Post-restructuring, which future for Greece?

The events around Greece and its government debt are taking new turns every day. It understandably has the financial markets on tenterhooks. A good deal of the commotion comes from the fact that more and more economists and market participants are trying to do the math, and they end up with more or less the same conclusion: No austerity policy will make it possible for Greece to repay its debt. In particular not when the austerity measures are meeting increasing resistance from the voters.

Some of the more sanguine observers have begun to make – not entirely unfounded – comparisons between Greece and Argentina. Two decades ago Argentina introduced a “currency board” whereby the currency was pegged to the USD in an attempt to control inflation. After an initial period where exports picked up strongly, the domestic economy floundered, unemployment increased, government deficits exploded, and the current account worsened. The government debt was largely sold abroad, where investors believed in the strength of the currency board.

However, in absence of serious reform, the government deficit continued growing, and servicing the debt meant a serious further strain on public finances, and even a wave of privatisations was insufficient. In 2001 the currency board evaporated, the currency depreciated by a whopping 70%, and in 2002 Argentina defaulted on the debt. It has taken nearly a decade of economic hardship to rebuild the economy and in 2010 Argentina offered to resume paying back the debt.  

There are some eerie similarities between Greece and Argentina. Most significantly, both entered into a very rigid currency regime with an economy that was clearly not ready for such a move. The ensuing drop in interest rates mainly led to an increase in property prices and consumption. The economy did not in any way undergo a development whereby investments were made in sectors that would increase the export competitiveness.

That is the main problem with Greece. No matter what happens to the Greek government debt (my guess: debt rescheduling, followed by a small haircut, eventually default), or Euro membership (my guess: will be maintained for now), in order for Greece to move forward, some serious structural reform is necessary.

The problem here is that “serious structural reform” has a meaning that not everybody likes. I may mean that established power concentrations will have to be dissolved, labour market conditions may have to be liberalised, public sector reformed, a serious privatisation programme will have to be introduced.

All of that will upset the existing status quo and that is usually not wanted. But since Greece’s exit from the
Euro is far away, such reforms will have to be more profound, since no currency devaluation will help the adjustment. I am afraid that the full weight of the necessary changes in the aftermath of a restructuring has not yet dawned on all parties.

It is interesting to see that the European consensus of “extending and pretending” is beginning to unravel. Whereas Germany is beginning to see the advantage in restructuring Greece’s debt while Spain and Italy have strongly denied that such a thing could happen. They are obviously afraid that they will stay out of the limelight as long as EU covers up for Greece. That position becomes increasingly untenable as time passes. 

A Japanese reactor meltdown will not undermine the euro

Regional elections in Germany gave negative results for Chancellor Merkel’s Christian Democrat Union. The disaster at the Fukushima nuclear power plant has apparently given the Green party a boost, and so much so that all other parties also lost ground. In the financial press, Merkel’s weakening domestic stance is likely to be used in attempts to discredit the new European Stability Mechanism.

The arguments will be something like: Merkel is losing support. Younger generations of Germans are unlikely to accept the sacrifices imposed by the German financing of the bail-out of Southern Europe. Merkel will be less firm in her support and will try to impose further draconian measures on the countries in need of a bailout. If she does not have her will, Germany may simply withdraw from the euro. 

Given the German-bashing that in particular the London-based financial press thrives on, there is nothing new in that view. However, there are two things that need to be said in return. On 12 March 2010, German Finance Minister Schäuble published an article in Financial Times laying out the principles that Germany wanted to form the basis for any new agreements.

German policy towards the Euro crisis has been in line with Schäuble's statements. Nonetheless, there has been a lot of talk that Germany has in fact only saved her own banks and that Southern Europe/Ireland are “sacrificed” in order to avert significant losses in German banks.

Yes, German banks have certainly been exactly as greedy and silly as any other banks. And yes, there may well be an important element of self-help in the German bankrolling of the ESM.

But let us not forget that Greece had falsified public accounts to fool the world while the government tax collection was in shambles. Ireland let herself go in an orgy of cheap credit while using corporate tax rates as a means of stealing jobs from other EU-countries. Portugal studiously avoided economic reform and it it shows now, as the rest of the world is on the mend.

Still, the German policy is built on the rather healthy observation that you cannot have a monetary union unless there is some kind of cohesion in the economic policy.

