The New Republic

I rather doubt we have the means to "rescue" the Euro even if we wanted to. The economy of the EU is rather larger than that of Mexico, after all. On the last day of class in my international trade course, a week or so ago, we had a free-ranging discussion of everything. In the course of the discussion, the professor said, with no particular drama that Greece will default within the year. I asked, "Are you sure?" He said he cannot think of any means by which it can be avoided. Europe is making the same mistake as the United States, allowing itself to be held hostage by bondholders. When a bond issuer cannot pay its debts, it should default and it should be allowed to default. It is just paper. The result is that the debt, one way or the other, is wiped out, but whatever assets exist on the other side of the ledger are not gone, particularly in the case of sovereign debt where there is nothing to liquidate. THEN assistance may be needed to provide new credit. This is how we rescued the auto companies. Bondholders of course want everyone to believe that they and the institutions that owe them money are one and the same thing, that the institution cannot be restructured without making the bondholders whole. This is a self-serving lie, a fiction that terrorizes everyone into leaping in and shelling out a fortune to rescue bondholders from their own folly. We let the auto bondholders and, lo and behold, the autos are now stronger for it because we rescued the productive enterprises, or the productive parts thereof, without wasting our money paying off the bondholders. We should have done the same with the banks, rescue the institutions and the depositors while subordinating the bondholders and equity holders to get whatever value was left after the restructuring and after the government had been paid back with an appropriate profit for its risk. Apart from the perpetual class war against labor, the biggest problem of capitalism is that capitalists hate capitalism. The blather on about reward for risk, but, when they are facing losses, their devotion to capitalism and the principles of risk and loss vanishes and they want the public to pay them off. The Icelanders and Irish took the bait, hard, and are suffering for it, although the Icelanders much less because the independence of their currency has given them a second means, devaluation, to write off their debt. The EU should establish means for resupplying a defaulted country with fresh credit to keep its economy going and then let the chips fall, the sooner the better as these things are always more expensive to clean up the longer you wait. If sovereign lenders begin to get the idea that they can lose their money, as they should, there will be many fewer such crises as they exercise appropriate restraint in lending. The may even be willing to structure workouts and haircuts rather than see outright default which would be all to the good for everyone concerned.

- roidubouloi

December 22, 2010 at 11:10am

How is Iceland an "historically backward polity"?

- ironyroad

December 22, 2010 at 12:54pm

How's Argentina doing, Malahat? That was my professor's example of a successfully managed default. My whole point is that there is no reason to make bondholders whole, but that will require support for the contrary so that it has access to new credit. Paying off the old bondholders, who deserve to lose because of their profligacy, both eliminates moral hazard and makes the cost of bailout much more expense. Better to bailout Greece itself with credit for its trade needs and stiff the bondholders. Yes, credit will be more expensive later, but that is as it should be. Artificially cheap credit is a big part of the problem. What do Swiss bankers know? Their whole system is built on helping people defraud other governments. As investors, they stink. Last place any honest person should put his money is in a Swiss bank. Your argument, malahat, is like claiming that there won't be another asset or debt bubble after one bursts because investors will have learned their lesson and won't reinvest. That clearly isn't true. We can have as many bubbles as we are willing to inflate because people never learn. With support in the short-term, a fiscally responsible Greece can both default on its existing debt and return to the credit markets, but not without restraint. That will be to the good. There is no reason for investors to shovel money at Greece and then try to stick European citizens with the tab when it goes sour.

- roidubouloi

December 22, 2010 at 1:26pm

Let's not save the EU! Aside from the practicalities as Roi noted, the world worked so much better before the European Union as I recall (there were a few little conflicts I understand). The success of the EU, as a purely bureaucratic enterprise is stunning from both a political and economic perspective. Legions of drones working away at a thankless (and often criticized) job removing barriers, establishing standards and doing all the other things that only the government will do that makes life easier for free enterprise. Its not that long ago that something a stupid as a roll of toliet paper (or was it paper towel?) was of a significantly different size between a number of EU countries. Bet that led to economies of scale.

- Nari224

December 22, 2010 at 1:47pm

I don't care enough about the Eu to wish to engage in this non debate. However some people like Malhat, or Itzik might find this article of interest. http://nationalinterest.org/print/bookreview/what-rawls-hath-wrought-4570 It's about "human rights" as a utopian ideal.

