What was it all for? The latest Greek Bailout-PSI in the Morning After’s cold light

12/03/2012 by

So, Greece defaulted. In the beginning, May 2010 to be precise, Europe and the IMF put up the largest loan in history supposedly to avert any kind of debt restructuring.  Then, when by the summer of 2011 it had become clear that debt restructuring was unavoidable, Europe embarked on ten months of navel gazing and a series of odd negotiations in order to effect the type of debt restructuring that would not, we were told, trigger CDS contracts. This week the default occurred and the CDS contracts were triggered. In terms of the troika’s own criteria, this was a spectacular failure to meet both targets.

But was there a silver lining, as the powers-that-be say there is? Did Greece’s debt enter a sustainable path, even if belatedly? Again the answer is a definite No! Exhibit A is, of course, the fact that the new English Law bonds issued by the Greek state (to be swapped for the distressed older Greek Law government bonds) are trading at prices which shriek: “Fresh default coming soon!” Could this be another instant when markets are wrong? So, let’s look more closely under the bonnet of the new Bailout-PSI combination.

Why a Fresh Default/Haircut is inevitable

The success or failure of a haircut depends not on its extent but on the viability of the debt that remains. When Greek and European politicians celebrate the fact that almost €100 billion have been shaved off Greece’s public debt, they state a useful fact but use it as a smokescreen that veils the numbers that count the most.

Suppose I owe a bank €100 thousand and the following agreement is struck: The bank will write off €53 thousand and will receive from me, in return, €15 thousand up front plus, say, 32 interest bearing IOUs of €1000 face value each and long maturity (assume also that the interest rate on these IOSs is around 4%). Has my debt been rendered serviceable? It depends. First, it matters that, since I do not have it, I must borrow the €15 thousand cash that I have promised my bankers. Who from? My metaphor is strained here. One could say, from ‘family’ (although families come in different guises, not excluding the Sicilian type). Secondly, as part of this deal, I must borrow immediately (or find it in the not distant future through liquidating whatever assets I have) another €30 thousand to put in a trust fund that will be used as collateral in case my IOUs bounce in the future (or in case I fail to meet my interest rate payments). Thirdly, for this deal to go through, I must bind myself to a behavioural code (also known as austerity) that most analysts believe will further shrink my already diminishing income flow over the next few years.

For these three reasons it is clear that it will take a miracle for my post-haircut debt to be, and to be seen to be, viable. Thus, it is no wonder that markets are pricing in a fresh Greek bankruptcy, by not wanting to touch the new Greek bonds, while northern politicians are refraining from any real commitment to keeping the Greek state/economy afloat. In summary, our brand new Bailout-PSI deal reinforces the climate which ensures that no self-interested investor will invest in the Greek economy as long as a freshly forged Damocles sword is hanging over the country.  And in a never ending circle of negative expectations, this climate and prospect makes the above mentioned sword heavier and its fall upon our heads surer.

What was the point?

Two years, two Bailouts, and €240 billion of official loans later (the purpose of which was to prop up a once €250 billion economy whose debt had risen, unsustainably after the Credit Crunch, to €290 billion), what has the result been? Nothing to write home about: a shrinking economy (whose collective income will soon dip below €200 billion) and a still unsustainable debt that will, only by some miracle, fall to below… 130% of GDP in eight years. This is the stuff of fabulous failure. Not so, however, if you look at things from the perspective of bankers, hedge funds and assorted members of the global and european financial sector.

The greatest achievement of the Bailouts was to buy the financial sector two long years during which to unload their Greek bonds onto the official sector. Henceforth it is the official sector, alongside the crushed Greek people, that will bear the costs of a forthcoming Default 2.0. Of course, given what has been going on on both sides of the Atlantic since the Fall of 2008, it is not unknown for taxpayers (for this is who ‘hide’ behind the so-called official sector) to bear the brunt of a financial disaster. Indeed, Europe’s taxpayers have been shouldering the costs of the Crisis since even before it erupted (toward the end of 2007, that is). We are (wrongly) almost conditioned to accept that the costs of finance’s folly will be born by voiceless taxpayers. Be that as it may, there is another real issue, one that concerns the efficiency, or otherwise, of the way public monies were used to prop up the financial sector.

Could it have been done otherwise?

Of course it could. Back in November 2010, Stuart Holland and I put forward the first, tentative version of our Modest Proposal. In it we had, at those early stages of the euro crisis, noted that:

“Europe desperately needs a two-pronged plan for tackling at once the deficit states’ debt and the banks’ problematic assets. Until this is done, markets will continue to speculate on which will be the next domino pieces to fall and thus the crisis will be reproducing itself.”

