LETS TALK ABOUT OUR FUTURE.NOW! Because we shouldnt wait until the damage has been done.occupyfrankfurt.de/eurocrisis POWER TO THE PEOPLE
TABLE OF CONTENTS 2 3 S UM M ARY 4 C L A R I FI CAT I ON 5 A N A LYSI S 8 D ATA 1 2 D I A G RAM OF T HE E UROCRI SI S IN O NE S LIDE ! 1 3 EN D SCE N ARI OS 1 5 EX P L A N AT I ON S 2 8 S TA R T ASK I N G QUE ST I ON S…
SUMMARY 3The following review of the economic and ﬁscal situation of the Euro-zone attempts to make a realistic assessment.Our aim is to educate people about the importance of Europes current situation and to allow them to form their own opinion.This review does not represent the views or demands of the Occupy movement.It does, however, point to approaches that could be adopted via the grass-roots democratic process of the Occupy movement(for example, reform of the banking system, debt write-offs for Greece, Portugal, Ireland and more).This assessment also knowingly ignores the causes of the debt crisis and looks to the future. The damage has been done.Now the crucial question is how to undo it.Our conclusions are as follows: • The proposed policy of "muddling through" (the attempt to pay for old debts with new ones/ the "everything will be ok" mantra) conceals half the truth and neglects important aspects. • Politicians have missed several opportunities to address the root cause of the debt crisis (e.g. bank restructuring 2009/Greece haircut in 2010) so that only third- and fourth-best solutions are left to deal with a protracted crisis of historic proportions. • The entire world is looking to Germany for clear political and economic guidance of Europe. We are the only nation that has sufﬁcient amounts of money left. As a society we have to democratically debate on who we are, what our vision of Europe is and how we get there. This process involves all our opinions. • Policymakers do not recognize the complexity of and necessity for joint action. They listen to the representatives of big business and do not have the courage to engage in the dialogue with the population that is necessary to solve the crisis.
CLARIF ICATION 4We admit that our review does not paint a positive picture. BECAUSE Critics will say that this pessimistic view will contribute to a deterioration of the situation, because it will worry people (and the "markets") and thus reduce consumption… and theyre right.Economic cycles are subject to human decisions that are inﬂuenced by emotions andpsychology. The "animal spirits", as J. M. Keynes called the phenomenon – have the BUT !!!potential to reinforce a downward spiral. As Roosevelt summarized this relationshipin 1933, "The only thing we have to fear, is fear itself". However, the same critics will not mention what will happen if we continue as before, refusing to confront the problem, only buying more time with more debt, and failing to tell people the truth: in the course of the next one or two years we will be faced with a shambles that was once the European economic and ﬁnancial system. Have a look at the overview and explanatory texts and form your own opinion!If we all stand up now, stick together, are honest and show solidarity with one another throughout Germany and Europe,then we have the power to make difﬁcult decisions for coping with the crisis, so that we eventually will see the beginningof a sustainable economic recovery.
ANALY SIS 5W H AT I S TH E PROB LEM ?The debt burden is too high (periodic interest and redemption payments) in comparisonwith the real size and strength of the developed nations economies.W H AT E XACTLY I S DEBT?The concept of debt always involves two parties. The creditor (=lender) and the borrower. Debt is a claim on futurepayments from the borrower to the creditor. Within an economy there are many classic types of debt claims: S ov ereign bond ows Borrower Creditor Checking account n bond Bank Bank deposit Private household Sovereig Loan ! State Cre Many people are not aware, that they Corporate d it So Corporate bond indirectly own claims against the ver ﬁnancial eig governments, companies and foreign nb credit on countries via real mutual funds or d Company insurance contracts. Foreign StatesW H Y I S TH I S A PROBLEM?Debt in itself is not a negative thing. But, at a certain level of indebtness, the burden will hamper economic growth, because toomuch income is used up to service the debt rather than to invest. Once this threshold is reached, the high debt level can triggera downward spiral. "Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period,when bang!- conﬁdence collapses, lenders disappear, and a crisis hits." (The Endgame, page 97, J.Mauldin/J.Tepper citing Prof. C.Reinhart/ Prof. K.Rogoff (This time is different))