- jdyer

December 22, 2010 at 6:40pm

malahat, I get that a default can restrict credit access, which is why I think the best function for the EU is to manage a default by providing credit support after the fact, not pay everyone off at phenomenal expense to the public. It is unhealthy for lenders to think of sovereign debt as riskless and fail to make normal credit judgments about the way the national fisc is being managed. If things are well-run, I do think that countries that have previously defaulted can return to the credit markets. One also has to give thought to why credit is needed in the first place. Sovereign borrowing from abroad to run budget deficits is a really terrible idea that should be discouraged. Sovereign borrowing to finance trade deficits is an equally terrible idea unless the country needs to import capital, and even then it is better if the borrowing is done privately. There is too much sovereign borrowing altogether. It is not healthy for the system or generally for those economies that are doing it. The case of Finland is particularly awful in my opinion because they stepped up to guarantee private obligations. I would have let them all go and then backed the banks and depositors, letting the overzealous investors float out to sea with the cod. I am in a a part of Mexico that is far from the drug wars as there is nothing here to interest them, and I stay in the town I know after 12 years coming here. Thanks for your good wishes, and best to you and yours in the New Year. Feliz año nuevo, bonne année.

- roidubouloi

December 22, 2010 at 8:14pm

Maybe Iceland is "historically backward" because of the number of geysers there. You know how they tend to be conservative voters afraid of too much change.

- ironyroad

December 22, 2010 at 8:36pm

Great Idea, Malahat. Perhaps after the New Year.

- jdyer

December 22, 2010 at 9:02pm

"Maybe Iceland is "historically backward" because of the number of geysers there." It's because it's so cold over there. And they have an archaic system of naming family names. For example, if Irony Road had a son, his name would not have been "Junior Road", but, "Junior Ironyson".

- noga1

December 22, 2010 at 9:38pm

True. And if he had a daughter and named her Satire, she would Satire Ironysdottir. It's kind of impressive. I thought it was great, too, that the Mongolians held off taking surnames until a few years ago, even in the capital city. The Ulanbator phone book would have read Ironyroad 297 64, Ironyroad 433 99, Ironyroad 234 07 then malahat 333 82, malahat 921 44, malahat 545 23, then Noga 201 81, Noga 638 21, Noga 714 45. And so on. Of course, informal identifiers were very common, leading to exchanges such as "Which Noga? AlwaysquotingJaneAusten Noga or Geyserspecialistwhowearsgreenwoollyscarves Noga?"

- ironyroad

December 22, 2010 at 9:55pm

An intriguing imagination you have, Abu-JuniorIronyson.

- noga1

December 22, 2010 at 10:13pm

Uh-oh, not only that, but I just realized I messed up the joke -- there are no geysers (and probably therefore no geyser specialists) in Mongolia. Apologies, Noga de Nord.

- ironyroad

December 22, 2010 at 11:10pm

Unlike Peretz suggests, this whole story has nothing to do with exceptional profligacy of brownish and Catholic Southerners, even if many racists and anti-Europeans are dying for that to be so. The spectacle of qualifying Spain or Portugal as the downside of Modernity while congratulating oneself is centuries old. And it is indeed getting old... Hey, compare Portugal's numbers with the US or the UK one's. Maybe you're up for a surprise: they're better! And they're not much different from France's. So when Portugal defaults, come back to me. If you honestly addressed the causes of this crisis, you would understand that this has to do with markets exploring the gap between currency union and lack of budget union and fiscal harmonization in Europe, in order to make a dirty profit. But you know what? The gap is already being filled. And those markets are up for a big loss on their "bets and shortings". Of course the gap is not being filled as the markets wished it would be, i.e., by increasing dependy on their financing at high interests (bailout after bailout with no costs attached, something like the plans Paulson and Geithner endorse, mutatis mutandis). Germany wouldn't allow it and rightly so. Besides, it doesn't have to. No European country, except the UK, was crazy enough to develop an economy with 40% GDP made of hot thin air (meaning, financial "services") as the US did. And because of that, no European country, except the UK, is under the markets' blackmail to the level the US is. And that's precisely why the markets are furious. Too bad. At the end of the day, the "PIIGS" story is going to be their Stalingrad!

- Ideaot

December 23, 2010 at 3:30am

"Apologies, Noga de Nord." You make me sound like a railway station in Paris.

