Greece: Please Take More of the Medicine That Has Already Failed to Treat the Disease

With respect to the Greek sovereign debt situation, two statements reported this morning stand out.  First, Simon Tilford, chief economist at the Center for European Reform in London is quoted as saying: “The Greeks have been told to accept more of the medicine that has already failed to treat the disease.”  The consequence of this is that Greece has already entered a “death trap.” (http://www.nytimes.com/2011/06/23/world/europe/23greece.html?_r=1&hp)

The other statement deals with how the European banks will deal with some of the cost of a second bailout of Greece: “The trick will be for the private sector to take losses on Greek bonds, without Greece being declared in default.” (http://professional.wsj.com/article/SB10001424052702304657804576401471860518598.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The problem: “If the banks are forced to accept losses, ratings companies likely will declare a default.  Even if the banks act voluntarily, Greece could still be considered in default on some of its debts.” 

For more on this issue you might check the column by Satyajit Das in the Financial Times, “Final arbiter in Greek saga is an untested private body.”  Das is referring to something called the Determinations Committee, a group set up by the International Swaps and Derivatives Association.   This body may be the one that determines whether of not Greece goes into default or not.  (http://www.ft.com/intl/cms/s/0/95e3131a-9bf9-11e0-bef9-00144feabdc0.html#axzz1Q6N7EfJG)

Marty Feldstein, the Harvard economist, considers the dilemma facing European leaders: “If Greece were the only insolvent European country, it would be best if its default occurred now…But Greece is not alone in its insolvency and a default by Athens could trigger defaults by Portugal, Ireland and possibly Spain. (http://blogs.ft.com/the-a-list/2011/06/22/postponing-greeces-inevitable-default/)

Oh, oh!  The “I” word!

So, Greece is insolvent.  Portugal is insolvent.  Ireland is insolvent.  Possibly Spain is insolvent. 

And the European leaders are forcing Greece (and these other countries) to just continue taking more of the same medicine.

But, we can’t have insolvency squared or insolvency cubed?  Or, can we?

And the determination of whether or not a default takes place seems to depend upon a private organization that has never rated any debt before and must, it seems, determine what the definition of “is” is. 

This seems like a scene out of an old Peter Sellers movie!

This is nothing more than a Ponzi scheme being enacted by a bunch of comedic characters.  The Ponzi scheme: borrowing more and more money to pay the interest on the growing body of debt. 

This is the “death trap” mentioned above.

My belief is that the financial markets will be the final arbiter of this picture.  I believe that the “leaders” of Europe are creating a “risk-free” bet that many hedge funds and other investors with lots of money are waiting anxiously to exploit.  Governments seem to have a penchant for creating such “risk-free” bets.  Just ask George Soros.

Marty Feldstein has declared Greece insolvent.  So have a lot of other people. 

The financial markets will take care of this.

An aside about the situation in the United States: the Congressional Budget Office just released new projections for the federal budget.  In the new projections, the interest paid on United States debt will increase from around 2 percent of Gross Domestic Product in 2011 to over 9 percent in the year 2035. And, this is with relatively benign projections on interest rate movements. (http://professional.wsj.com/article/SB10001424052702304657804576401592689113956.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

Is this just another rendition of the “death trap”?

Economic Policy in the Decade of the Twenty-Tens: More of the Same

Happy New Year!

I have spent a good portion of the last week and a half reviewing my perception of the foundational philosophy undergirding the economic and financial policies of governments in the United States and Europe and I come to the same conclusion over and over again.

Governments in the United States and Europe and the people working in and for them have learned little or nothing over the past fifty years.

These governments are still united in their belief that continuing credit inflation is what their economies need. It is the policy that they plan on delivering. And, if troubles develop, then they just bail troubled institutions out and continue on their merry way. Europe, in the first quarter of 2011, seems to be headed for another round of this bail and run behavior.