6NO R M AL CY CLE V S . VICIOU S CIRCLE Loss of conﬁdence impossible to forecast interest eco n ing improved economic o mi w rate rise cd c ups prospects/higher tax ow ntu o mi rn on revenues ec riskhigh amount debt burden vicious circle increases normal cycle premium of debt fall e c wn do o n tu om r c n i default interest creditor demand rate rise risk rises debt burden higher risk declines premiumHOW T O NOT S OLVE THE DEBT PROBLEM!To pay old debt claims borrow new money from someone else. This technique is called a Ponzi-Schemeand takes its name from the Italian Charles Ponzi († 18. Jan. 1949).Why doesnt it work?When all creditors want their money back at the same time (e.g. when they have reason to question the credibilityof the borrower) there is insufﬁcient money to cover those claims. The money cannot be paid back. As a consequence,the end result is a panic. Charles PonziExample: Madoff investment scandal: Mr. Madoff admitted to operating a P onzi -Scheme that is considered to be the largest ﬁnancial fraud in U.S. history
HOW TO SOLVE THE DEBT PROBLEM? 7 Too much debt Debt Cut Middle way Print a little bit of money and e.g. Russian Bankruptcy 1998 e.g. Merkozy 2011 use it to pay debt Ordinary insolvency proceeding e.g. US, UK 2011Release from debt burden but loss ECB prints money Inﬂation 2–5%for creditor. to buy Italian and Spanish debt risk risk Haircut on Greece and Portuguese Debt The pressure to print new moneyProblem: + Economic growth to support the economy does notLosses can be high and are concen- subside. Prices and income rise buttrated in the banking system. at some point prices rise much-> banking crisis and recession more than incomes. -> Inﬂation 20 –40% risk riskEverybody suffers from losses whichare very high.Downward spiral and deﬂation. Is that possible? -> Hyperinﬂatione.g. severe recession/Depression 1930 -> Currency reform -> Savers and the working class lose most
DATA 8HOW HI G H I S TH E DEBT BU RDEN IN EU R OP E ? ! Between 1970–2008, ~50% of all countries with a ratio of external debt to GNP equal to or lower than 60% have defaulted or restructered* ** DATA What matters is not only government debt, but also the level of private debt. Source: Debt Levels Alone Don’t Tell the Whole Story NYT, September 23, 2011* "This time is different", page 24, Prof. K.Reinhart/Prof. K.Rogoff** External Debt/GNP ratios are smalller compared to Total Debt/GDP ratios but in most cases are > 50% for developed nations
10ISNT AGGREGATE DEBT IN EUROPE LOWER THAN IN THE US?That is correct! Safety in Numbers BUT WHY IS THE PROBLEM IN One possible solution to the euro-zone debt crisis is for EU-wide bonds. The currency blocs overall debt ratio is less than that of the U.S. EUROPE SO ACUTE? Debt as a percentage of GDP, selected countries, 2010: Because the European countries suffer to a different degree from the disease called lack of competiveness… Greece 144.9 % Italy 118.4 Belgium 96.2 Ireland 94.9 Portugal 93.3 Germany 83.2 France 82.3 Austria 71.8 Netherlands 62.9 Spain 61.0 Finland 48.3 Euro-Zone avg. 85.4 U.S. 94.4 Source Eurostat …but cannot individually stimulate their respective economies via expansionary monetary policy or currency devaluation because these are not possible under the Maastricht-Treaty. The graph shows that these three countries Spain, Greece and Ireland, ideally, should have three different individual interest rate levels.
11HOW DOES THIS EFFECT ME? Abstract academic concepts such as high inﬂation and deﬂation have We discuss the real effects in what we call the possible future real and painful consequences for the daily lives of all of us and can scenarios that we think are realistic projections of the possible last for a period of several years. The problem is that our generation paths we could go through within the next three years. and the generation of our parents have no experience with this We name them provocatively: situation and dont expext them to recur during our lifetime. Again, arent we the people who are supposed to live in the prosperous a) everything is ok time of the great moderation in which the volatility of cyclical b) (hyper-)inﬂation business cycles has been smoothed away? Isnt the 21st century c) uncontrolled reset button different from the previous centuries because we are smarter and d) controlled reset button have been inventing new technologies?INTRODUCTION TO THE GRAPHIC The current graphic assumes that the new concept of the leveraged As you can see from graphic on page 10, the US has a higher debt efsf will be implemented. burden on aggregate than the Eurozone area. The Tea Party and Occupy Wall Street movements have been gaining political momen- Recent comments indicate that a leverage of more than 2–3x for tum because they are sceptical towards reckless debt-ponzi-systems. insurance-type guarantees of newly issued Spanish and Italian Do you think the people of the United States will accept having to government bonds has become less feasible. This seems to depend also pay for Europes self-made problems? on the scope of the efsfs additional responsibilities. Our current analysis works on the optimistic assumption that a 4–5x leverage is Please note that quantiﬁcations of bank recapitalization needs still possible. Despite this, the outcome of the analysis is perhaps can only be seen as guidelines. The real size depends on multiple not much more promising than assuming a lower leverage capability. factors. Estimates by experts vary by a wide range. Most recent proposals suggest the imf will play a more important role by backstopping Italy and Spain with its asset reserve. Ultimately, the risk of providing these funds will be born by its member states of which the US has the greatest weight.