- noga1

December 23, 2010 at 10:19am

I was thinking more of a classy restaurant in Montreal, serving its famous Israeli-Persian rice-and-potato dish. :)

- ironyroad

December 23, 2010 at 1:27pm

More on Argentina's default-- The default itself quickly allowed Argentina to resume economic growth (in comparison to the stagnation that continues to dog bailout-afflicted Europe and the USA). For a country with Argentina's profligate history, being shut out of international debt markets is not necessarily a bad thing. The default was, however, defaced by various populist touches whose unfairness does more to deter new investment, eg: (1) Foreign utilities borrowed dollars to rebuild Argentina's infrastructure, but are being paid back in sharply devalued pesos. The government has refused rate increases to compensate. (2) Foreign banks saw their loan portfolios converted to pesos, but were told they still owed their Argentine depositors balances in dollars. They had no reasonable choice but to abandone their Argentine subsidiaries to bankruptcy. European economic authorities could oversee defaults to ensure that foreign bondholders and depositors got fair consideration, rather than being the *only* ones to bear sacrifice.

- hcunn

December 23, 2010 at 1:36pm

To malahat: I am aware of your point about pension funds and ordinary savers. But how does it affect my point?

- hcunn

December 23, 2010 at 3:05pm

I am arguing that bankruptcies and lower-level (State, municipal, and European country) defaults can be a superior outcome to endless 100% bailouts, that encourage more unwise lending and borrowing. For example, Ireland should have forced bank investors and depositors to take a significant "haircut," rather than saddling Ireland's budget and taxpayers with the whole cost of a bailout. Some bailing-out is acceptable, even necessary, but it should not be 100% for speculative activities.

- hcunn

December 23, 2010 at 10:23pm

Why do you think that sovereign debt is the primary source of credit in advanced economies, malahat? The purpose of credit is to bridge the gaps between spending and income within an economy. Sovereign debt is a rather different matter. You are conflating a lot of different things. Given your thesis, how do you explain the renewed growth in Argentina following the default? According to you, growth When there is too much credit to or investment in a given borrower/asset, then there are losses. The question is, who should bear them? I say it is the people who assumed them by extending the credit or making the investment. That they are pension funds is quite irrelevant. Why should an entire society suffer by taking on after the fact the obligations of feckless investors? Sovereign debt means the sovereign can repudiate the debt and you have no recourse. That is part of the risk you take. If the purchasers of the sovereign debt had been prudent, it wouldn't be an issue. The workers in the country were not given any choice. Having investors bear the losses they agreed to assume is not "handing them losses." They are trying to hand off their losses, and the public in whatever country should not accept. Bailouts of key institutions are necessary. Bailouts of their investors are not. See, e.g, US auto industry When you say that bailouts are the least worst option, you are doing what investors want us to do which is to identify them with the institutions at risk. We can easily save those institutions without saving the investors, and we should. That's what bankruptcy is for -- to reduce the liabilities to the value of the assets -- and it can sensibly apply to nations as well as corporations.

- roidubouloi

December 24, 2010 at 12:24am

According to you growth in Argentina should have been stifled by the default, but the opposite happened.

