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.


  1. Actually I agree with much of your post. In fact, our opinons don't even contradict each other. What needs to be done are three things.

    (1) First, we need to transfer money and risk from Northern Europe (most prominently Germany) to Southern Europe.

    (2) Second, we need to make sure that this isn't going to make Southern Europe spend as much as they did in last ten years, again. (Because, hello, it worked!)

    (3) Third we need to convince the electorate that this is the right thing to do.

    Along the way we will need to use the ECB and even the prospect at Eurobonds as well as already estabilished institutions like the ESFS.

    Right now Mrs. Merkel works to get point (2) going. As soon as it works we will move towards point (1).

    I am optimistig right now - and German shares, like almost all shares on the planet, will profit.

  2. Right there, point number 1! That's the problem. Germany wants to transfer money and risk to Greece. Their belief is that if they just charge a high enough interest rate, they'll have factored in the risk, and put it on the Greeks. However, the Greeks aren't going to pay it back, so the risk is all on the lenders. The lenders have already agreed that half of what they've already lent they'll never see again. What Mrs Merkel knows is that de facto they'll never see the other half again, either.

    Meanwhile the Irish, Portuguese and Spanish are asking why they've been forced by their "partners" to shoulder private banking debt. The real answer to that question is "because it's owed to German banks, and at the time, Bundeskanzlerin Merkel would rather Portuguese, Spanish and Irish citizens took the pain than the Germans". I think that with hindsight, she would not have done this if she'd realized the Greeks would default. We have a much bigger crisis now than just a few banks going bankrupt.

    So Ireland Portugal and Spain don't want a transfer of money and risk to them, they want a transfer away from them! They want to repatriate the banking debt to the bondholders who took the risk in the first place. As it stands at the moment, these bondholders took the risk of buying junk bonds in dodgy banks but for some reason Spanish, Portuguese and Irish citizens, who never entered into any contract with them, are expected to underwrite that risk, leaving only reward for the bondholders.

  3. The risk should (obviously) flow the other way. I wasn't clear enough, sorry.

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  5. I think we can agree on this:

    Southern Europe conned Northern Europe: They consumed while Northern Europe produced and they never intended to pay. At the same time Northern Europe conned Southern Europe: They created a workforce that *can* produce while Southern Europe didn't.

    What needs to happen is to create balance here. Whole Europe needs to start to produce AND consume. Anything else is not sustainable.

    To achieve this a simple bailout is not enough. The story would simply repeat itself. We need incentives for Southern Europe to not consume so much and at the same time produce more. Of course, we could also reduce how much Northern Europe produces, but then China would say thank you. The whole of Europe profits if the South becomes more competetive.

    Just sending money over there (directly/by printing it/by introducing Eurobonds) may be necessary in the short run, but it doesn't solve the long-term problem.

  6. Nils, I don't think we can agree on this, either. Greece conned Germany. They consumed and never intended to pay. Nobody but Germany truly believed they would pay.

    Germany conned Portugal, Spain and Ireland. They persuaded them to take bad banks into public ownership with the promise that Europe as a whole would shoulder the burden. In fact all that the eurozone partners did was to make sure the Portuguese, Irish and Spanish had access to loans. They did not take any portion of the debt, which was in the first place not Portuguese, Irish or Spanish sovereign debt at all. This latter move was to save German financiers from having to pay for their mistakes in lending money to these bad banks.

    Iceland did the right thing by simply defaulting. Greece is going to default, whether we like it or not. Spain, Portugal and Ireland should have just let those bad banks go bankrupt, never mind what Merkel might say. They can still repudiate those banking debt, which their citizens did not cause. This is an example of capitalists running to government and whining when they lose their bets: they always want to privatise profits and nationalise losses.

    Now it seems, from what you say, that many Germans thinks there is some north-south divide here, between lazy southerners and industrious northerners (there's a hint of racism in that). This is not the case. To see that, let me take a short diversion.

    The Euro itself has taken an important monetary instrument from the hands of natonal governments: setting interest rates, controlling the money supply and influencing exchange rates. Now the ECB is in charge of this. The result was that counties like Spain, whose economy was strong, much stronger than the German economy, found themselves tied to the currency and interest rates that the ECB set for the whole Eurozone. Those rates were set low to support the ailing German and French economies. Just when the Spanish government would have liked to have cooled their economies, back 5 and even 10 years ago, they found the ECB lighting a fire under them with low interest rates. When Spain should have been raising interest rates to cool their economy, the ECB was dropping them and fanning the flames.

    So it is ironic that you see "Southern Europe" as not able to produce. Spain has no such problems. Quite the reverse. The same is true of Ireland, whose growth rates from 1995-2005 were phenomenal, fanned again by cheap money from M. Trichet. And the money was cheap because "Northern Europe" (really Germany and France) couldn't get their economies out of first gear.