I broadly agree with the Angloamerican consensus about the, um, challenges associated with the Euro from an economic perspective. (David Beckworth has a very nice explainer.) We do understand that the Euro was adopted for political more than economic reasons. Unfortunately, with the benefit of hindsight, the hoped-for political benefits of the common currency seem to have materialized less than the long-warned economic problems, and the economic problems have now poisoned the politics. But we are where we are. I think it unlikely that the Euro will be dismantled except in the context of a crisis that would put the whole European project at risk, even more than recent crises already have. So the challenge, I think, is to come up with institutions that would help mitigate the economic flaws of the common currency, and that might be acceptable in a political union whose electorates, for the moment, feel no great solidarity with one another. Ideally, Europe might pursue a US-style union, where transfers made upon universal criteria to households and business blunt regional wealth and income asymmetries, without provoking the indignation that direct intergovernmental transfers provoke (and would provoke in the US as well). But, after the trauma of recent events, I doubt that a Pan-European safety net will be politically achievable anytime soon.

If “ever closer union” is on pause for now, perhaps Ashoka Mody has it right when he advises, “To stay close, Europe’s nations may need to loosen the ties that bind them so tightly.” Mody’s specific suggestion is that Germany and other Northern European countries depart the Euro, replacing one very suboptimal currency area with two more reasonable blocs. He makes a good economic case, but the political symbolism of a Dollar/Peso Europe would be pretty terrible. I think there is a better way.

In the heat of the recent Greek crisis, many commentators (Coppola, Koning, Mason) noted that “membership” in a currency zone is not a discrete, all-or-nothing thing, but rather a continuum. Many people advised Greece to loosen its bonds to the currency zone just a bit by issuing its own scrip, not denominated in a new Drachma, but in the Euro itself. This is not a new or radical idea. Even in the United States’ famously functional currency union, the State of California has periodically resorted to issuing dollar-denominated “registered warrants” in order to sustain necessary spending through cash crunches. For related proposals, see Bossone & Cattaneo (1, 2), James Hamilton, Rob Parenteau, and of course Yanis Varoufakis.

Issuing Euro-denominated scrip would not mean leaving the currency zone, any more than California’s registered warrants took California out of the dollar zone. However, in the context of the current crisis, if Greece had issued such notes, it would have been interpreted as a first step away from full-fledged membership in the common currency. Looking forward, what would be better would be to normalize the practice, throughout the currency zone, of having governments make domestic expenditures (and only domestic expenditures) in scrip. Greece would issue scrip, and so would Germany. The characteristics of the scrip (but not the value) would be standardized across the Eurozone. In particular, each country’s scrip would be a zero-coupon security, to be redeemed in Euros at face value over an uncertain term. (I think fixed-payout, time-varying claims represent an underused design for securities; I’ve suggested them elsewhere.) Each week, each government would issue a new batch of scrip, to cover that week’s domestic payments. The rules for redemption would be simple: first-issued, first-redeemed, at a pace determined at the discretion of the Treasury without precommitment. Governments whose tax receipts easily cover their expenditures could choose to redeem the scrip nearly instantaneously (after some minimal period, perhaps one week). Governments that wish to run a deficit would redeem scrip more slowly.

The scrip would not become a de facto domestic currency. It would be too fragmented; each week’s vintage would have a different market value. Scrip would not be redeemable at face value to pay taxes.

What this all amounts to is a means by which states can finance themselves with forced borrowing from their own citizens who receive government payments. That sounds a bit mean, but it solves two important problems that currently plague the Eurozone:

• International fragility — As the Greek crisis highlights, sovereigns ought not rely upon foreign borrowings in a currency the state cannot issue. The future is always uncertain, and when things go wrong debt securities must default or be renegotiated. That is awful even in small-scale private contexts. In an intersovereign context, it can lead to immiseration on a large scale through depression or war. Successful states mobilize the risk-bearing capacity of their own populations in order to finance government activity. Domestic politics can adjucate conflicts between local creditors and the public’s interest in government services in ways that outside institutions cannot. The interests of domestic creditors overlap much more with other domestic constituencies than the interests of foreign creditors do. International creditors have very little reason to support the work of a foreign government (other than taxation and debt service), while domestic creditors balance their interest in getting paid against other interests related to government performance.