- roidubouloi

December 24, 2010 at 12:26am

I think we agree pretty much about the things you think we agree about. The difference seems to me to be about the importance of bailing out investors. Certainly, we needed to prevent the banking system from defaulting on deposits. But we could have done that in a variety of ways without doing anything to secure to bank investors, bondholders and stockholders, their value. They could have been wiped out, as was done in the case of autos, or they could have been subordinated in such a manner that, if the value did not increase so that the assets were worth more than the deposits, they took the hit, not the government. Investors want us to believe that bailing out the asset, which we need, is the same as bailing out the holders of liabilities. It isn't. Since there is no reason why we must bail out investors to avoid the liquidation or cessation of the underlying operating business, I don't see why we should. Why is the public better saddled with the losses that the investors agreed to assume and that their own behavior likely contributed to? Beats me. And that is quite apart from the moral hazard created by doing so. Same with Greece. The EU can let the sovereign debtholders sit around waiting while providing, at much lower cost to the EU, support needed to assure Greek trade flows. Then it can tender to buy up the defaulted debt at 20% of face against the threat that it will not only be in default but outright repudiated, canceled as a matter of law. By and by, the Greeks can pay back the 20% that it cost the Germans to buy it up. Will there be dislocation in the credit markets? Sure. But there will be plenty of dislocation, and loss, down the road if someone has to pay off the excessive Greek debt in full. PLUS you avoid exacerbating moral hazard by shifting the losses from the people who agreed to bear them, the debtholders. __________________ The matter of sovereign debt is not as simple as you make it out to be, and it is not quite the analog of private debt. If an economy is closed, or its trade is balanced, then it has no reason to incur external debt. External debt is the flow opposite trade deficit in goods. How then does a government come to be spending more than its tax revenues? The economy is in trade balance so, be accounting identity, it is producing what is consumed in the private sector (including investment goods) and what is consumed by the government. The economy therefore has sufficient output. If the government's resources are not great enough, it is simply not taxing enough. It is taking the same share of output and therefore of purchasing power but giving people back pieces of paper in exchange for their money, rather than just taking the money. If the government raised the same amount it is raising from taxation and borrowing and spent the same amount, the consumption of the private sector would be unchanged. Now, there are some issues of efficiency of tax collection and of income distribution and of the effect of taxation, as opposed to borrowing, on spending and hence output. In an extreme emergency, such as WWII, greater reliance on debt makes sense. It can also make sense counter-cyclically, to stimulate demand in a recession by increasing government spending temporarily. Otherwise, what is the purpose? Why is the government taking its share and returning pieces of paper promising a greater share later rather than just taxing? Where external debt is used to enable trade deficits, the good purpose would be to create capital infrastructure that the country cannot afford without severe restriction on consumption. The capital is invested in anticipation of growth that can outpace the debt and make it easy to pay off in the future. This is like any start-up investment in a sense. It is still, however, dangerous compared to private borrowing and investment. With private investment, if a project fails, then the investors take the loss -- see above -- and the country is not worse off. If the borrowing is done at a sovereign level, then the nation is still on the hook for the cost of the failed project. Hence, sovereign external debt as a means of financing investment should be used sparingly. My conclusion is that sovereign debt is way overused and thence abused. For sovereign borrowers who are not credit worthy, we have the IMF. Properly managed, I do not see the danger that you do in sovereign default or in the contraction of credit to nations. It is more abuse than anything else, a system designed to avoid taxation of the rich (where the unspent income accumulates) who then want everyone to eat their losses. If need be, I would rather provide support to pension funds. Still cheaper than bailing out all the investors because some of the holders are pension funds. If they are undiversified, then I have little sympathy.

- roidubouloi

December 24, 2010 at 10:09am

Ok, but let's just say that the claims of the investor class, including finance, that default leads only to disaster and that they will punish the defaulter need to be greeted with some skepticism. They have an enormous self-interest in making the world believe this and we have the recent counterexample of Argentina. If a country has goods to sell that people want, they will buy, regardless of what the investor class thinks. If not, the good opinion of investors merely leads to more debt by the time insolvency results. We also know that urrency devaluations are a de facto default and have not historically led to all of the disasters malahat foresees. Iceland's currency declines are helping it recover. An alternative for Greece is to bolt the Euro and then watch the New Drachma fall. The bondholders will take the haircut, just as they would with a default managed by the EU.

- roidubouloi

December 24, 2010 at 3:09pm

Malahat: Why don't you just repost the entire edited comment? It saves you the need for all this cross-puzzle directions and the reader the need to count sentences, remove and replace entire phrases, etc.

- noga1

December 24, 2010 at 4:37pm

In the US, the dollar is legal tender for all debts public and private. That means you can always settle an obligation denominated in another currency in dollars. The Greeks can do as the Argentines did, convert their Euro obligations to their new currency, if they declare one, at the initial rate of exchange and then just let the drachma sink. The obligations will no longer be Euro obligations. Of course the holder can hedge, a matter of indifference to the issuer. This just sells any loss on the currency decline to a third party. The issuer will still be paying off in depreciated currency which is a de facto default, a haircut, no different than if they just paid it off in Euros at a discount. The currency decline also helps the Greek economy compete. This is why the Chinese are pissed at the prospect of quantitative easing. If the dollar falls against the yuan, they take a haircut. The Fed can issue dollars fadter than the Chinese can buy them, then they buy treasuries driving our rates down as the Fed wants to do. Of course, the miscreant Republicans take the side of the Chinese against the US in the hope that the economy will worsen and they can ride that to victory in 2012.

