before about Greece...

In the current situation, whom you believe is going to determine the fate of some of these governments. If market participants believe Italy or Spain will default then their interest rates will keep increasing and those two governments will not be able to sustain their current debt levels. But if there is trust and interest rates remain low, they have a higher chance of surviving. Expectations are key and both outcomes are possible. If we all become pessimistic we end up in a self-fulfilling crisis.

Being pessimistic when doing stress tests on financial institutions is a way to generate confidence. We build a capital buffer that is large enough to deal with any possible crisis. But if you send a pessimistic message about sovereign debt then you cannot achieve the first goal! How do you strike a balance?  This is what the Europeans have done: they have built a capital buffer to deal with potential loses derived from default by Spain or Italy. But then they turn around and they tell us that this buffer should not be seen as a validation of the assumption that these countries will default because they will not!

In the words of the EBA (European Banking Authority):

"The objective of the capital exercise is to create an exceptional and temporary capital buffer to address current market concerns over sovereign risk. This buffer would explicitly not be designed to cover losses in sovereigns but to provide a reassurance to markets about banks’ ability to withstand a range of shocks and still maintain adequate capital."

So this buffer is not designed to cover losses in sovereigns but to provide reassurance to markets. This is a explicit statement that we are dealing with a crisis of confidence and we are trying to combine both optimism (about sovereign debt) with pessimism (when it comes to building a large enough capital buffer) in order to improve the confidence of markets. Not an easy exercise.

Antonio Fatás