Andy Xie, our renowned Chinese economist shared his insights on the Europe’s Greece dilemma:
BEIJING ( Caixin Online ) — After failing to form a government after last month’s parliamentary election, Greece is redoing the poll on June 17. The market gyrates with every new survey result that may show the popularity rise or fall of the pro- and anti-euro parties. Even though Greece is small, the fear is that its exit may trigger bank runs in Spain and Italy. Until the election outcome is known, market volatility will remain.
The renewed crisis in Spain has its origin in how the European Central Bank (ECB) calmed the previous one. The ECB lent over 1 trillion euros ($1.26 trillion) over three years at 1% interest in two batches to the banks in the euro zone.
The big amount temporarily convinced the market that the euro zone banking system wouldn’t have liquidity problems. Hence, market pressure eased. However, the liquidity didn’t change the reality that the region’s banks were over-leveraged and very weak in capital.
Many, if not most, were technically bankrupt. When the market found out that weak Spanish banks used the money to buy its government debt, Spain’s relative recent calm was exposed as a sham, and turmoil followed.
Bank runs could precipitate the euro zone’s total collapse. Greek bank deposits have declined by 30% since the crisis began in 2009. There are signs that Spain is experiencing bank runs too. Its retail bank deposits declined by 32 billion euros in April.
When depositors want their savings in cash, banks cannot liquidate their assets to meet the withdrawals and must borrow from the ECB. If this process goes to the extreme, the ECB will be on the hook for all the liabilities of the banking systems, which means that the creditor countries in the north will become liable for all the bad loans in Spain’s banking system. Knowing these consequences, Germany would stop the ECB from lending more, which forces Spain and other countries to shut their banks, preventing people from withdrawing money.
The Spanish bailout
The euro zone has to bail out Spanish banks soon. Bankia, the largest government bank, asked for 19 billion euros in extra help, a move that precipitated the current round of panic. Spain’s banking system had exposure to the property sector of more than 100% of gross domestic product in 2009.
The country’s property market has since collapsed. From the experiences of other countries that have gone though burst property bubbles before, the losses to the Spanish banking system could be hundreds of billions of euros. The bond market won’t lend so much to the Spanish government. Outside help is necessary, which could exhaust all the bailout money that the euro zone countries have recently put together.
The Spanish banking problem is now at center of the crisis. It dwarfs Greece’s problems. Some euro zone countries are pushing for a European equivalent of America’s Federal Deposit Insurance Corporation, which guarantees deposits in U.S. banks and manages bank bankruptcies. However, is likely too late for such a mechanism to deal with the situation.
Italy is pushing euro bonds again. This allows troubled economies to borrow at German interest rates, which makes it possible for Spain to bail out its banking system. This is no different from borrowing directly from Germany.
So far, Germany is resisting. In the past, the euro zone has done just enough to calm the market. It is likely to be the same this time. I think that Germany may agree to use the current bailout money for Spain’s banking system. The amount is likely to be big enough to calm the market, but not enough to solve Spain’s crisis for good.
Greece may stay
I expected Greece to default two years ago. The last restructuring plan cut the nominal value of its debt by 50% and net present value, including the value impairment due to extending the repayment schedule and decreasing interest rates, by 70%. It is one of the biggest sovereign bankruptcies, through orderly, in recent memory. Apparently, the restructuring terms are not satisfactory to the Greek people, who voted for the parties that are against implementing the plan last month.
The June 17 election may not lead to a government, which would require another election. If the pro-euro parties are elected, the current crisis should ease for the time being. If anti-euro parties form the next government, I believe that they will renegotiate the terms of the restructuring plan, but not walk away from it. The cost of doing so is too high.
Greece has a primary deficit, i.e., it spends more, excluding debt services, than its revenue. Hence, if it walks away from the plan, it must print money to pay the difference, as no one would lend it money, including the Greek people.
Greek depositors have been taking money out of its banking system rapidly. They will accelerate the withdrawals if the new government makes its intention of pulling out of the euro known. Hence, when it is ready to print its old national currency, there may not be much bank deposits left to be converted into drachma. Without a bank deposit base, printing money quickly leads to hyperinflation. The government will certainly fall.
Greece still gets positive inflow, net of debt service, under the existing plan. It is trying to extract some more. It would be crazy to walk away from the aid because it wants more and loses everything.
Living with globalization
Globalization has dramatically narrowed the room to maneuver for nation states in managing their economies. The most important change is the declining correlation between the income of an individual and his or her surroundings. The income correlation between neighbors in different businesses may be lower than that between those in similar activities across the world.
Multinational companies have severed the relationship between supply and demand at a country level. It is not just about factory jobs anymore. Multinational companies can move office work easily around the world in today’s connected world.
Without the ability to control income, a nation state must control expenditure to match income. An economic trajectory that expands the divergence between the two will be punished by the financial market. Bailouts merely push out the inevitable adjustment.
Most prominent economists in the world believe in stimulus, especially when unemployment rates are so high: 8.2% in the United States and United Kingdom, 14.2% in Ireland, 21.7% in Greece and 24.3% in Spain.
Unemployed workers are an output gap. If governments throw in demand, they are employed at virtually no real cost because the government expenditure becomes someone’s wage. The multiplier on the expenditure of the employed workers will give the economy more benefit than the government expenditure.
The above line of thinking doesn’t take into account of the demand leakage due to globalization. The bigger the cost of misalignment, the more leakage. It is just difficult to hide structural problems through demand manipulation.
Currency adjustment could be an effective policy to realign a country’s cost to its competitiveness. The euro zone is in so much trouble partly because its member countries don’t have their own currencies. However, currency devaluation doesn’t work over time if it results in inflation and the real cost rises again. Most countries that resort to devaluation without structural reforms have suffered this fate.
Realigning competitiveness requires changing the cost of living to be effective. Housing, health care and education are non-tradable and comprise of about half of a typical family’s expenditure. When such costs are high, it is difficult to increase a country’s competitiveness through devaluation, as demand for wage increases is bound to happen with inflation.
Germany has been highly successful in containing the costs of all three in addition to its efforts at decreasing wages and increasing the retirement age. For developed economies Germany should be a role model for improving competitiveness.
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