As Germany is again pressured into taking out the check book, of course concessions are being forced upon the most profligate EU members in order to secure the long-term viability of the Euro project.

The far more important point is that Germany will not leave the Euro, irrespective of local election results. Membership of the Euro is one of the geopolitical imperatives Germany must live with, as it is the guarantee against ever again having to fight a two-front war. Following the defeat in 1945, clear-headed thinkers across Europe understood that in order to make Germany change her ways, it was necessary to change the strategic position, whereby Germany was facing Russia on one side and France/UK on the other side.

By tying Germany into the EU, the most important military enemy, France, was turned into an ally. When the Berlin wall fell, French President Mitterrand managed to convince (maybe even bluff) then-Chancellor Kohl that a currency union was the best way of anchoring Germany in Western Europe, now that the big enemy in the east was retreating.

Germany has not at any point – irrespective of whether the foreign minister came from CDU, SPD, FDP, or indeed the Green Party – questioned Germany’s Euro membership. No matter whether this week-end’s skirmishes will eventually undermine Chancellor Merkel, whoever succeeds her as German Chancellor must accept the geopolitical situation and embrace the EU solution of having a single currency.

However expensive it is to support the Euro’s continued existence, the alternative to doing so would be a major transformation in Germany’s geostrategic situation. It would require a complete political about-face and would mean that Germany again had to ready herself for a two-front war, as the demise of the EU would follow. Given the price of this alternative, Germany will remain a firm supporter of the Euro. But will of course not be willing to be taken for granted to pay for the foibles of everybody else.

Three weeks into the market correction, dynamics may be changing

The guessing game has been on for some days now: Will the Japanese disaster be positive or negative for the world economy. Personally, I believe that initially it will be negative and then turn positive as the efforts to rebuild gathers steam. But it really is anybody’s guess, and to be cynical about it, it does not really matter. At least not for the financial markets. So while my thoughts go to all those who have lost lives and property in the disaster, the markets are more interested in the global policy reactions.

In that respect it looks fine. Japan finally joined the club of countries embarking on “Quantitative Easing”, also known as monetising public sector deficits. G7 and others are intervening in order to drive down the JPY, which adds strength to the monetary initiatives already taken. It all looks good and the markets have taken their cue from the developments. Stock markets will profit in the short term.

Over the past five-six months the stock markets have been supported by the fact that global economic data have surprised on the upside, indicating that the world economy is doing a good deal better than expected around the middle of last year.

This will not continue. Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

Despite decades of economic research on the formation of economic expectations, most economists and stock market analysts display “adaptive expectations”: if they are surprised positively, they revise forecast upwards. If they are surprised negatively, they revise downwards.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, they will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.

On 22 February I wrote that the market had a set up for a correction. Not because of overvaluation or what not, but simply too many had become complacent about risk. I thought the unrest in North Africa and the Middle East would be the trigger. In the end it was a combination of that and the Japanese disaster that caused the markets to run for cover. The policy reaction around Japan has already taken some of the uncertainty way. I am not sure that it is enough to put an end to the current market correction.

More on the New Inflation

In a recent article in New York Times, Christina Rohmer, former chairwoman of the Council of Economic Advisors to President Obama, describes a debate that limits Fed’s ability to act decisively to support economic growth. It is between “empiricists”, i.e. those who want to see solid evidence of inflationary pressures before they begin to rein in the monetary policy, and the “theorists”, who claim that one has to step on the brake in rational expectation of future inflationary pressures.


It is Rohmer’s claim that the schism between these two approaches effectively paralyses Fed at a point in time when it needed to do more to stimulate the US economy. She lays out the most important channels through which low interest rates stimulate the economy. Courteously, she remains silent on the theories that would be used to explain to explain the emergence of inflation when a large excess capacity is available.

Rohmer should know what she is talking about. A scholar renowned for her studies of the Great Depression in the 30’s, her contention is that by keeping the interest rates low, the interest sensitive sectors of the economy will eventually pick up. Manufacturing (cars!), construction etc. will all be strengthened as a result of lower interest rates. Just like it happened in the 30’es.

By making it clear that deflation will be fought at almost any cost, real interest rates are reduced. Since the difference between present nominal interest rates and expected inflation is reduced. That reduces the perceived financing cost and stimulates investment.

Given the recent data from the US housing market, there is no doubt that Christina Rohmer has a strong point. House prices are still falling, and sales of repossessed property are a significant part of the overall turnover in the market.