Banks and Insurances Debit hair cut Ireland 40 % Portugal 40 % n e ur o / Greece Belgium 60–80 % 40 % 0b bad banks good banks 20 450bn euro ACTIONS AT PRESENT DECISION TO COMEEZBprinting money EFSF EU European Financial Stability Facility O R TA EF KE P AC 25 0b HO TI ON n eu ro x4 x 70% 30% MOR E R EFOR MS + 880bn euro Debt haircut B U Y B OND S / B U Y TI ME + WITH H EL P OF IMF Spain & Italy hope for generating Spain & Italy receive debt haircut Secondary market budget surplus and economic growth Euro-Bond + North-South Euro ? + EU harmonization + 3rd bank recap/Marshall-Plan + democratic integration + transfer union europe ˜ 500bn Euros? 40% No US recession 60% US recession 60% 40% US recession No US recession No EU recession EU recession EU recession No EU recession Spain+Italy recovery Spain+Italy no recovery Spain+Italy no recovery Spain+Italy recovery France: AAA France: AA France: AA France: AA 50% 50% 50% 50% 14% (HYPER-)INFLATION 14% "EVERYTHING IS OK" 51% UNCONTROLLED RESET BUTTON 21% CONTROLLED RESET BUTTON global currency reform 2013 3% global growth Severe recession (-5/-8% growth rate) Recession (-1/-5% growth rate) gold price: $4k–8k United States of Europe Attack on democracy from left and right New start finally possible
DESCRIBTION OF END SCENARIOS 13 14% "EVERYTHING IS OK" 14% (HYPER-)INFLATION 3% global growth global currency reform 2013 United States of Europe gold price: $4–8k a) "Everything is okay" — 14% b) (Hyper-) Inﬂation — 14% Business as usual. Please note that the severity of all other scenarios is The magnitude and the timing of inﬂation is difﬁcult to estimate. much more difﬁcult to estimate. Even experts vary in their assessment The stylized high inﬂation cycle exhibits higher income growth of downside scenarios. In the following we attempt to give a guideline. than price increases in the ﬁrst part but massive price accelerations in the second part that outpaces income growth by a large margin.Does printing money automatically mean high inﬂation? Inﬂation rates may be running in double digit rates as EVERY major global central bank is printing money. Politicians will promise toTheory 1: No (MORE POPULAR) reduce the money base but then again: Why do you think they willPrinted money needs to ﬁnd its way into the economy before it creates hold their promise if they have not been courageous enough toinﬂation. If money parks on the balance sheet of commercial banks it enforce the Maastricht treaty budget laws in the past?does not enter the blood circulation -> (no inﬂation) A new global monetary system will be coordinated from a centralProblem: If the economy does recover, the money will re-enter the institution such as the imf. The structure of the imf in the future willblood circulation VERY quickly. Politicians and central bankers will fear be different from the current structure. The bric countries will accounta withdrawal of money might slow the economy. Therefore, the money for signiﬁcantly more voting rights. A new global monetary system willwill ultimately enter the real economy and cause high inﬂation rates. need an anchor of value. This is likely to be gold metal more than anything else. The main argument for using gold is the mere fact thatTheory 2: Yes is has a proven track record of credibly backing monetary base systemsAssumption: There is the base money (called M0). In addition, a lot of in the past. Gold could be trading anywhere in the range 4000–8000$.consumption is ﬁnanced by borrowed money, i.e. credit. The build up ofcredit claims exceeds the build up of base money. Towards the end of the The effect of inﬂation:debt cycle, the credit claims need to be settled via conversion into cash (M0).Since M0 is scarce only two possibilities remain: Savers who do NOT own real assets such as commodities, machinery,a) M0 will be signiﬁcantly increased (Inﬂation) precious metals, art, diamonds, etc. will lose tremendously.b) M0 remains the same and deﬂationary pressures rise as Employees will lose because they have few real assets and their everybody tries to convert assets into cash income grows more slowly than the price level.
DESCRIBTION OF END SCENARIOS 14 51% UNCONTROLLED RESET BUTTON 21% CONTROLLED RESET BUTTON Severe recession (-5/-8% growth rate) Recession (-1/-5% growth rate) Attack on democracy from left and right New start ﬁnally possible c) Uncontrolled reset button d) Controlled reset button The uncontrolled reset buttom is the worst possible outcome. While this scenario will also start with a severe recession, It can take various forms but the main characteristic is that the prospects for mid-term growth are much better. The reduction the process of debt deﬂation will run its course while politicians of absolute debt burdens will make economies more resilient to fail to develop a well-thought-out plan to deal with this process. negative shocks. Citizens and investors at some point will realize The risk is that negative developments will not be anticipated that lower debt burdens lower long-term uncertainty and can be by the consumer and investor. The abrupt adoption of reality a very powerful tool to combat the debt deﬂation process. has the potential to cause an economic standstill similar to the situation in 2008. This relationship is highlighted in the graphic by the fact, that even if an EU recession follows the debt restructuring of Italy & Spain, The euro zone area is likely to break up. A development like the there remains a 50% chance that the economies wont break down. Great Depression cannot be ruled out. Although many macro factors Unemployment will rise in the short term. have improved structually since the Great Depression, there remain signiﬁcant risks globally. Chinas growth has been ﬁnanced A haircut for Spain and Italy will cause further losses in the European by cyclical investments rather than consumption. The debt/gdp- bank and insurance system. Transparency is required to ensure ratio In Japan is approximatelly 200%. Those risks have the potential that losses are distributely evenly within the system as far as regulatory to slow global trade. Unemployment rates will increase globally, control and monitoring system allow for it. social welfare systems will come under pressure. France and Germany could be part of a Northern European currency Depending on the magnitude of income inequality in each country, union which should be intermediate in nature. social unrest will increase. Parties on the extreme ends of the political spectrum will become more powerful.
