Good and Bad Reasons for Greek Debt Relief

In a Vox column, William Cline argues that

it is important to recognise that the headline debt figure overstates the true burden of Greek debt. Because most of the debt is owed to official sector partners at concessional interest rates, the interest burden is much lower than would usually be associated with the same gross debt. Under the Fund’s own criterion for sustainability in these circumstances (ratio of gross financing needs to GDP), Greek debt should remain within an acceptable range at least through 2030. It is questionable to base debt relief policy on problems that might or might not materialise beyond such a distant horizon. Moreover, most of the projected sharp increase in debt could be avoided by carrying out bank recapitalisation directly from the European Stability Mechanism (ESM) to the banks, rather than through the Greek government as an intermediary.

There is still an important potential role for using interest rate relief, for two purposes. First, if fiscal balances fall below target because of lower than expected growth (rather than policy slippage), a portion of interest otherwise accruing could be forgiven to avoid the need for additional fiscal tightening and its recession-aggravating consequences. Second, because Greek unemployment is at depression levels (26%), special employment programmes would seem appropriate, and forgiving a portion of the interest due could provide a significant source of funding for this purpose.

Cline also discusses the claim that Eurozone loans mainly saved Eurozone banks:

  • not true, they received only one-third of the official sector support;

that the Troika called for too much austerity:

  • true, the cyclically adjusted primary balance swung from -13.2% of GDP in 2009 to +5.3% in 2014, much more than in Portugal, Spain or Ireland;
  • but Greece was cut off from financial markets;
  • and Eurozone support as a share of GDP exceeded 100% in Greece compared with roughly 30% in Ireland and Portugal or 5% when the US supported Mexico;
  • “even at the upper bound of the IMF’s upward-revised multipliers (1.7), smaller spending cuts would not have boosted GDP and revenue by enough to pay for themselves;”
  • and the adjustment mostly occurred in the early years when spreads were high and would have been even higher with less adjustment.

Cline estimates that the third rescue package will raise Greek net debt by 10-15 billion Euros.

Long-Term Interest Rates, Now and Then

A report by the White House Council of Economic Advisors surveys long-term interest rates. The “key takeaways” include:

Real and nominal interest rates in the United States have been on a steady decline since the mid-1980s. Declining interest rates are a global phenomenon. … [F]orecasters largely missed the secular decline of the last three decades.

The Ramsey growth model implies a link between labor productivity growth, per capita consumption growth and the real (inflation-adjusted) interest rate. Historically, periods of low real long-term interest rates have tended to coincide with low labor productivity growth. Projections of labor productivity growth, while imprecise, suggest 10-year real interest rates in the range of 1.5 to 3.5 per cent.

Asset-pricing models that incorporate risk suggest that the long-run nominal interest rate is the sum of expected future short-term real rates, expected future inflation rates, and a term premium. The 10-year rate in ten years that forward transactions in nominal Treasuries imply is currently 3.1 percent. Forward transactions in the market for TIPS suggest a long-term real rate just above 1.00 percent in ten years. Adding the CPI inflation rate implied by the Federal Reserve’s PCE inflation target would imply a forward nominal interest rate of 3.25 percent. The term premium in nominal Treasuries is currently estimated to be near zero, with a 2005-2014 mean of 1 percent. These components together suggest a 10-year nominal interest rate in the range of 3.1 (forward Treasuries) to 4.6 percent (based on FOMC forecasts of the long-run federal funds rate).

In a world with financially integrated national capital markets, the general level of world interest rates is determined by the equality of the global supply of saving and global investment demand. Capital markets of advanced economies are now tightly integrated while emerging market economies are becoming increasingly integrated into the global financial system. Low-income economies remain partially segmented from the global capital market. As a consequence of increasing international market integration, long-term real and nominal interest rates are increasingly moving in tandem and have declined along with U.S. rates. Nominal interest rates also tend to be correlated across countries though differences in inflation expectations can produce differences in nominal rates. In a world with uncertainty, global long-term real and nominal interest rates will include risk premiums that can reflect country-specific risk factors. Strong economic linkages, however, reinforce substantial correlation in countries’ long-term bond risk premiums.