Instead of the combination of Bailouts with Austerity that would, in our eyes, inevitably lead to wholesale haircuts that affect all creditors indiscriminately, we proposed the following:

“The two-pronged attack at the current crisis can take a very simple form: A politically mediated Tripartite Negotiation between the following participants:

  1. Representatives of all high deficit countries that will, potentially, require assistance during the next five years (e.g. not only Greece and Ireland but also Spain, Ireland, Italy).
  2. The heads of the ECB and the eurozone, who will effectively be representing, as is their wont, the interests of the more dominant, low deficit, countries (e.g. Germany, Austria, Finland, Holland).
  3. Representatives of all the main European banks holding the majority of the high deficit countries’ bonds 


 By bringing these three sides to the same table, it will become possible to tackle the problem in its entirety; to avoid squeezing it in the domain of public debt only to see it balloon in the banking sector; or vice versa. Here is an example of a possible Grand Agreement that the Tripartite  Negotiation  might bring about:

  1. European banks agree to limit their demands over the debt of the high deficit countries (i.e. to restructure the debt of Greece, Ireland etc.)
  2. High deficit countries agree to implement reforms that reduce waste, corruption and parts of their deficit whose reduction will have limited impact on poverty, social cohesion and long term productivity growth (e.g. defence procurement, tax breaks for wealthier citizens, subsidies on environmentally damaging agriculture)
  3. The Eurozone-ECB undertakes to come to the assistance of European financial institutions that are stressed by (1) above and, crucially, to utilise the European Investment Bank (EIB) to increase productive investment throughout the continent, but more so in its recession-hit regions.


Note how such an agreement would reduce the total amount of debt and would instil confidence in the banks. Currently, under the Greek rescue plan and the EFSF, deficit countries borrow at high interest rates (5% plus) to pay existing bank debts to banks. That money is itself borrowed by the rest of the eurozone at various interest rates (depending on each country’s credit worthiness). Meanwhile, the banks (who are already borrowing at less than 1% from the ECB) have no confidence that the deficit countries will manage to continue meeting their payments beyond 2012. Thus they hoard funds and refuse to lend to businesses at decent rates. This merry-go-round reinforces the crisis and, in fact, increases the overall burden of debt. The Agreement above would both:

  • deflate the gross debt [by combining: (a) a partial, multilaterally negotiated,  haircut that is born only by banks which are already being drip-fed by the ECB, with (b) increased liquidity into the banks by the ECB at interest rates of 1% or less] and
  • make banks more confident and thus more willing to lend [by removing the prospect of a series of much worse, and totally unilateral, haircuts on the bonds that they hold after 2012-3].

Imagine if by the end of 2010 Europe had followed our advice. If, in other words, it had adopted the logic of a quid-pro-quo; i.e. of targeted write downs of all stressed peripheral bonds (i.e. not just Greece’s) held by stressed european banks (which were, after all, just as responsible as the profligate governments for the debt build-up) in exchange for liquidity and capital. That would mean that, on the one hand,  pension funds, private bond holders and the official sector (plus assorted innocent parties) would not be caught in the crossfire of the current, unending ‘voluntary’ haircuts (that began in Greece but will surely spread to Portugal and elsewhere). It would also mean that the ECB would not have to accept every scrap of paper picked up by bankers on the street as eligible collateral for ECB loans.

Europe’s spectacular, but highly motivated, failure

Were there good alternatives that would have avoided indiscriminate haircuts, the highly dubious LTROs, and the extension of the Crisis into the indefinite future? Of course there were. One such idea was presented above: that of a grand negotiation between the stressed banks, the official sector and the stressed states, that would lead to selective (rather than indiscriminate) haircuts in exchange for liquidity and capital injections (and which have not affected other parties who are not seeking official financing).

Alas, instead of such a rational approach what we ended up with was a fallacy in search of a rationale; a complete separation of the process of providing liquidity and capital to the banks from that of writing down debt; a negotiation leading to an utterly unsustainable wholesale haircut for one country alone. The official sector is thus now exposed to half a trillion euros of loans to the european periphery, it has to keep printing mountains of new money that it channels, without rhyme or reason, to the banks (thus pushing them further into zombie territory) and, to boot, none of that has managed to make any appreciable dent into the vicious cycle that is deepening Europe’s fault lines.

A spectacular failure indeed. Yet not an unmotivated one. Europe’s banks have managed to unload their Greek bonds over a period of two years while, at the same time, receiving mountains of cash from the ECB to mop up any remaining losses. Greece’s bankers are to receive €25 billion (and counting) of EFSF-sourced capital without having to forfeit an iota of voting power to the official sector (for at least three years). Even hedge funds have not suffered, indeed some will end up with significant gains: the new bonds issued by the Greek state, despite being stressed, will compensate them for the low, low prices they bought the old bonds at and, in addition, will be able to claim CDS proceeds plus several cases of full payment of the old bonds (as a result of skilful strategic holdouts).

In the cold light of the Morning After, Europe looks sad, rueful, dejected. The citizens of the surplus countries feel shortchanged, their deficit country brethren crushed under the weight of hopeless austerity, the winds of recession blowing a cold chill across the continent. Meanwhile the financial sector can enjoy its new delivery of fools’ gold. Why fools’? Because every smart parasite ought to know that, if it overdoes it, its own demise will follow the death of an overcompliant host.

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