15THE ECB printing money Can the ecb go bankrupt? The ecb is allowed to purchase Spanish and Italian sovereign bonds Given that the ecb continues to buy assets with default risk, in the secondary market through the Security Market Purchase can the ecb go bankrupt? It depends on the angle from which programme (smp). As the ecb purchases the bonds it increases the you look at it and the answer to this is a political decision. size and the riskiness of its balance sheet. The transaction is not in accordance with the original Maastricht Treaty. This is why the smp Yes: is currently limited in size. Like any private bank, the ecb can suffer losses if its assets decline in value to such an extent that the banks equity capital is zero. The ecb has government bonds on the asset side of the balance In this case, the member states have to inject new capital according sheet. The liability side is made up of currency (the physical bank to their proportional share. notes and coins) and bank reserves that commercial banks hold at the central bank. The structure of the government bond assets No: should represent the weighting of the proportional size of each The ecb could use the printing press it has in its basement. The member state (gdp data/citizens). The execution of the smp amount of newly printed Euros represents fresh new equity capital. programme has skewed the asset mix towards riskier bonds from the Southern European area. The ecb is a private entity which is owned by the individual As pointed out above, Germany is the only country which has enough European national central banks which also appoint members money to help the Eurozone buy time. In reality this means that it to the central body, the ecb Governing Council. is Germany who, to the greatest extent, decides what the ecb will do. The ecb has no authority to print money. Article 123 of the German politicians promised their citizens before the introduction Treaty on the Functioning of the European Union does not allow of the Euro that Germanys post war hard monetary policy would not the ecb to provide central governments with credit facilities. be sacriﬁed. If our politicians decide that the ecb will be allowed to print, the ecb will have money to BUY TIME, but we will have passed the last milestone on the way to high inﬂation. From now on, the full control of inﬂation rates is no longer in our hands (see page 13).
16463bn EFSF European Financial Stability Facility E u ro p e a n Fin an cial S tability Facilit y (efs f) We assume that Greece, Ireland, Portugal and presumably Belgium The Graphic on page 20 highlights this point. Assuming a certain will default in 2012 on their sovereign bonds and will receive a haircut. recovery value for Spanish/Italian debt, the potential loss for an investor might be less if he can buy oustanding bonds at very In this case we consider the main objective of the efsf low prices even if they dont have a loss absorption guarantee. a) to guarantee newly issued Italian and Spanish government bonds This would likely cause a lack of demand for new bonds and would so that foreign investors will buy them in the primary market and lead to a failure of reﬁnancing. b) to provide funds for an adequate capitalisation of European banks. In order to prevent this constellation from happening, the ecb We neglect a description of additional objectives of the efsf since will make the old bonds less attractive by buying those bonds we consider them less relevant. Operational features are of interest in the (secondary) market and thereby pushing the prices of those because they determine the credibility of the structure. oustanding bonds higher. The basic concept of the e fsf. Why Leverage? As pointed out above, the main problem is that investors refuse to lend The original idea of the efsf was to guarantee losses up to the full Italy and Spain new money as their redemption payments come due: 100% should Italy or Spain default. Table xyz on page 23 shows that Italy and Spain are not able to reﬁnance their debt (see graphic page 18). a 450bn efsf (AAA guarantees) in this original idea would have only been able to guarantee 6 months of bond issues before the The efsf is an attempt to convince foreign investors to buy newly- guarantee amount would have been used up. Clearly too little time issued sovereign bonds of Italy and Spain in 2012, 2013 and perhaps for Italy and Spain to convince investors that sustainable reforms 2014. To achieve this objective the efsf guarantees that if Spain have been successfully implemented. In order to buy more time, or Italy default in the future, the ﬁrst 20% of the losses will be borne the compromise was to guarantee fewer losses per bond, which by the efsf. would permit guaranteeing more bonds and gaining more time. In order for the structure to succeed, the newly issued guaranteed The 4–5x leverage allows the efsf to guarantee a higher volume bonds (bonds are always issued at a price close to 100) need to of newly-issued bonds. The downside of this leverage is, that if Spain be attractive for investors. They are only attractive if the investor who and Italy default, the actual loss for the German/French taxpayer buys the new bonds (with a 20% loss guarantee) at a price of 100 (guarantees will turn into real cash payouts that will not come back) cannot lose more (if Spain/Italy default) than if they had bought the will be 4–5x higher and likely reach the full amount of 211bn Euro. old bonds.