Long-term interest rates are lower now than they were thirty years ago, reflecting an outward shift in the global supply curve of saving relative to global investment demand. It remains an open question whether the underlying factors producing current low rates are transitory, or imply long-run equilibrium long-term interest rates lower than before the financial crisis. Factors that are likely to dissipate over time—and therefore could lead to higher rates in the future—include current fiscal, monetary, and exchange rate policies; low-inflation risk as reflected in the term premium; and private-sector deleveraging in the aftermath of the global financial crisis. Factors that are more likely to persist—suggesting that low interest rates could be a long-run phenomenon—include lower forecasts of global output and productivity growth, demographic shifts, global demand for safe assets outstripping supply, and the impact of tail risks and fundamental uncertainty.

Eurozone Finance Ministers Approve Third Greek Bailout

In the FT, Duncan Robinson and Christian Oliver report about Eurozone finance ministers’ approval of the third bailout for Greece, amounting to 86 billion Euros.

Contrary to Germany’s recent demands, the approval came in spite of the fact that the IMF has not committed to participate in the new program. In fact, the IMF has committed not to participate unless Greece’s debt burden is further reduced. Finance ministers effectively promised such further cuts in the future.

The deal falls short of what the German government had hoped to secure (see also this previous blog post).

 

MoU between Greece and its Creditors

In the Guardian, Heather Stewarts reports about the contents of the memorandum of understanding that the Greek government and its creditors have agreed on. It contains four pillars:

  • Fiscal sustainability, including pension reform and social welfare review;
  • Financial stability, including bank recapitalization;
  • Growth, competitiveness, investment, including liberalization of consumer markets, labor markets and professions;
  • Modern state and administration, including judicial reform and anti corruption measures.

European Unity and the Principle of Unity of Liability and Control

In its recent special report entitled „Consequences of the Greek Crisis for a More Stable Euro Area,“ the German Council of Economic Experts has stressed the dangers due to institutional deficiencies and discretionary decision making in the Euro area. The executive summary concludes with the statement:

The institutional framework of the single currency area can only ensure stability if it follows the principle of unity of liability and control. Reforms that stray from this guiding principle plant the seeds of further crises and may damage the process of European integration.

See also my earlier contributions here and here.

Greece’s Financial Position Is Widely Misreported

In an FT letter to the editor, Ian Ball, the Chair of CIPFA International (Chartered Institute of Public Finance and Accountancy), argues that Greece’s financial position is widely misreported. He writes:

While the debt burden is commonly cited as being between 175 and 180 per cent of gross domestic product, this number is incorrect and indefensible because it is based on the face value of Greece’s debt that doesn’t take into account long maturities and concessional interest rates, as well as grace periods.

Greek debt, calculated on an International Public Sector Accounting Standards (IPSAS) basis, is significantly lower, and at the end of 2013 was 68 per cent of GDP. If this is not an appropriate method for measuring debt, then every company on major stock exchanges around the world has got its debt measurement wrong. In neither accounting standards nor economic principle is debt measured at face value. This pervasive misunderstanding of Greece’s real fiscal position has seen agreements reached between Greece and its creditors that do not address the real problem and instead may actually intensify it.

See also my earlier blog post.

Sovereign Debt Seniority

In a Vox column, Matthias Schlegl, Christoph Trebesch, and Mark Wright document an implicit seniority structure of external sovereign debt: IMF > Multinational > Bonds > Bilateral > Banks > Trade Credit (see the figure).

They argue that Greece’s recent default on the IMF constitutes an outlier.

… Greece in 2015 is clearly an outlier case, having defaulted on the most senior creditor (the IMF), while continuing to service historically more junior creditors. The evidence also suggests that the Eurozone rescue loans, which are essentially bilateral (government-to-government) credit, are likely to be a junior creditor class going forward. The evidence also rationalises why Greece may have an interest in exchanging the debt it owes to the IMF and the ECB into loans to the European Stability Mechanism, which is likely to be junior debt in the future, as discussed in the run-up to the July Eurozone summits. Policymakers should be aware of the associated changes in seniority and repayment incentives.

trebesch fig3 7 aug

Swiss German, Standard German, and Swiss Standard German

In the NZZ am Sonntag, Reto Hunziker argues that the schooling system in the German speaking part of Switzerland undermines students’ ability to speak proper German. Hunziker wants the Swiss to speak either their Swiss German dialect or Standard German—not the Swiss German dialect or Standard-German-As-Spoken-In-Schools-In-Switzerland.