- roidubouloi

December 24, 2010 at 4:43pm

I tried to hunt for our mutual friend on these here threads too, for the same purpose but couldn't find a trace of irony. So I sent him an email message, instead.

- noga1

December 24, 2010 at 6:17pm

All debts can be settled in dollars. Technically, a bond to deliver a foreign currency is commodity contract, as foreign currency is a commodity in the US, not legal tender. This is not the sort of contract as to which specific performance can be required. Hence, if you tender the full value in dollars, the other party can refuse but that is all he can ever get even if he pays to cost of a suit. If the Chinese stop buying Treasuries, they have no place to put their trade surpluses with us. And if they stopped accepting dollar tender, their surplus with us would necessarily fall to zero. That would be the best thing that could possibly happen to us. As the buyer, we have much more power than the Chinese. But bcause we are in the grip of free-trade ideologues, we don't use it or know how to use it. It is a misunderstanding to think that Chinese debt purchases finance our government. They only finance Chinese trade surpluses. If they went away, domestic demand woukd rise and we would replace imports through additional output. The ability of the government to finance would rise accordingly. Failing that, domestic consumption would fall, but we shouldn't be borrowing from abroad for consumption. That really is living beyond our means.

- roidubouloi

December 24, 2010 at 6:34pm

Done.

- noga1

December 24, 2010 at 8:20pm

Noga, malahat, I'm here. Have had a hectic couple of days, need to recover. Noga, thanks for the email, reply already winging its way. malahat, best wishes and a good holiday season to you too. marting_1@comcast.net is the email if you want to contact me at any point.

- ironyroad

December 24, 2010 at 9:11pm

Lot of different points here, somewhat at cross purposes. The point about Greek obligations being converted to drachmas, if they chose to bolt the Euro, is that, as a sovereign borrower likely subject only to their own jurisdiction, they can decide what constitutes satisfaction. Just as any debt subject to US law can always be settled in dollars, even if the contract is for some other currency, the Greeks could decide that drachmas are again the only legal tender in Greece and that would be that. That is what Argentina did. The bond market could in theory punish them, but it is still without recourse. It doesn't matter whether the Chinese invest in stocks or land or Treasuries. If they buy land, someone else then has the dollars. They have to do something with them. They buy stocks. Then the sellers have the dollars. Sooner or later, they end up in Treasuries as that is the expanding asset class. The point rather is that the Chinese have no place to put their dollars other than into US investment in some form. If that doesn't happen, then someone is left holding dollar deposits. Those are a US investment too. There is no way out because we issue our own currency. So, the Chinese are not doing us some kind of favor by buying Treasuries. If they took a trillion out of circulation by holding the deposits and essentially sterilizing them by doing nothing with them, then the Fed could buy up a trillion of Treasuries to replace the sterilized currency without any resulting inflation. We would have a trillion dollar free ride. Think of it this way. All that is happening is they send us goods and we send them Treasuries. If we weren't running a trade deficit, then we would have no need to print the Treasuries with which to pay them, but that wouldn't affect the budget deficit at all. It would affect output and consumption. So, if the Chinese stop investing their trade surpluses in American assets of some sort, it is of no consequence to us. And if they stop accepting dollars in payment, they cannot run trade surpluses with us which they are moving heaven and earth to continue doing. They need the surpluses far more than we need their goods. That's why we have the whip hand in the trade relationship and could set things right in a heartbeat if our policy were not dominated by free-market fundamentalists. To return to the Greeks, they have the option of returning to the drachma and again becoming the issuer of the currency in which they owe the money. They can print drachmas to pay off, which could result in inflation, but then their currency depreciates and their trade balance improves. It is not necessarily continuing inflation, but a transient, a repricing due to the larger money balance. This gives them the means to lower their real costs of production in international terms without the trauma of deflation. Yes, they might have trouble borrowing, but that is where the EU can help out. I actually think an explicit default would be better in that there will be fewer dislocations. But, with institutional support, I still fail to see what terrible consequence is supposed to follow from their being unable to borrow abroad in the normal course. Is Argentina suffering for having defaulted?

- roidubouloi

December 24, 2010 at 9:22pm