Greece explodes, Italy ticks

I started watching the live BBC feed last night after it became obvious that European markets had reacted very poorly to the call by the Greek PM to allow for a democratic process to occur in his country by asking its citizens to make a decision as to which poison they will imbibe over the next decade. The Greek PM is now running a fine line between his people, the Greek parliament and the rest of Europe which could fall either way. Overnight there were reports that the government was crumbling, then that the referendum was off but neither were true. There will be a confidence vote on Friday for Mr Papandreou, whom at this stage seems to have the numbers, and a spokesperson for the government has re-stated that a referendum is on.

Obviously the rest of the European elite are in damage control, but exactly how they will fight against a nation’s right to vote on its own future without coming off looking like the erstwhile Col. Gaddafi will be interesting. I note that there have been some ominous signs of something a little more dangerous occurring with a surprise re-shuffle of the Greek armed forces. The latest update is that this was a “planned” event but given the recent history of Greece this is sure to add tension.

Although the markets seem to be of the opinion that the Greeks could scuttle the bail-out plan and therefore doom Europe to a messy default, I am not sure a vote would be that clear cut. This isn’t exactly a choice between two diametrically opposing outcomes, it is a choice between years of hard economic times and years of hard economic times, as I said above “choose your poison”.

What this latest episode once again highlights in the short-sighted memory of the financial markets is that Europe’s leaders are unable to deliver a co-ordinated response to the on-going economic crisis. Many will see this as a political failure, which in some regard it is, but the true problem for Europe has always been that their politcians are unable to tackle the underlying issue that the Eurozone itself is built on unsustainable macroeconomics. This was once again highlighted  last night as I watched the feed from the BBC:

18:08 More on the phonecall between Silvio Berlusconi and Angela Merkel (see 1750 entry). AFP reports that Mr Berlusconi assured the German chancellor that Italy was “determined” to introduce the necessary reforms “rapidly”, according to his press office.

17:50 Italy PM Silvio Berlusconi says he has spoken to German Chancellor Angela Merkel about the current crisis on the phone and confirmed Italy’s determination to implement reforms, Reuters reports.

These are the same promises that we heard from Greece. In fact we have now heard them from Portugal, Spain and most recently France. What we also heard from those countries was initial denial that they had a problem. We are now seeing the same from Italy as highlighted by a recent interview with Paolo Romani, the minister for economic development:

Italy should not be painted with the same brush as Greece or Portugal as its fundamentals are strong and the economy can support the debt stress it is facing, says minister for economic development Paolo Romani . Excerpts from an interview with Rishi Shah & Amiti Sen .

Are you concerned about the state of Italy’s economy? 

The Italian economy’s fundamentals are very good. We are the second-largest manufacturing country in Europe with value added manufacturing of Euro 233 billion, just behind Germany. We only have one problem- our debt is 180% of our GDP (gross domestic product). But it is not a problem of today or yesterday. It is a problem of day before yesterday and dates back to the nineteen nineties. So all this speculation in the market about Italy is not justified. The crisis is related to the paper economy, and we have a real solid economy. But this does not mean that the strong real economy of Italy cannot support this kind of stress.

But markets don’t seem to think that Italian economy will make it through crisis of confidence! 

It is because the markets are frightened about Greece, Portugal, Spain and Ireland. Italy is one of the founders of EU and, as I said before, is the second largest manufacturing economy of Europe. It is also the fourth largest economy of Europe. So speculation against our country is a speculation against Europe

These words seem surreal against the backdrop of the debt markets and a 7% overnight tumble in Italian equities, but they also misrepresent the sustainability of the Italian economy. If you have a look at the sectoral debt of the Italian economy you will notice that that up until 2009 the government debt level hadn’t grown in any meaningful way for over a decade:

But what had occurred was a growth in debt in parts of the private sector. As I have explained previously if a country runs a current account deficit then it must be accumulating debt in one of the non-export sectors. This is simple accounting, but for some reason the world’s economists don’t seem to understand it.

The dynamics of the economy, including taxation, determine exactly where the debt accumulates. It is different in each country but the overall effect and outcome is the same. Paolo Romani’s statements about Italy having debt since the 1990’s is true and before 2000 it may have been sustainable. The Italian current account chart explains why:

Prior to 2000, Italy actually ran current account surpluses. This meant that it was able to offset its government spending with inflows from the export sector. But you can see from the chart that something happened at the turn of the millennium. I’ll let you take a guess when Italy joined the euro.

Was it the currency or was it the deregulation of capital flows that caused the problem? I’ll leave that argument for another day, but either way, once Italy joined the euro it appeared to lose any competitive export advantage it had under its old currency and to maintain its standards of living embarked on a journey of ever greater debt accumulation. This was the engine that ran these economies for the last 11 years. But the outcome was inevitable. Once the debt of one of these nations reached a level where it could not be sustained by the real economy then the implosion would begin. We saw this with first with Greece. Once austerity is enacted the engine is turned off, and the real economy collapses while the debt, and interest on it, continues to accumulate.