17Guarantees of AAA-rated countries amount to approximately 450bn Euro.Table The bric countries have built up wealth by retaining foreign currency reserves, which are denominated largely in US dollars. Due to theGermany 211 likely to deteriorate in the US debt problem, the value of the dollar isFrance 158 future. To compensate for this loss in purchasing power, the sovereignNetherlands 44 the dollar. A strong euro wealth funds seek to diversify away fromAustria 21 helps to achieve this goal.Finland 14 Slovakia 7.5 to achieve important The brics could use their negotiation stakeCyprus/Luxembourg/Malta/Slovenia 7.5 objectives: geopolitical = 450 • increase voting power in the imf • improve trade conditions under the wto legislationThe second objective of the efsf is to recapitalise ﬁnancial institutions • buy physical assets in developed countrieswith valid business models. A minimum capital ratio, deﬁned • minimize foreign policy interventions into domestic policy affairs and called T1 capital ratio, has been set at 9%. Practically the efsf such as human right violationswill not inject cash and therefore equity capital directly intoindividual banks but will lend to the member states which then However, supporting the efsf in order to achieve the aforementioneduse the proceeds to make the necessary injection. goals comes at a price: the risk of suffering signiﬁcant losses due to debt defaults of either Spain or Italy. Foreign investors will try toAssuming a debt haircut on Greece, Portugal, Ireland and perhaps make sure that Germany/France take care that the guarantee solutionBelgium in 2012, the required equity capital injection will amount retains credibility. The most direct way to express this idea is toto from 150bn to 250bn Euro! require an AAA-rated entity guarantee. The backstop of the efsf AAA rating is derived from France and Germanys rating strength.Who are the potential investors in European bonds andwhat are their objectives? Realistically, foreign investors might accept a rating downgrade of the efsf to AA, but this analysis is highly controversial and hypothetical.It is completely rational for bric countries to support the euro zone Recent demand for efsf bonds has been very low and indicatesby investing in Spain and Italy using the efsf as a safety backstop that relying on the functionality of an AA-rated efsf poses a veryfor the following reasons: high degree of risk.
18 Reﬁnancing(=rolling) government debt before after efsf supports the sale of new bonds (by issuing guarantees) Volume VolumeSovereign debt Sovereign debt Price~100 Price ~100400 400 ecb (imf) support bond prices in300 300 secondary market Price ~90200 200 Price ~90 Price ~90100 100 2012 0 2013 2014 2 0 15 2 0 16 time 0 2 01 2 201 3 201 4 201 5 201 6 time Redemption and new issue in the primary market
19 recapitalise Spain Cajas AAA Countries Italy recapitalise Unicredit Germany 210 Intesa France 170 lend Netherlands 70 EFSF Finnland 40 ECB Belgium recapitalise Dexia Vehicle Support price by buying su cce ss Existing Creditors Italy and Spain China, imf good Brasil, Russia scenario 250 bn Euro 2,4 trillion buy new Spanish/ Italian Bonds austerity 1,08 trn 2012 and 2013 growth as planned 100 100 } potential bad develop- loss for } Price ment ~90 potential NEW investors loss for NEW investors } 20% Garantierecovery recovery ~40 ~40 201 2 201 3 market t im e stabilises crash
Debt haircut 20Ireland 40% Greece 60–80%Portugal 40% Belgium 40% Sovereign Haircut for Greece, Portugal, Ireland in 2012 Eurozone Exit A debt haircut for Greece in 2012 is all but unavoidable. It will An exit from the Eurozone would have signiﬁcant ﬁnancial and involve ALL creditors except the imf. In order to bring the debt economic ramiﬁcations not only for the exiting country but also for level of Greece down to a sustainable level the magnitude of the remaining member states. the haircut needs to be in the range 60–80%. The ecb would likely cease to provide short term funding to the A more radical scenario is possible in which the Greek people banking system of the exiting country. Many banks would instantane- decide to leave the Eurozone and thereby default on an even higher ously be bankrupt und would shut down for several days. The new percentage of their debt. local currency would be introduced and its value versus most other currencies would decline immediately by anything between 30–100% In either case, it will be rational for Portugal and Ireland to demand percent. Because of this, prices for imported goods would increase debt forgiveness as well. Who can blame them for this? Why should signiﬁcantly and cause inﬂation. the citizens of those countries work hard to deliver the austerity promises and repay foreign debt, while other countries, receive a The goverments priority would be to ensure political stability, free lunch? There are sufﬁcient indications from national politicians to rebuild the domestic banking system and to ensure the functioning that such a request will be made. of the state pension system. This process would involve economic pain but the countrys debt burden would be gone. Even Belgium could be in a position to demand a haircut on its sovereign debt. The reason is that Belgium too might soon reach The ramiﬁcations for the remaining member states depend on the unsustainable debt levels. Its debt/gdp ratio is already as high magnitude of the so-called contagion effects. In this example it as 120%. The country is politically divided between the North and is fair to assume that depositors in fragile Eurozone countries such South region and had no legitimate goverment for more than as Portugal will fear losing the purchasing power of their Euros half a year. It was forced to bail-out its major bank Dexia overnight deposited in their bank accounts. with the help of France in October 2011. There is little information about the amount of losses derived from overpriced toxic assets on Dexias balance sheet and how those losses will be allocated between France and Belgium.
