Monday 28 November 2011

Poker isn't chess.

I have long assumed that the average German doesn't understand (and perhaps doesn't want to understand) how perilous their situation is. Bundeskanzlerin Merkel understands the depth of the crisis. And I was pretty sure the smart people in Germany do, too. But having read Nil's blog entry "Poker against Mrs. Merkel", I'm now not so sure they understand how close to collapse Germany's banks are. Don't worry if you haven't read Nil's article. It's isn't right, anyway. It isn't even wrong. It's simply so far off base that it's irrelevant.

It all started so innocuously. Portuguese, Irish and Spanish growth was kicked off by a regime of low interest rates in the eurozone, caused by the fragile state of the German, French and Italian economies (which really extended over most of the last two decades - in fact since reunification in the German case).

Seeing this growth, European financial institutions (primarily pension funds and banks) pumped money into these economies, so they could take part in the growth, and get their share of the gravy (to a large extent in housing, through mortgage lending). When those bubbles burst, investors were in a bad situation. They found themselves holding bonds that were unlikely to be paid off (most of these bonds were in mortgage lenders - banks). The biggest group of such bondholders were German financial institutions, and they came up with a plan that they took to Bundeskanzlerin Merkel, a plan that they hoped would save their bacon. Here was their plan:

Preamble 1. It would be a Bad Thing for the eurozone if any eurozone bank went bust. It would cause a crisis of confidence in the euro.

Preamble 2. Those banks (such as Anglo-Irish Bank in Ireland, or Caja de Ahorros Castilla La Mancha in Spain) are about to go bust, taking a large chunk of our profits with them, and possibly inducing a banking crisis in Germany, just as the shaky German recovery is finally gaining pace.

Rather than let them go bust, why don't we make this deal:

1. We lend these banks bucketloads of money that they could otherwise not get on the open market, saving them from bankruptcy, and protecting the euro from a crisis of confidence.

2. You guarantee our loans by getting the Irish, Portuguese and Spanish governments to nationalize the bad banks, so that their citizens become liable to pay back the debt.

ReichsBundeskanzlerin Merkel thought about this proposal for a while and said, okay but you know, I've got a problem as well. Our Greek province is short of cash to pay its minions, and nobody will lend them any money. If you'll agree to fund Greece on the same basis, we'll agree to turn these bad bank bonds you own into sovereign debt.

"It's a deal!" squealed the German bankers, delightedly.

For a while everybody thought that it was the greatest idea since the atomic theory, and all the smartypants German bankers thought themselves too smart for their pants, lending money to stupid PIGS at high interest rates, so they'd have the money to pay the German bankers back what they'd lent them earlier at high interest rates! But then the Law of Unintended Consequences kicked in.

First, the Greeks looked at those smart German bankers and thought "what stupid bankers they are! We already can't pay our debts, so they want us to take on more debt! If we can't pay our small debt, what makes them think we're going to pay a bigger one back?" So the Greeks thanked the Germans for their cash, widened the letter-box a little in case the Germans wanted to shovel some more money into it, and carried on with their original plan, which was to default on their sovereign debt.

"But, but...", spluttered the Germans, "you can't do that!", because they never dreamt of anybody doing such a thing, even though Greece is a serial defaulter and has a history of default.

Meanwhile the Irish and Portuguese were muttering to themselves about why they'd been asked to shoulder the private debt of stupid bankers addicted to gambling who'd put their savings (sorry, their customers' savings) on the wrong horse. The poor French, who'd agreed to go along with this whole sorry mess in the hope that Merkel knew what she was doing, refrained from telling her "I told you so", and instead just kept patting Ireland and Portugal on the head, saying "good boy, good boy". Ireland and Portugal are looking enviously at Greece.

Meantime, the Germans carry on pouring good money after bad in the hope that if they pour enough in, they can pay themselves back. When put baldly like this, it is obvious that it won't be paid back, and in fact it's a lot worse than this, because linked to this banking crisis is a general economic crisis.

Germans don't seem to realize how perilous their own situation is.