Without some mechanism to address this fundamental issue nothing can be fixed in Europe, everything else is a side-show.

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  1. What a delicious problem! Call me a troublemaker or what you will, but I think it’s richly amusing when a bit of democracy creates panic for those in high places. And then there’s trouble for the ECB too — despite buying large slabs of Italian debt the yield went higher. We are told the ECB isn’t allowed to do QE — but how much more sovereign debt can it buy before it’s deemed QE? Is there a limit? Or can it buy Italian bonds indefinitely?

    • They broke the rules about bailing out other nations, they regularly ignore clear majority consensus of the people, they invalidate CDS contracts. I’ve been saying this for a while. They will do anything and everything to try and contain this. They will keep burning money on containing this crisis until there is nothing left to burn. They will sell everyone’s future just to buy an extra day, in the end reaching the same end but in a worse state.

      Unless I’m mistaken, the ECB spent ~5 billion Euro in one day buying bonds, compared to spending 2 billion per week not too long ago and 5 billion last week.

      Just think about it like a gambler stuck in a insurmountable hole chasing his losses. There is nothing he won’t do, no debt too great, no law or act sacred enough when it comes to trying just one more time.

      The trouble is now that they are really out of options. Leveraging didn’t work. 50% non-default haircuts didn’t work. Anything else will not even buy a day of market euphoria. Additionally, by the time the referendum happens, I think Italian yields will make it unable to fund itself yet no-one will be able to bail it out. Expect the printing presses. Before long we will be hearing back flips on that. Printing creates jobs!

  2. “As I have explained previously if a country runs a current account deficit then it must be accumulating debt in one of the non-export sectors. This is simple accounting, but for some reason the world’s economists don’t seem to understand it.”

    Yo brother! Would everyone in MB who disagrees with this statment please come forward now so that we can have done with this argument forever and get on with some sort or proper proposals for the cleaning up of the debt mess!

    • Would everyone in MB who disagrees with this statment please come forward now so that we can have done with this argument forever and get on with some sort or proper proposals for the cleaning up of the debt mess!
      As far as I can see, nobody has ever disagreed with that!!
      It is just that you keep tilting at the same windmill and try to re-litigate over the same issue over and over again. Stop fighting the non-existent enemy on MB!!

      • Mav
        I SEEM to you to tilt at the same windmill. I guess that is because the economy is one big windmill with a mass of interconnected parts.

        Discussions in here seem to be carried on as if the matter under discussion is the only moving part in the economy.
        Elsewhere, at the moment, we have a discussion on interest rates which was being carried on as if interest rates had no effect on the CAD or the structure of the economy.
        Continuously we have reference to the Rudd Swan Henry axis ‘saving’ Aus by their quick spending action…none of which happens without causing an increase in the CAD, or as happened in our case a sell-off of assets and more external borrowing! This effect is simply ignored. As posted elsewhere I get tired of people saying how great a Treasurer Costello was (not in this forum!)! Hells bells!
        We had a discussion on the Carbon Tax ignoring the CAD when half the blessed Carbon Credits have to be bought overseas….for what purpose?

        OK I doubt I’m tilting at the same windmill although i do seem to be, in my dotage, some sort of modern day Quixote.
        I think I’m actually desperately holding on to one eroded economic pillar that everyone else seems hell bent on undermining.

    • It is an accounting identity, i.e. it is true by definition.

      It is analogous to assets minus liabilities equals equity. An accounting identity. Do people argue about that as well?

  3. I think you’ve captured it totally, and the Greek army re-shuffle (sackings../sarc) says a lot. And I’m guessing retaliation

    It’s unraveling ….

    Looking yesterday at Italy’s re-financing of the it’s debt:

    From 2012 on with predicted lower growth how will they be able to roll over that debt? China will buy some I guess, but who else?

    The Greek PM will have to hide soon IMO.

  4. Clearly there are a lot of eurocrats that think it’s easier to control the citizens of 5 sovereigns than it is to control a dozen badly run banks.

    Reality’s a b**ch

  5. To insure or not to insure. That is the question. At least, it is one of the questions provoked by the prospect of Greek default.

    The markets and the politicians are unwilling to see Greece default because of the chain reaction that could set off in the CDS markets, as we saw when Lehman collapsed. Because – it is argued – the CDS market is opaque, no-one really knows whether counter-party undertakings can be relied on or not, or whether the market will just seize up in the event that contracts are called.

    In the current context, the fear of market failure has been great enough to deter lenders from declaring default and then seeking to recover losses arising from write-downs on Greek debt.

    This really begs the question, “What good is the CDS market at all?”

    If it actually does not offer reliable protection against default when you actually need it – that is, in the event of a default – why buy the “insurance” purportedly offered by CDS contracts.

    As it turns out, all the CDS market has done is to induce a quite false sense of security among both lenders and borrowers. At the same time, those who sold default insurance are effectively making windfall gains. They have been let off the hook, at the expense of their counter-parties and taxpayers, as a result of bargaining by terror-struck politicians.