At the same time, there are no signs of inflationary pressures. And yet we see that across the world, central bankers are now beginning to worry about inflation creeping upwards. As I wrote in my blog earlier, it has to do with your definition of inflation. As long as one only considers “core inflation”, I share Christian Rohmer’s view.

But there is a little snag. In the 30’s the financial markets were not as developed and integrated as now. Financial institutions could not freely invest abroad. Commodities markets were largely reserved for those who needed the physical product. I need not describe how that has all changed. Just note that banks and other financial institutions are now major players in the commodities markets.

We know that the QE programs have given the banks access to tons of liquidity that they have not passed on the consumers. It seems fair to assume that the money instead has remained within the financial sector, invested in stocks, bonds, and commodities worldwide. Given that the commodities markets are the smallest by volume there is every reason to assume that the combination of monetary policies and the freeze in the normal credit markets has led to significant asset reflation. Even Ben Bernanke has stated this publicly. And of course it has also been a contributing factor that the Asian economies have recovered nicely from the downturn.

US monetary policy has contributed in a significant way to the headline inflation through the price increases in food and energy, the two “volatile elements” of inflation.

It has already given Rohmer’s “theorists” more reasons to be aggressive about reining in the monetary policy prematurely. Same situation in Europe where Axel Weber’s withdrawal from the race to become ECB’s next chairman has left the situation wide open. Prospective candidates are now jockeying for position by improving their hawkish profile, well knowing how tough talking on inflation could garner support from Germany.

So the situation is that the spill-over into the commodities markets from the US monetary policy is now leading central bankers everywhere to indicate that monetary tightening should be just around the corner. That would not be the right thing to do just yet.

A textbook example of increasing risk

One can only have sympathy for the protesters in the Arab countries, demanding democracy and the most basic of personal freedoms. The stories continue to dominate the headlines and the TV screens.

But when it comes to the effect on the financial markets, there has been a strange silence. It is as if the events have no real impact on the rest of the world and we can treat it with the same indifference as if it was a Soccer World Cup final. It makes us feel good, but Monday everything is back to normal.

I shall not try to guess where the Middle East is going. But if we look at the influence on the financial markets, a few remarks are necessary.

The risk is not skewed in the direction of a positive outcome for the stock markets. If we see a quick return to orderly conditions, possibly with democratic governments, civil rights, and rule of law, it will make us all feel better. Best of all, it will give us the same stability in terms of oil deliveries as we had before the whole thing started in January.

In terms of impacts on the stock market it is not good news that things remain unchanged. In fact, It is no news at all.

On the other hand the situation can also escalate in ways that could seriously impact us all. Trouble in Saudi Arabia, supply disruptions, new regimes with limited democratic credentials but with a serious grudge against the Western world. Now that is a situation that would make itself felt in the stock markets.

Facing a choice between several outcomes, where the best is a return to status quo ante, and all other events are worse, it simply translates into an increasing risk for trouble in the financial markets in the short term.

If we add that risk willingness has clearly been increasing in the past months, we have a convincing case for limiting exposure to the stock markets. It is interesting to see that this message obviously has not yet made it to the stock markets. The reason for this appears to be clear.

The whole chain of events has unfolded quickly. The financial markets were in a sweet spot and economists and analysts have been busy improving on their outlooks for growth and earnings, and now reality suddenly shows its ugly face. Right when we were busy doing other things.

For investors interested in timing their exposure to the stock markets, it may still be too early to exit (unless you are a high-risk, high-leverage, high-everything hedge fund manager in which case you probably already have left). The rest of us are just waiting for the stock markets to wake up. And panic.

On markets and monetary policy

Seen as an asset class, equities continue to rally on the familiar background of ample central bank liquidity and a surprisingly late rotation into equities by institutional and private investors alike. A major reason for this rotation appears to be that the return on bonds is unattractive – to say the least.

 However, in the background several trends are quietly working to change the dynamics of the financial markets. We have already described the fact that monetary policies are being tightened at different speeds in different countries. The relative performance of the stock markets shows this clearly. The countries that have already started tightening experience underperforming stock markets.

Apart from Japan – who increasingly looks like a total basketcase – USA is the laggard among the large economies and the main culprit in flooding the markets with central bank liquidity. Recent data from the US Loan Officers Survey indicate that things are changing. Banks are resuming lending activity, albeit on a small scale.