Wikipedia article on High German languages. Wikipedia article on German dialects.

Europe, Monetary Union and Fiscal Union

In a recent blog post, John Cochrane criticizes the common wisdom that, on economic grounds, the Euro was a bad idea for Europe.

He responds to an earlier New York Times article by Greg Mankiw who argued that conventional wisdom: A monetary union requires (1) cross-subsidization/insurance across regions (“fiscal union”) or (2) significant labor mobility across regions. The US has both, Europe does not; Europe therefore needs regional monetary policy instruments and fluctuating exchange rates to dampen the consequences of adverse regional economic shocks.

Cochrane retorts

I am a big euro fan. … I am also a big meter fan. I don’t think each country needs its own measure of length, or to shorten it when local clothiers are having trouble and would like to raise cloth prices.

Cochrane takes aim at the “deeply old-Keynesian” notion that small regions with fewer inhabitants than the Los Angeles metro area (Greece or Ireland say) are exposed to regional “demand” shocks which require regional fiscal or monetary policy responses. In his view, these are small open economies, and demand shocks arise externally.

Cochrane questions the characterization of the US as “fiscal union.”

In the US, we have Federal contributions to social programs such as unemployment insurance. Europe has the common agricultural policy and many other subsidies. We do not have systematic, reliably countercyclical, timely, targeted, and temporary local fiscal stimulus programs. Just how big is the local cyclical variation in state or local level government spending or transfers? (And why does fiscal union matter so much anyway? If you’re a Keynesian, then local borrow and spend fiscal stimulus should be plenty. The union matters only when countries near sovereign default and can’t borrow.) … Yes, both US and Europe have some pretty large cross-subsidies. But most of these are permanent. … Monetary policy has at best short-run effects, so the argument for currency union has to be about local cyclical, recession-related variation in economic fortunes, not permanent transfers.

He also points out that US monetary union far precedes US “fiscal union.” (And he questions the notion that “tight fiscal policy” lies at the root of Greece’s problems and easy monetary policy would have helped.)

Regarding labor mobility, Cochrane emphasizes again that it is cyclical labor mobility which should matter according to the conventional wisdom. He doubts that there are large differences in cyclical labor mobility between the US and Europe.

Not only are the gains from monetary decentralization in Europe small, according to Cochrane, but the benefits from monetary centralization are large, because of gains in credibility.

When Greece and Italy joined the euro, they basically said, defaulting and inflating now will be extremely costly. They were rewarded for the precommitment with very low interest rates. They blew the money, and are now facing the high costs they signed up for. But that just shows how real the precommitment was.

And Cochrane makes the point that policy should address underlying frictions:

The case for separate currencies is to protect the economy from sticky wages, sticky prices, and sticky people. But none of these stickinesses are written in stone. A plausible answer to my question about pre-new deal US is that prices and wages were not sticky (whatever that means) before the era of regulation. Well, that is a loss, and only very imperfectly addressed by artful devaluation of the currency.  Not every block can have its own currency, so local and industry variation within a country remains hobbled by sticky prices, wages, and people. If sticky wages,  prices and people are the central economic problem, we ought to have a lot of policies to unstick them. We do the opposite, and Europe even more so. The very social programs that Greg implicitly praises for fiscal stimulus tie people to location and undermine labor market flexibility.

He concludes:

So I think a lot of the conventional view seems to think implicitly of fairly closed economies, operating in parallel. But Europe’s economies are open. Moreover, the whole point of the eurozone is to open them further. Small open economies are much worse candidates for their own currency.

Greece and Austerity

In a Project Syndicate column, Edmund Phelps argues that it is not “austerity” which is to blame for Greece’s plight.

So spending more is not the remedy for Greece’s plight, just as spending less was not the cause. What is the remedy, then? No amount of debt restructuring, even debt forgiveness, will suffice to achieve prosperity (in the form of low unemployment and high job satisfaction). Such measures would only help Greece to revive government spending. Then the economy’s stultifying corporatism – clientelism and cronyism in the public sector and vested interests and entrenched elites in the private sector – would gain a new lease on life. The European left may advocate that, but it would hardly be in Europe’s interest.