• No constituency for taxation — The Euro was conceived as currency of “prudence”, with its Stability and Growth Pact intended as a straitjacket on government borrowing. So it is ironic that the architecture of the Eurosystem destroyed the incentives of domestic constituencies to support efficient tax collection. By design, the Eurosystem preserved the practical ability of Eurosovereigns to borrow from the banking system inexpensively and at will (a privilege which remains intact, supported by the ECB, for all countries except Greece). Beneficiaries of government expenditures had little reason to support taxation, since the funds they wanted spent could be borrowed. More importantly, the Eurosystem absolved domestic constituencies of the usual consequence of undertaxation, that their incomes and saving would lose value from inflation. Ordinarily, creditors in any country are powerful constituencies for balanced budgets and “sound money”, which sometimes means cutting expenditures but also means raising taxes when expenditures cannot be cut. [1] While Eurozone states that borrowed (whether as sovereigns or through banking systems) did experience higher inflation than creditor countries, the difference was modest. Citizens knew that the value of their money was externally anchored, a Euro would always be a Euro. This imported stability hindered the emergence of any domestic constituency in favor of developing (and exercising) the state’s capacity to collect taxes.

  If government domestic expenditures, including transfer payments like pensions, are made in the scrip proposed, the market value of those securities would be directly related to the perceived willingness and ability of the state to tax in order to retire the IOUs at a reasonable pace. The villains’ in lazy creditor morality tales — beneficiaries of the welfare state, govenment employees, vendors of goods and services to the state — would become powerful constituencies for building and maintaining an efficient tax system. This would restore the natural tension in domestic politics, a balance that Eurozone institutions uninintentionally destroyed, between domestic constituencies with an interest in taxation, and other domestic interests who would be net payers of tax and so lobby to streamline expenditures.

This proposal would not fragment the Eurozone. The Euro would remain the universal unit of account and medium of settlement. [2] The proposal would loosen the strictures on government expenditure compared to existing arrangements, but importantly, the risk associated with that extra fiscal freedom would be borne entirely by domestic constituencies, not by external creditors. It would restore to Eurozone states some of the tools they lost for managing domestic shocks, without requiring unpopular transfers or destructive borrowing from other states. It would strengthen Eurozone states, as polities.

The lesson of the Asian Financial Crisis and the extraordinary reversal of financial flows that many Asian countries were able to engineer is that the strength of a state is largely a matter of its capacity to mobilize domestic risk-bearing, rather than rely upon external finance. Eurozone institutions unintentionally short-circuited that capacity. It’s time to restore it.

Some institutional details:

• Universality — This proposal should be implemented universally within the Eurozone, as an institutional innovation for the common currency. Within states that have no immediate need for new borrowing, the market value of “state expenditure notes” would be par, and no one would have reason to complain. However, if adoption of the notes were made optional and became associated with perceived-as-weak states, states that could really benefit from financial flexibility and incentives to develop an effective tax system would be reluctant to adopt them for fear of stigma. A fig leaf — “Even the Germans do it!” — is the one concession to solidarity that this proposal requires. Otherwise, this proposal segregates risk, rather than blurring borders, which might be a relief to Northern European publics.

• Liquid Markets — All states would be required to arrange low-transaction-cost, liquid markets in state expenditure notes. Recipients of government expenditures who need to make immediate payments may choose to convert them to cash Euros at a discount. Others may hold their notes and await redemption at face value. The discount to face at which the securities trade would provide ongoing information about the perceived fiscal strength of the state, and a very visceral incentive for recipients to see to that strength.

• Banking considerations — Domestic, and only domestic banks, would maintain custody of the notes on behalf of customers. However, the notes would be held in segregated accounts, not on bank balance sheets. The Eurozone desperately needs to eliminate bank exposure to the sovereign debt of member states. These proposed notes would be an unusually speculative form of sovereign debt, and absolutely inappropriate as bank assets. Banks would merely provide the service of holding notes for customers and liquidating them into customer accounts on demand, as an important convenience and at regulated spreads.

• Definition of “domestic expenditures” — A “domestic expenditure” by a member state would be defined as a payment to a domestic bank account. All domestic bank accounts would be paired with custodial accounts for expenditure notes. States could insist that transfer payments be made to domestic accounts, and might prefer to purchase goods and services from firms with domestic accounts as well. Foreign firms wishing to do business with cash-strapped governments and willing to accept the financing terms might open local bank accounts, but in general this restriction would ensure that most of the notes are spent to domestic constituencies. Speculation in the notes by nonresidents would be discouraged, in order to keep incentives (maximize the rate at which notes can be redeemed) and control (vote and participate in domestic politics) well-matched.