This is important news for the financial markets. It is an early indication that event the US will at some point in time begin to tighten. The discussions whether Federal Reserve will be “behind the curve” are interesting, but irrelevant in this context.

The conclusion is that the dynamics in the financial markets increasingly will be determined by the timing of monetary tightening, and this movement will reach a crescendo once the US Fed decides to rein in liquidity.

For investors it means that we cannot any longer rely on just buying stocks and commodities when the market mood is for increased risk. Or buying bonds when the market mood is for decreasing risk.

The markets/asset classes will have to be bought and sold on their individual merits. And exactly the same goes for currencies.

As an example, take Sweden. The SEK plunged in 2008 as the Riksbanken lowered interest rates aggressively. Sweden – like Germany – is a strong manufacturer and exporter of industrial goods. Sweden therefore profited nicely when the European demand began to pick up.

Now the SEK has appreciated and seems set to continue. Exports are strong. Unemployment is falling and predictably, Riksbanken is tightening as it should be. Having been one of the strongest performers in 2010, Swedish stocks are now underperforming, as the market is discounting the combined effect of higher interest rates and a stronger currency.

Take this story and compare with recent developments in China, Norway, Australia, Canada, and several other countries. The stories may differ in their details, but the main tenet is the same.

Does all of this sound way too simple? Maybe it is. But it is a clear sign that after nearly 3 years of turmoil in the markets, we are returning to some kind of normalcy.

There is, however, one European aspect that should not be overlooked. Germany is the leader inside the Euro zone. Guess who are the laggards. Just look south.

It can be argued that for a long period, Europe had too low interest rates because of sluggish German growth. Maybe we will now have a period of too high rates because of strong German growth. Creating a one-size-fits-all monetary policy is not as easy as it seems. We will hear more about this.

The New Inflation

Long time ago, back at university, I tried to make sense of the concept of “core inflation”. Consumer price inflation minus what was known as the volatile components, food and energy. I sort of understood it, but never really came to terms with it.

It is correct that by keeping the notoriously volatile elements out of the equation, one arrives at a notion of inflation that can be used in analysis of such important questions as the deflationary effects of the output gap. We have all been conditioned to believe that this is the most important way to think of inflation.

But still we have a slight problem. We, the consumers, let our economic decisions rule by the inflation as we see it in the shops or in the street. No matter how much the textbooks tell that the core inflation is the most important to watch, shop owners who increase their prices would be unwilling to let me pay only part of the increase just because the “core inflation” was lower than the headline inflation. The supermarket bill goes up and it will have to be paid, no matter where the increases come from.

So while core inflation is an element that makes sense to economists, headline inflation makes sense to the rest of the population. Including possibly even some of those working in the financial sector.

Right now we are at a point where this distinction between core inflation and non-core inflation is as important as ever. Looking at core inflation in most of the OECD area tells us that inflation is not a problem. Looking at the output gaps gives the same conclusion.

But inflation is on the rise. Food and energy prices are pulling up the headline inflation to a point where it is getting uncomfortable. A combination of financial market speculation and adverse production circumstances are working their magic.

Add a point we have made several times in 2010. Federal Reserve’s re-acceleration of the QE programme in September was bound to create asset inflation and nowhere more clearly in the comparatively small markets for commodities and energy.

The increase in the volatile inflation components have been one of the elements in destabilising regimes everywhere from Venezuela to North Africa. Following a very bad harvest, the Chinese Government is seriously concerned about food inflation – to the point where initiatives have been implemented locally to curb the inflation.

It all adds to an uneasy feeling: are we heading towards a period of inflation, pulled by exactly the elements that according to economists are irrelevant for understanding the “real” inflation? Can policymakers be forced to step on the brakes early in order to avoid inflation expectations taking hold, even if core inflation remains benign? Or, will the financial markets – in particular the bond markets – begin to take discount this inflation, no matter if bank economists tell that it is irrelevant.

The answer to this question is more important than the financial press seems to have understood. If the markets begin to fear inflation, bond yields will push upwards and threaten to put the brakes on the recovery at a time when policymakers consider using the increasingly self-sustained recovery to begin cutting the budget deficits. The combination could prove very negative for the economic growth in a global economy where consumers in the western world still need to consolidate their balance sheets.