Banks and Insurances bad banks good banks 21 The Swedish model for a successful reform of the banking system / Why is it necessary to reform the banking system? The main objective of a well-functioning banking system is to 1) If the banks do not get bailed out, the ﬁnancial system will collapse efﬁciently allocate savings from savers to entrepreneurs who need because of chain-reaction effects the money to invest into projects that offer an attractive risk/reward relationship. Standard neoclassical economic theory postulates 2) If banks do not get bailed out, a recession is unavoidable that this process automatically promotes the economy and society. because banks will need to reduce lending and thereby blocking The economic allocation of resources is considered to be efﬁcient the blood circulation of the economy ("Credit Crunch"). (a discussion about what the correct economic theory is/should be is beyond the scope of this publication). This incentive structure represents what every student of economics and business administration learns/in his or her ﬁrst semester 101 The main duty of a banker would be to correctly assess the credit- econ course: The bad incentive structure called Moral Hazard! worthiness of the borrowers. The classic banking business is therefore simple, transparent and boring. Moral Hazard means that it is rational for banks to take on big risks: If everything works out, banks earn decent proﬁts and reward The current status of the banking system has few things in common shareholders, management and employees generously. If things go with the classic banking system. wrong the bank goes bankrupt and the society is asked to step in and pay the bill. And paying the bill doesnt just involve direct Over the last 20 years, a wave of global and European deregulatory capital injections! Any government intervention that supports the measures has led the banking system to decouple not only from market comes at a cost or has high opportunity costs. the real economy but also from ethical values/standards. Most important were the abolition of the Glass-Steagall-Act, the lowering The concept of Moral Hazard is abstract and it is hard to comprehend of equity capital requirements for banks, the introduction of short- the severity of this problem. The damage to the society only term-orientated stock-based management reward systems and broad becomes clear when the unavoidable crisis ﬁnally confronts us in approvals with respect to size and transparency of derivatives trading. our daily lives. As a consequence, bank capital structures have become much more The current state of the banking system is unfair, unjust and risky, both for the banks shareholders and, because of the size damaging to our economy! of the banking system, also for the society. A banking system has evolved which continuously exploits this weakness to put poltitics in a stranglehold in two ways:
22A fair, stable and robust banking system has the The key elements of a successful reform of the banking systemfollowing characteristics: 1) Decisive policy action legitimated by broad parliamentary1) Balance sheets are transparent and can be analysed approval across political parties to achieve credibility (This should be obvious but in reality this is not the case!) 2) Guarantee to bank creditors (see below)2) Banks are small enough so that they are allowed to fail without causing chain-reaction effects 3) Early and decisive policy response in the context of a well-thought-out holistic plan3) Limited size and transparency of interbanking interdependencies 4) Sufﬁcient liquidity provision by the central bank4) Robust balance sheets based on strong equity capital buffer 5) Temporary nationalization of insolvent banks/layoff of senior management/creation of good/bad banksThe Swedish reform of its banking system during the domestic crisisbetween 1991–1993 is the instruction manual for a successful and 6) Separation of retail banking and investment bankingconsequent reorganization of the banking system. The measures (Re-implementation of Glass-Steagall-Act)taken by the Swedish parliament still serve as the key guidelines today.Those measures cannot be applied on a 1-to-1 basis to the banking 7) Break-up of Too-big-to-fail institutionssystem in 2011: While the Swedish crisis was an isolated bankingcrisis which was not subject to negative external feedback loops, the 8) Enforcement of the Sarbanes-Oxley-Act: No legal loophole forcurrent banking crisis is global in nature. directors who personally sign ofﬁcial ﬁnancial company reportsEuropean Economic Papers 360, Lars Jonung 9) Banking recapitalisation via debt-equity-swaps. In special cases senior unsecured creditors (excluding depositors) may need to accept a haircut. This measure is controversial and needs to be part of point 3). Interbanking links via senior unsecured credit are extensive and lie at the heart of the ﬁnancial systems chain 10) Enforcement of mark-to-marked accounting rules 11) Exchange based derivate trading and limitation of the volume of derivative trading as a function of the underlying notional outstanding
