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Saturday, May 19, 2012

Transcript: 502 Greece and Reality, with Ritholz, Roubini, Goodman v. Demand Side

How does Europe play out?


Debts that cannot be repaid will not be repaid, no matter how high you hike the interest rate.
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The country of Greece owes, say 360 billion euros, that's about 450 billion dollars, and there are eleven million people. What is that 32,000 euro per. Say $44,000. Shame on the Greeks, you say. Well, shame on the lenders.

Oh yeah, the federal deficit is maybe $15.7 trillion, a country of 311.5 million, mmmm, that's $50,315 per. We count things in percentages of GDP, though. And the US pays 1.2 percent, the Greeks north of 25 percent.


Gone are the mentions of how small the Greek economy is and how trivial a contribution to the European economy. Drifting in around the edges are mentions of the banks and their exposure. Austerity for banks? Perish the thought.


The Greek exit, other than at the fringe, such as with the bush-era ideologues like Brian Wesbury, who made it to idiot of the week this time, the Greek exit is now accepted. But what does it look like?


As we said many weeks ago, it looks like a bank run. It is testament to the Greeks' hopes for a rational outcome that there has not yet been a run. A jog now, I guess. But when the banks run out of money, they go to the ECB. When the ECB says no, we're not giving you liquidity, the Greeks are out. Banks collapse, all the bad stuff happens.

Does the Greek government plan a middle of the night conversion of euros to drachma? No. Does the EU eject them? No. Does the ECB cut them off? Yes. At least that's how we see it.


Could it be different? Will there be contagion to others? We'll take the second up in a moment after Ritholz and Goodman. For the Greeks, 360 billion euro, 11 million people, rollovers costing north of 25%. Austerity eating at the foundation of the economy. Citizens saving and hoarding against frightening uncertainty. The drumbeat from the market-first economies saying, "You need to starve your way to health."

Here are Ritholz and Goodman, edited as always, but not distorted.

I'm not buying it. Ritholz is rosy about exit, Goodman is rosy about the sturdiness of the euro. Sure, somebody could come in and micromanage an economy according to his or her own view of what is right or wrong. The micromanaging, however, would be done by the lenders on the debtors. There would be no reorganization of the Finnish economy or the German economy. It would be cut wages and benefits in Portugal, Ireland, Greece, Belgium. Therefore it is only austerity.

The problem is the debt. Maybe the audio is too thick, but it Goodman is essentially saying that competitiveness is near par and that with some so-called structural reforms, it could be made right. The problem is the debt. The divergences between the currencies, the so-called trade weight, is a measure of the capital flows. The deficits. Over time that has created the debt. When interest rates balloon, the carrying cost of that debt balloons.

If you look at Goodman's chart of his synthetic currencies, you'll see the Finns and the Germans have been exporting debt. The Italians have been financing their own debt. And the rest are borrowing. The Finns are absurdly undervalued. No wonder they're hardline.

A better look was presented by Nouriel Roubini, who has been so far out in front he has lapped the field. On project syndicate, he outlined the ways an orderly arrangement might proceed.


NEW YORK – The Greek euro tragedy is reaching its final act: it is clear that either this year or next, Greece is highly likely to default on its debt and exit the Eurozone.

Postponing the exit after the June election with a new government committed to a variant of the same failed policies (recessionary austerity and structural reforms) will not restore growth and competitiveness. Greece is stuck in a vicious cycle of insolvency, lost competitiveness, external deficits, and ever-deepening depression.

says Roubini. We should have made this clear. The program of restoring Greece to solvency involves first making them net income earners. Not happening. So we never get to the second step where they spend decades making the bankers whole.

Back to Roubini

The only way to stop it is to begin an orderly default and exit, coordinated and financed by the European Central Bank, the European Commission, and the International Monetary Fund (the “Troika”), that minimizes collateral damage to Greece and the rest of the Eurozone.

... all of the options that might restore competitiveness require real currency depreciation.
The first option, a sharp weakening of the euro, is unlikely, since Germany sees this as inflation and imprudence. The ECB, European Central Bank, as a child of the Bundesbank will never aggressively ease monetary policy.