The underlying rationale for this is that the leaders of these governments believe that every effort must be made to keep unemployment as low as possible for as long as possible by aggregate governmental actions.

These leaders are unwilling to accept the fact that their policies only make it harder for them to achieve their goal over time and just applying more and more stimulus to the economy will just make things worse.

It is not enough to see that, in the United States alone, underemployment has gone from around ten percent in the 1960s to about twenty-five percent now and that over these past fifty years the income distribution has become more and more skewed toward the higher income end of the spectrum.

The reasons for these results? First, you cannot keep putting people back in their legacy jobs by means of fiscal and monetary stimulus and expect them to maintain their productivity and job competitiveness in a fast changing world. Second, credit inflation can only be taken advantage of by the wealthier people in the country; the less wealthy in such an environment, even though they might be benefitted by it in the short run, lose out to the wealthier over the longer run.

Stock markets, of course, like this environment of credit inflation. Note the following measures of stock market performance. Here we have charted Bob Shiller’s CAPE measure (Cyclically Adjusted P/E Ratio) and Jim Tobin’s q ratio. These statistics, obviously, roughly measure

the exact same thing, whether or not the capital stock in the United States is over- or under-valued. In the 1960s and early 1970s equities seem to be overvalued as the period of credit inflation gets underway. In the late 1970s, of course, we get the period of extremely tight monetary policy aimed at thwarting the rapid acceleration taking place at the time. However, the 1980s revived the bias toward credit inflation, and, as can be seen, the stock markets seemed to take advantage of this policy stance as both measures never dropped below their long-term averages even through the “Great Recession” up to the present time.

This fifty year period was, of course, the time in which the financial sectors of the economy grew to become such a large proportion of the economy and it was the heyday of financial innovation.

It was not the less-wealthy part of the country that benefitted from this policy stance over this period of time.

If the current foundational policy stance of the government remains one of credit inflation similar to the one in place for the last fifty years then all we can expect is more of the same.

And, in my mind, there is no separating out Republicans or Democrats on this issue. Both have proven equally committed to the same policy stance (just using different words to justify it) and both seem to remain oblivious to the facts.

Also, in my mind, the amount of debt people carry matters, but many of our policymakers seem to believe that the existence of debt carries with it no consequences. In fact, the belief seems to be that the solution to the problem of too much debt outstanding is the creation of even more debt. And, if the amount of debt outstanding seems to be troublesome, well, then just let a central bank buy it.

I see nothing on the horizon to change my mind concerning the economic philosophy that serves as the foundation for policy making in the United States and Europe. Credit inflation remains the underlying stance of the economic policies of these governments for future.

Thus, we can expect, over the next decade, a continuation of the economic and financial environment of the last fifty years.

More on Europe's 'Trilemma'

The name of John Maynard Keynes became prominent once again with financial collapse beginning in 2008 and the “Great Recession” that followed. I would like to introduce his thinking once again to maybe put the idea of the “Trilemma” into a historical perspective.

Yesterday, I wrote of the idea of the “Trilemma” and how it applied to the current situation in Europe (see “Europe’s ‘Trilemma’, http://seekingalpha.com/article/204066-europe-s-trilemma). Today I would like to hold up an earlier example that I believe highlights the difficulties faced by the European Union in attempting to resolve the problems it now faces. The earlier example is that of the United States going off the gold standard in August 1971.

The basic economic framework the world worked within in the 1950s and 1960s was created at the Bretton Woods conference in July 1944. Essentially, the Bretton Woods system was a fully negotiated monetary order aimed at governing monetary relations between member nations. The conference included 730 delegates from all “allied” nations which numbered 44 at the time. Out of this conference grew the International Monetary Fund (IMF) and the body that became the World Bank. These latter organizations became operational in 1945.

Primary among the obligations flowing out of the Bretton Woods system was the obligation for each country to adopt an economic policy that would maintain a fixed exchange rate (within a range of plus or minus one percent) in terms of gold. The IMF would be used to bridge temporary imbalances in a country’s balance of payments.