880bn euro 23 + Bailing-out Italy and SpainSecondary market Italy, Spain - Primary market Euro-Bond Bailing-out Italy and Spain There is only one way for Italy and Spain to master the current economic situation: Reﬁnancing needs The deﬁcit has to shrink and ultimately be turned into a surplus without hampering economic growth. The only way to achieve this goal is to: I t aly Spain 1) increase taxes on the margin, e.g. 2–5% 800 2) decrease spending marginally, e.g. 2–5% 3) focus spending on projects that foster sustainable growth 700 Italian and Spanish sovereign bonds will be supported by the ecb, 600 perhaps via the imf as an intermediary. 500 The efsf mechanism has been explained above. If economic and political reforms appear credible and successful a Eurobond 400 will be issued. 300 Sovereign re-ﬁnancing needs Italy and Spain 2011–2014 200 450bn € -200bn € bank recap 100 = 250bn € for leveraged guarantees 0 201 1 /1 2 201 3 201 4 leverage 4 –5x = 1–1,25trn Euro Covers bond maturities for 2012 and 2013 (see table)
Debt hair cut 2430% Sovereign Haircut for Italy and Spain Sovereign Haircut for Italy and Spain This path is currently not the policy option favoured by European fail and Spain and Italy have to declare bankruptcy because austerity politicians. This is why we assign only a 30% probability to this path. and economic restructurings have failed. It doesnt mean we dont think its the right way to go. Imagine if, as discussed on page 25, one of the following things The decision to accept haircuts on Italy and Spain is difﬁcult to make happens: for politicians, because political advisors and bank lobbyists will claim that this will be the end of the world. It surely wont, but it 1) Many more hidden losses are discovered in the Spanish banking will not be easy either. system than those which were ofﬁcially disclosed. These would bring the Spanish economy down to its knees The main argument in favor of haircuts is: 2) Government statistics turn out to be incorrect (e.g. Greece) 3) Spanish and Italian citizens vote for parties that block austerity The sober realization and acceptance that there is no other programmes (could you blame them for doing so?) longterm solution. Tackling debt problems with more debt makes the ultimate breakdown only more painful and dangerous. Is this unrealistic? It is better to make a clear break, even if it hurts everybody in the How will Germans react, if they suffer austerity measures just to short term, and be able to start on a fair and transparent basis again, buy time and then get screwed anyway? rather than to kick the can down the road and thereby to continuously suffer from moral hazard problems. Isnt it better to openly communicate the view NOW that solidarity has its limits and cannot be fully based on mere beliefs about "One step back and two steps ahead" in the European integration promises that lack credibility? process must be a policy option if we all agree and accept that mistakes have been made in the past (conceptually ﬂawed model Wouldnt it be better to save the money for a programme to build of Eurozone). The intermediate process can involve the creation up Europe AFTER a clear and transparent break has been made? of a North-South Euro system (Germany und France in North Euro) Something like a Marshall plan? Clearly, it will not be as easy and that could last for a period of 5–15 years before more radical painless as it sounds, but isnt it at least worth an intensive integration models can be applied again. society-wide discussion? Only few people ask what a crash scenario could look like in for example two years, if additional debt ﬁnanced support programmes
2560% US recessionc Spain + Italy no recovery EU recession France: AA US recession/EU recession/France downgrade/Failure of Italy and Spain to successfully restructure their economies A complete analysis of the stage of the European/US business Financial markets might rally on any interventional political cycle is beyond the scope of this paper. However, the following action, be it the introduction of Eurobonds or ecb printing facts that strongly argue for a Euro/US recession in 2012, activity. But this will not cure the underlying problem of too can hardly be dismissed by professional economists: much debt. EU recession probability The ecb senior loan ofﬁcer survey shows that lending activity is deteriorating. The banking system will inevitably have to deal with haircuts in Greece, Portugal, Ireland, Belgium. Italy and Spain are likely to have already entered a recession. Real house prices; index: 1979=100 Banks continue to reduce their balance sheets. Spain experienced a housing bubble between 2000–2010 (see graph). The Spanish banking system, which is heavily exposed to the construction and real estate sector, has so far only seen a limited amount of defaulted loans. This is a big risk. One reason for the imprecise statistics is that Spanish accounting rules are less strict and give Spanish banks more degrees of freedom in marking non-performing loans. The two banks that defaulted in 2011, Cajasur and cam, reported much higher non-performing loan statistics after they were nationalized. An EU recession will automatically lead to rating downgrades. Fitch already issued a statement that it will downgrade Italy Source: Bank of International Settlements, per national sources; Haver Analytics; McKinsey Global Institute analysis from A+ to low BBB if a EU recession becomes more likely.