Second, Greece could rapidly reduce unit labor costs. Not happening. They've already cut standards of living. The pension funds are fully invested in the government's debt. Would you – after seeing the disaster of the first three years of austerity – say, "Yes, give me more. I believe?"

It took Germany ten years to restore its competitiveness this way; Greece cannot remain in a depression for a decade.

Third, a rapid deflation in prices and wages, known as an “internal devaluation,” would lead to five years of ever-deepening depression.

None of those three options is feasible, says Roubini.

the only path left is to leave the Eurozone. A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth.

Of course, the process would be traumatic – and not just for Greece. The most significant problem would be capital losses for core Eurozone financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks, and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it “pesofied” its dollar debts. The United States did something similar in 1933, when it depreciated the dollar by 69% and abandoned the gold standard. A similar “drachmatization” of euro debts is necessary and unavoidable.

Losses that Eurozone banks would suffer would be manageable if the banks were properly and aggressively recapitalized. Avoiding a post-exit implosion of the Greek banking system, however, might require temporary measures, such as bank holidays and capital controls, to prevent a disorderly run on deposits. The European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) should carry out the necessary recapitalization of the Greek banks via direct capital injections. European taxpayers would effectively take over the Greek banking system, but this would be partial compensation for the losses imposed on creditors by drachmatization.

Greece would also have to restructure and reduce its public debt again. The Troika’s claims on Greece need not be reduced in face value, but their maturity would have to be lengthened by another decade, and the interest on it reduced. Further haircuts on private claims would also be needed, starting with a moratorium on interest payments.
Some argue that Greece’s real GDP would be much lower in an exit scenario than it would be during the hard slog of deflation. But that is logically flawed,

says Roubini.

We agree. And we see those who argue such a thing as often working for the banks.

More importantly, the exit path would restore growth right away, via nominal and real depreciation, avoiding a decade-long depression. And trade losses imposed on the Eurozone by the drachma depreciation would be modest, given that Greece accounts for only 2% of Eurozone GDP.

Reintroducing the drachma risks exchange-rate depreciation in excess of what is necessary to restore competitiveness, which would be inflationary and impose greater losses on drachmatized external debts. To minimize that risk, the Troika reserves currently devoted to the Greek bailout should be used to limit exchange-rate overshooting; capital controls would help, too.

Those who claim that contagion from a Greek exit would drag others into the crisis are also in denial. Other peripheral countries already have Greek-style problems ... Portugal, for example, may eventually have to restructure its debt and exit the euro. Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, without such liquidity support, a self-fulfilling run on Italian and Spanish public debt is likely.

Substantial new official resources of the IMF and ESM – and ECB liquidity – could then be used to ring-fence these countries, and banks elsewhere in the Eurozone's troubled periphery. Regardless of what Greece does, Eurozone banks now need to be rapidly recapitalized, which requires a new EU-wide program of direct capital injections.

The experience of Iceland and many emerging markets over the past 20 years shows that nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness, and growth. As in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.


Make no mistake: an orderly euro exit by Greece implies significant economic pain. But watching the slow, disorderly implosion of the Greek economy and society would be much worse.

Even Roubini is too rosy. Not that it wouldn't work. It just won't be tried. The politics are not there.

We remember the various calls for more political integration. But I'm not sure you would find political integration in the U.S., even, if New York, or Texas, or California were making rules for the rest of the country.

We recall Mundell's trilemma, the unholy trilemma, which posits that a country can have any two of these three: stable exchange rates, free capital flow, and domestic economic sovereignty. The Europeans chose stable exchange rates and free capital flows. It was a mistake. Now they need a period of capital restrictions as they change back to floating exchange rates and domestic sovereignty.

So, not too disjointed, we hope.

Oh, got to plug the book. We got word back from a publisher. Liked it. Pretty dense. And we need a bigger platform than the podcast. Good stuff, though. We enjoyed our conversation and were, I think, rightly encouraged. We're still shooting for June 1. Check it out at DemandSideBooks dot com. Still in review and comment, but there's lots of free sample there.

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