The remedy must lie in adopting the right structural reforms. Whether or not the reforms sought by the eurozone members raise the chances that their loans will be repaid, these creditors have a political and economic interest in the monetary union’s survival and development. They should also be ready to help Greece with the costs of making the necessary changes.

Short-Sales, Bans on Them, and their Price Impact

In a 2012 edition of the New York Fed’s Current Issues, Robert Battalio, Hamid Mehran, and Paul Schultz discuss how short-sales work and whether bans on short-sales have had the desired effect of slowing down stock price declines. They haven’t.

Some quotes:

Our analysis of the empirical evidence from the United States suggests that the bans had little impact on stock prices. Even with the bans in place, prices continued to fall. At the same time, the bans lowered market liquidity and increased trading costs. …

Short-selling is the selling of borrowed shares by investors who expect to cover their positions later by repurchasing the shares at a lower price. … during 2005 it accounted for 24 percent of trading volume on the New York Stock Exchange and 31 percent of Nasdaq trading volume.

Most short sales are conducted by market makers or high-frequency traders, or by options market makers who short to hedge their options positions. Market makers and high-frequency traders generally do not maintain short positions for long periods. In fact, they typically close them within minutes or even seconds of opening them.

Our focus is on investors who short stocks for longer periods because they believe the stocks are overpriced; they expect to profit by repurchasing the stocks after prices have fallen. These investors generally borrow the shares from an institution, often one with a passive investing strategy. In exchange for the stocks, the borrower places collateral, usually cash, with the lender. (The standard collateral for U.S. equities is 102 percent of the shares’ value.)

The lender of the stocks pays interest on the collateral at a rate that is negotiated between the borrower and lender—referred to as the rebate rate. For stocks that are easy to borrow, rebate rates may range between 8 and 25 basis points below the federal funds rate …

Despite concerns that short-selling can artificially drive prices below fundamental values, it is not easy for investors to make money in this way. Short sales may depress stock prices, but the short-seller profits only after buying back the shares at low prices to close the position. If purchases and sales have a symmetric impact, such that a sale of shares moves prices down by about the same amount as the purchase of the same number of shares would raise prices, prices will rise to their original levels when the short-seller buys back the shares. In that case, the short-seller will not profit from this strategy and will instead lose money on trading costs.

One way for a short-seller to make a profit shorting a stock that is not overvalued is to somehow fool other investors into selling him the shares at a price that is lower than the one he charged the original investors. This is a risky scheme, however, and may prove very unprofitable. … Moreover, if short-sellers spread false rumors about a company or attempt to manipulate its share price, they are engaging in illegal activities and the targeted company may fight back.

… Lamont (2004) finds that, on average, the stocks of the targeted companies underperformed the market the following year by a whopping 24.7 percent. … “many of the sample firms are subsequently revealed to be fraudulent.”

In addition, investigations into the activities of the short-sellers were requested by sixty-six of Lamont’s sample firms. As Lamont notes, if the Securities and Exchange Commission (SEC) had found that these short-sellers were spreading false rumors, manipulating prices, or committing other illegal acts, their criminal activity would have been revealed and the stock would have rebounded. In fact, the companies that requested investigations earned abnormal returns of -27.7 percent the following year.

Another way in which a short-seller can profit from shorting a stock … is by weakening investor confidence in the firms whose stocks are shorted. This seems to have been a concern of the SEC when it imposed the 2008 ban on short sales. …

Still, it might take time to damage a financial firm in this way. Prices may need to be held artificially low for an extended period. Moreover, the firm would have an interest in convincing investors of the soundness of its assets. If other smart investors believed that the financial firm’s assets were solid, they would trade against the short-sellers, making the shorting strategy a risky one.

The Guardian reported in 2011 when four European countries introduced bans on short-sales while the UK did not.

“Institutionelle Schwächen der EU (Institutional Problems in the EU),” FuW, 2015

Finanz und Wirtschaft, July 15, 2015. PDF. Ökonomenstimme, July 16, 2015. HTML.

The collapse in Greece is a consequence of major institutional problems:

  • Political decision makers in Berlin, Paris, Brussels, Frankfurt and Washington didn’t follow the rules. This seemed optimal ex post, but is suboptimal ex ante (see Kydland and Prescott).
  • The ECB’s mandate is unclear.
  • The monetary system is fragile.