26Will an EU integration and harmonization work? Probability of a US recession in 2012Every politician and banking analyst will tell you that in order for the The US has seen the most dismal post-war economic recoveryfuture United States of Europe to function properly, the euro despite historically high stimulative government initiatives.zone will need to integrate politically and harmonize economically. Ofﬁcial US debt volume stands at 15trn USD and there does notBut what does that mean? seem to be the political will to tackle the problem ahead of the election. Monetary policy options are almost exhausted withDo you think that in two year’s time, when Italy and Spain suffer from the Federal Fund rate at 0% and with two monetary basethe implementation of austerity measures, the Spanish people expansions, which seem to have a decreasing marginal impact.will accept having German/French technocrats dictate the conditions Stimulative tax cut programms are politically controversialunder which they live? Do you think that the Germans actually want to say the least. ecri weekly leading indicators are deep into play this role? Why do you think it will work in the future under negative territory. A serious negative reversal at this time ismuch more strained relationships when it has not worked in the past likely to be the ﬁnal conﬁrmation of the start of a new recession.when the problem comprised simple 3% budget violations? The senior loan ofﬁcer survey partly indicates tightening creditWhy do you think that political unity will be successful in the future? standards as US banks are forced to delever their balanceDo you think just because there is no alternative, European nations sheets and reduce their exposure to the European bankingwill accept a centralized authority when the European parliament system. Bank of America 5-year cds spreads reached thehas not been able to gain broad acceptance over the course of 15 years? highest level ever on November 24th @ 480 basis points.The United States of America is considered to be one of the most This paper is not meant to disregard positive economichomogeneous economic spaces due to its geographic and cultural developments. But the overall evidence indicates a highcharacterisics, its national identity and history. The US has proven recession probability.to be the longest-lasting democratic nation in the world. The UnitedStates has incorporated a debt limit into their constitution. If the US sneezes then the global economy will catch a cold.The United States has violated the debt limit more than 50 times This description of the global economic interdependences stillsince 1970 (see graphic on page 27). The United States has created holds true in the year 2011.a higher debt burden than the European Union (see graphic on page 10)on aggregate and still cannot agree on a solution in the interest of We think that a rating downgrade of France in 2012 to thethe country because each political party aims to win elections in 2013! AA category has a probability of more than 80% irrespective of economic developments.The euro zone has 17 member states with parliaments that arecomposed of up to 6 different political parties!
INCREASE IN NATIONAL DEBT LIMIT, AN EXCEPTION? 27 5. Oct 1977 Rise in Debt Limit Approved in House 1. Oct 1981 Reagan Signs Increase In Federal Debt Ceiling 1. Nov 1983 SENATE DEFEATS BILL TO INCREASE DEBT CEILING 4. May 1987 Time Bomb in the Debt Ceiling 12. May 1987 REAGAN URGES A RISE IN DEBT CEILING 19. Oct 1989 Debt Limit Increase Is Sought 8. Oct 1990 U.S. Sales Contingent on New Debt Ceiling 11. Nov 1995 Debt Ceiling Impasse Dampens Bond Prices 11. Nov 1995 BATTLE OVER THE BUDGET: THE OVERVIEW; PRESIDENT VETOES STOPGAP BUDGET; SHUTDOWN LOOMS 1996 Gingrich Promises Solution on Debt Ceiling () 1. Mar 2002 G.O.P. Strategy On Debt Ceiling 25. Dec 2002 Bush Seeks Increase in National Debt Limit 15. Oct 2004 As U.S. Debt Ceiling Is Reached, Bush Administration Seeks to Raise It Once Again 16. Mar 2006 Senate Approves Budget, Breaking Spending Limits 30. Jul 2008 Bush signs sweeping housing bill Source: WhiteHouse.gov
START ASKING QUESTIONS… 28• Do you think politicians are capable of comprehending the • Who do you think advises our experts in the Bundestag? Wouldn’t complexity of the problem? you like to know with which experts the politicians meet? Shouldn’t they disclose this information publicly? Shouldnt the• Why do you trust politicians who have already promised the ﬁnal politicians discuss in more detail with the public the advantages bailout package several times but keep coming back to the taxpayer and disadvantages of the various courses of action proposed? to beg for a new one? Shouldnt the politicians listen to those experts who foresaw the crisis for the correct reasons? So, whats going on here?!• Do you trust politicians who attempted to circumvent the German Bundestag in deciding about the expected loss of up to 211bn Euros? • Given the magnitude and severity of this historic decision, shouldn’t we expect each member of the Bundestag to be informed equally well? Shouldn’t they decide based upon their personal individual• What do you think: Doesnt it seem odd that the ultimate end scenario conscience instead of merely executing the advice of banker- that politicians strive for has such a low probability of success? inﬂuenced expert committees? Shouldn’t politicians incorporate this expectation into their decision making process? • Shouldn’t we expect them to be smart enough to decide this on their own?• Do you think it is likely that if the entire monetary system collapses in 3 years time, politicians will argue that this was due to unexpected external shocks that no one could have foreseen? • Shouldn’t we listen to people who saw this crisis coming for the correct reasons? Who are they? Do you want to know? D.J. Benzemer (2009) No one saw this coming: Understanding• Wouldnt it have been better to let Greece default? They told us Financial Crisis through Accounting Models that the system would not have been able to absorb the shock. • If the efsf idea has to be withdrawn due to impracticability despite• But didnt we rescue Greece? Yet Ireland/Portugal/Spain/Belgium/ months of negotiations, what does this tell you? Italy have deteriorated to the extent that even Germany was not able to place an entire new sovereign bond issue, and meanwhile, Greece still suffers from all the debt burden! • Who made the proposal if it is obvious that it does not work?• Isn’t it strange that all ﬁnancial companies and investors around • Isn’t it odd that the EU is trying to ﬁnance borrowers who seem to the world beg and force our parliament to spend enormous amounts have lost creditworthiness by constructing a structured vehicle called of money? Why should these people advise our politicians at all? efsf, which seems to be some sort of cdo, and trying to put an AAA label on it? Where have we seen this before?