    The obvious thing to do here is to allow Greece to default, see where the dust settles and then put the system back together.

    If the CDS market really cannot cope with a default by a relatively small state, such as Greece, then the market should be closed. If those purporting to insure against risk cannot actually deliver on claims, then they should not be permitted to trade in risk. This is really simple.

    Given the incredible scale of potential risks in the sovereign market, it is about time the CDS market was given a reality-based stress test.

    If those now running the CDS market say this would be too much for the market to bear, then they are really saying, once again, they have badly mispriced credit risks and this somehow exonerates them from loss.

    The CDS market is clearly just one large incestuous fraud. It is a danger to everyone, large and small and should be closed if it cannot perform.

    • This really begs the question, “What good is the CDS market at all?”

      If you don’t have an insurable interest (i.e. using CDS for hedging) it serves no purpose whatsoever other than to increase world risk and provide a casino for gambling addicts who will get big bonuses if their bets win and at worst lose a job if their bets lose.

      • Critical Influence

        How is that statement any different for the much larger equity derivatives market, for example?

        As long as derivatives have existed people have claimed that they should only be used for hedging. The problem is, without speculators, there is no ‘market’. For example, who would sell protection?

        The answer is to make it safer by putting it all on exchanges, and require very high initial margins.

        Mind you, Sovereign CDS will likely die all on its own once people realise that Sovereigns are not like Corporates.

        • …who would sell protection?

          Who sells insurance? Insurance companies. I can insure my possessions. I can’t insure yours. The insurance industry understands that if I can insure against something happening to you I have incentive to make that event occur.

          As an example, in life insurance if you do not have an insurable interest then that (may) become grounds for the insurer denying a payout (notwithstanding the existence of viatical companies).

        • I actually overlooked the bigger problem in my previous reply, namely the amplification of risk.

          Sticking with insurance examples:

          The Qld floods were a once in a 2-3 decade events and cost a few billion.

          Flood to a single household on any given day is probably fairly common. So imagine I have no underlying exposure to a particular household but take out insurance. This is what is happening in derivatives markets. So the payout on the flooding of a house maybe say $100K but if a thousand people have policies on that house the relatively common event becomes a payout of similar magnitude to a rare event.

          The point I’m trying to make here is that you have this systemic risk in the derivatives markets that is not necessarily proportional to the risk of an insured/hedged/gambled event, and this is primarily because there is no “insurable interest” requirement (i.e. exposure to the underlying asset using finance jargon).

          I see no reason (other than vested interest) why the entire derivatives industry shouldn’t be run according to insurance principles. Hedging is basically insurance so derivatives should be organized along those same principles.

  6. “The CDS market is clearly just one large incestuous fraud” ..says briefly.

    Oh so true !
    When Buffett was referring to WMD in the finance theatre ..the CDS must be the nuclear H-bomb. It staggers me how freely the bureaucrats/regulators/legislatures have allowed this weapon to proliferate .

    The transparent ease with which the CDS buyer can put it out there :’ yep such and such issuer ..they’re in trouble” and then collect the gain on the increased price of the CDS ” insurance” policy.

    CDS must be outlawed immediately after they are taxed out of existence.

  7. I am wondering what sort of effect a default would have on both Greek society and the Greek economy as a whole. I have heard from various sources that Greek gdp would fall by anywhere between 30-40% very quickly.

    But my question is what sort effect is that going to have on the man on the street? Mass unemployment will become an issue naturally but what else? Essential government services like health and education collapse overnight?

    I would love to hear what the MB team have to say on the issue, as the mainstream media hasnt really tackled what a country in the eurozone defaulting would actually do to the defaulting nation itself.

    Is it possible that the collapse of the Greek state and its relatively high standard of living could actually be good for the Eurozone as a whole in the long term? Could Greece be the example for all of Europe to look at and see what happens when you dont pay your debts?

  8. Trough all my youth Greece was a, sometimes brutal, military dictatorship! It wasn’t THAT long ago!
    People forget.

    Maybe that is why what has gone on there is such a tragedy. Democracy just set about voting itself debt-laden prosperity which may/will in the end be democracy’s undoing.

    Don’t think it can’t happen again or indeed happen in other most unexpected places.

  9. I confess to heretical thoughts on “sovereign default”. I have been a longtime admirer of Roger Douglas, and the courage with which NZ paid off its debt burden from the early 1980’s.
    I now think NZ might as well have defaulted. Why not? I now doubt the pain is any greater, for any longer. International credit markets will end up lending again. And the benighted people need to experience “compulsory” pain following sovereign default, rather than have a person – Roger Douglas – to scandalously vilify for decades.
    I see no reason why a nation has to bother to pay back debt any more. International credit markets have asked for it, begged and prayed for it. “Lending to governments” is the world’s BIGGEST BUBBLE. I doubt ANY nation is ever going to do what NZ did once. Especially not NZ a second time.
    My sympathies are entirely with Roger Douglas still. He does not deserve the vilification he gets.