Thursday, May 13, 2010

Comparing sub-prime bailout with Greek crisis

Historians and economists will surely judge the recent sub-prime meltdown and the Euroland crisis as classic studies in contrast. The contrasting policy responses to these two systemic risk generating events are reflective of a deep ideological divide - intervene swiftly and massively to limit damage or wait and watch while the dynamics of the market plays itself out. This also points to the deep limitations of macroeconomic policy making and the lack of any unanimity among policymakers in effectively responding to such crises.

The EU and IMF may have finally cobbled up a 110 Euro (or $140 bn) joint bailout of Greece, but it is increasingly looking like a "band-aid on a corpse".

Assume Greece is AIG, Portugal is Wells Fargo, Italy is Citibank, Spain is Bank of America, and so on. In fact, bellweather Iceland may be seen as the Lehman of Europe. There are striking similarities between them, as they faced existential crises and generated an explosion of systemic risk. The large leverage that those firms ran up is similar to the unsustainable debt burdens of these European economies. These firms posed the "too-big-to-fail" problem, whereas the economies pose the "too-interconnected-to-fail" (German, French, and British banks own the bulk of Greek debt) challenge.

However while there are striking similarities in the problems facing them, the remedial actions taken by policymakers to address the respective situations could not have been more starkly different.

In response to the "mother of all credit squeezes" that followed the sub-prime meltdown, the US Federal Reserve, and the Bush administration first and then the Obama administration, moved in swiftly to contain the crisis. They hurled every available policy option at the problem ("shock and awe" the financial markets) and the Fed emerged as the lender and insurer of last resort. Even though the bailout programs changed course repeatedly, were characterised by much confusion and lack of clarity, and faced widespread criticism, the central thrust of bailing out the beleaguered financial institutions remained a constant. It is by now widely-acknowledged, that the swift action to bailout financial institutions and its enormity, have been responsible for averting a disastrous, long-drawn out meltdown of the financial markets and ensuring that Wall Street returns to some semblance of normalcy quickly.

In stark contrast, the response to the Euroland crisis has been marked by indecision, a stubborn refusal to confront the reality and the recent example of US bailouts, and a reluctance to commit anything other than the barest minimum of assistance to keep Greece afloat. The ECB has been virtually paralysed, deeply constrained in carrying out any monetary expansions by the rigidities inherent in the Stability Pact and its own ideological reluctance to undertake such operations. In the absence of a powerful enough central executive, the larger Euroland members, led by Germany, have been loath to volunteer with any assistance, in the mistaken belief that it was Greece's problem and any largesse would engender moral hazard.

Unlike the Bush and Obama administrations, the Germans and French governments have shown a remarkable preference to let Greece fail, strongly rationalizing against picking up the tab for Greece's indiscretions. This is all the more surprising given the fact that any Hellenic default, could devastate their own massively over-exposed banks. A recent estimate by the New York Times pointed out that the German, French, and British banks own $704 bn, $910 bn, and $420 bn respectively of Greek, Spanish, Portuguese, Italian and Irish debts (PIIGS). Therefore letting Greece default and force a "haircut" on its bondholders would be tantamount to cutting the branch while sitting on it.

Adding to the interconnectedness tangle is the fact that the banks from PIIGS themselves own large amounts of debts in each other. And dramatically amplifying the problem and giving it a global dimension is the fact that United States banks have $3.6 trillion in exposure to European banks, according to the Bank for International Settlements. That includes more than a trillion dollars in loans to France and Germany, and nearly $200 billion to Spain.

If worries about the safety of European banks intensify, it could push up their borrowing costs and push down the value of more than $500 billion in short-term debt held by American money-market funds. Uncertainty about the stability of assets in money market funds signaled a tipping point that accelerated the downward spiral of the credit crisis in 2008, and ultimately prompted banks to briefly halt lending to one other.

The Times has an excellent article that sums up the challenge facing the EU about the need to speed decision-making before irreversible damage is done and the euro itself slips into history,

"The delays are inevitable, most experts say, stemming from the nature of the European Union and its own institutional voids: no single government, no single treasury, no effective fiscal coordination, no mechanism for crisis management.

Every major decision on the euro must be negotiated among member states and European institutions, a torturous process that also plays up political fissures both within and among member countries. That breeds uncertainty and even panic among investors, who already doubt that the Greek deal that the European leaders finally sealed on Friday night will forestall an eventual restructuring of Athens’ crippling debt."


In the deeply interconnected global financial market, where market confidence can erode with spectacular speed, and contagion effects can be amplified dramatically, a "wait and watch" game can be fatal. In fact, it is now certain that the costs, to everyone including the Germans, of the inevitable default-cum-bailout of Greece will be many times more than what would have been required if a large enough debt restructuring bailout was executed at the first signs of the crisis. In many respects, given the strong moral hazard effect on other beleaguered peripheral economies, Europe will be facing the worst of all worlds now with its late bailout of Greece.

Both these events are testimony to the fact that the cascading effect of crashing market confidence can be far more damaging than the moral hazard concerns and dangers of "socializing private losses" generated by any swift tax-payer sponsored bailout. Once the crisis breaks out, a delayed response will only exacerbate the problems and leave policymakers to traverse a path which is both longer and more inclined, before some semblance of normalcy can be restored.

As economists like Paul Krugman have argued by pointing to the wage and price increases of these economies with resultant erosion of external competitiveness, the origins of the Euroland crisis goes much beyond the large national debt burdens. The Stability Pact, governing the rules of macroeconomic management of Euro members, and the single currency, have meant that the individual members do not have access to any of the conventional monetary and exchange rate tools - like lowering rates, stoking inflation, or even devaluation - to address such crises.

The Euro Project therefore highlights the ineffectiveness of economic union without much greater political integration. They underline the importance of a strong central co-ordinating power and fiscal authority within the EU, apart from a more powerful European Central Bank, with greter willingness to effectively manage such crisis. Some have suggested setting up of a European Monetary Fund to combat debt and balance of payments crisis among EMU members.

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