Historically John Maynard Keynes came to dominate the discussions at Bretton Woods and the resulting agreement that was signed by the participants reflected many of his ideas, some of which he had been promoting for twenty years or so. For more on the role Keynes played in international financial discussions during the 1919 to 1945 period see the book by Donald Markwell titled “John Maynard Keynes and International Relations” (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell).

Keynes was very forceful in promoting two policies he felt were crucial for the peace of the post-World War II period: the first was fixed exchange rates; and the second was independence for nations to follow their own economic policies. What he did not want was international capital mobility. That is, capital flowing freely between countries.

The driving force behind these policies was the worker unrest that dominated Western Europe in the post-World War I period which, of course, included the Great Depression. Of great concern was the possibility that Western civilization, the culture that Keynes was prominent in, was under siege. The problem was the Russian Revolution and the fear of potential Bolshevik revolution throughout Europe in the 1920s and 1930s.

It was crucial to Keynes that governments kept workers “fully employed” and not allow their (nominal) wages to decline. To do this, governments had to adopt economic policies that promoted “full employment” and that were necessarily independent of other nations so that they could respond to their internal labor markets.

The way to achieve the autonomy of the economic policy of governments was to fix the exchange rate of the currency.

But, there was a third part of the plan. The international movement of capital needed to be discouraged. Of course, at the time, gold was still an important aspect in the international movement of capital. Coming out of the experiences of the 1920s and 1930s there was grave concern that capital should remain inert, at best. A very lucid exposition of the existence of this attitude can be found in Liaquat Ahamed’s award winning book, “The Lords of Finance: The Bankers Who Broke the World” (http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s).

So, in line with the conclusions of the “Trilemma” argument, the post-World War II world implemented just two of the three policy goals. The Bretton Woods agreement created a world in which there were fixed exchange rates and autonomous national economic policies, but discouraged free international capital mobility.

The result: relative stability in the system during the 1950s when governments were generally conservative in terms of their monetary and fiscal affairs. However, in the 1960s, nations began to implement “Keynesian” type fiscal policies (note the “Keynesian” tax cut enacted by the Kennedy/Johnson administration) connected with a monetary policy stance that encouraged inflation (note the inflation/employment trade off in the popular economic model labeled the Phillips Curve). By 1968 or so, we Americans at least, were all “Keynesians” according to President Richard Nixon.

What occurred in the 1960s was the re-ignition of inflation and inflationary expectations as the Johnson administration pursued a fiscal policy that included both “guns and butter.” As inflation and inflationary expectations grew, financial innovation advanced as commercial banks became more international in scope and began raising funds throughout the world through the management of their liabilities. Note, for one, the development of the Eurodollar deposit.

International capital market mobility became a reality!

As a consequence, the Bretton Woods system could not hold. According to the “Trilemma” diagnosis, the world was trying to live with all three of the policy goals connected to the “Trilemma” and one of them had to go.

President Nixon believed that full employment was very important to him in terms of his re-election bid and so the autonomy of his administration’s economic policy could not be aborted. Furthermore, globalization was in its infancy and business and finance were pushing as hard as possible to keep international capital markets expanding. Hence, the fixed exchange rate had to go!

On August 15, 1971 President Nixon announced to the United States (and to the world) that America was going off the gold standard and the value of the dollar would be floated. The world was now different than it was before.

The basic reason I wanted to bring this episode to your attention was to provide some historical backing to the dilemma now facing the European Union. The “Trilemma” problem is relevant to what they are trying to achieve. Ignoring or assuming that Europe can overcome the conclusion reached in the “Trilemma” analysis is foolhardy. Therefore, we shall all be waiting to see how the European Union can resolve their dilemma. Enacting a bailout package is only a stopgap to dealing with the real issues the leaders of the EU face. The problem concerns the absence of real leadership in Europe!