• Interaction with traditional debt — The rate of redemption of expenditure notes would be entirely at the discretion of the issuing government, while coupon and principal payments on traditional debt must be made on a preagreed schedule. In that sense, one might imagine expenditure notes to be “junior” to Treasury bills and bonds. However, in the event of default, debt restructuring, or sovereign refinancing by ESM / EFSF / ECB / IMF / etc., expenditure notes would be treated as senior to other Treasury securities. (Expenditure notes would be treated analogously to uninsured deposits in bank capital structures, available for “bail-in” only after other unsecured creditors have been wiped out.) This is very important, as it would encourage buyers of traditional securities to price the credit risk of the sovereign’s full capital structure, including the debt embedded in outstanding expenditure notes. Formal seniority also reduces the risk that foreign creditors will be able to use the notes to shift the consequences of their own poor credit allocation decisions onto involuntary domestic creditors.

  Of course, short of an outright restructuring or refinancing, governments might choose to slow redemption of expenditure notes in order to retire traditional debt, which is fine. Strong domestic constituencies would limit the pace of such a reprofiling. If, eventually, finance via expenditure notes largely replaces traditional sovereign debt, that would be great. Domestic finance is much better for a polity than foreign finance, and variable maturity notes decay in value gracefully, while overextension of traditional debt causes disruptive oscillations between complacency and crisis.

Update: Perhaps the first proposal to address Eurozone problems via issuance of scrip came from Warren Mosler. When putting together cites for this post, I did not find that proposal where I had linked it previously, and simply omitted it. Fortunately, my commenters are not as lazy as I am, and point me to this 2012 version by Mosler and Philip Pilkington. I am very glad to acknowledge the prescience of Mosler’s work and the very strong influence of his “Modern Monetary Theory” on the thinking that underlies this post. My apologies for the original omission, and thanks to commenters JKH and Roberto for helping to remedy it.

I mean to write about something else today, so this will be short.

But I’d like to point out, as gently as possible, a mistake in the premise underlying this post by my friend Tyler Cowen. To be fair, it is not a mistake that is uniquely Cowen’s. Macroeconomists invoke price stickiness as an assumption in their models. They treat it as an axiom, a given, and therefore a mystery. Often they lazily fill in the darkness with catch-alls like “psychology” or “money illusion”, hypotheses about as useful as pomegranate seeds are as an explanation of seasons. Let’s not have the lazy conventions of macroeconomists stand in for actual thinking on a subject.

Downward price stickiness is a coordination problem, plain and simple. It has nothing whatsoever to do with illusions or cognitive biases or failing to spit after staring too intensely at a small child. Economic entities, both firms and humans, have liability structures rigid in nominal terms. A business has made forward-looking contracts — leases of facilities and equipment, price-stabilized arrangements to acquire raw materials, and yes, contracts with employees that cannot be altered without renegotiation. Businesses have also financed themselves in part with debt, and so taken on nominal obligations whose sustainability is based on forward-looking nominal prices of the goods and services they will sell. Individuals have signed rental agreements or taken mortgages. They have financed their education or their children’s, perhaps they have even taken on consumer debt. For both individuals and firms, these forward-looking nominal arrangements create a very large asymmetry between unexpected price adjustments upwards and downwards. For any economic unit, firm or individual, an unexpected price adjustment upwards in the commodities they sell to market is welcome news. The unit gets more money, its balance sheet expands in the happiest way of all, more assets matched by more equity. But for a leveraged economic unit — and we are nearly all leveraged economic units, if only because we are born short a future stream of housing and food — a downward nominal price shift may force deadweight adjustment costs, which may range from renegotiations of existing contracts to formal bankruptcy to discontinuous shifts in consumption of amenities like housing, education, and local community. (Since these amenities are marketed in sparse bundles, units are not able to continuously optimize consumption tradeoffs, and small changes in budget may lead to large changes of utility.)

Taking account of largely uncontroversial behavioral assumptions like habit formation and reference group anchoring reinforces this case, but is by no means necessary to it. Rational profit-maximizing firms exhibit downward price stickiness as do irrational left-wing humans, although how powerfully either exhibits it depends upon their solvency position and the flexibility of their capital structure, and upon a perceived probability distribution of revenue realizations under different prices. The naive microeconomic case why rational firms would not exhibit downward price stickiness — past arrangements are sunk costs, a rational firm will set prices to maximize future revenue in a forward-looking way — is flawed. It fails to take into account uncertainty surrounding the forward-looking revenue realizations. It ignores the fact that firms are usually quantity constrained in production over the short-term over which payments on their obligations come due. It ignores capital market imperfections, which yield correlations between access to external finance and downward price pressures that are unhelpful. For many firms, the costs and risks associated with an abrupt downward price adjustment are sufficiently large that the rational choice under a reduction of nominal demand is to gamble for the upside of their quantity-constrained revenue-realization distribution. So firms maintain prices higher than Marshallian scissors would advise, and try to sustain anticipated nominal revenues through marketing, product differentiation, and exercise of whatever market power they may have via relationships, network effects, etc. Of course, a strategy that is rational ex ante for firms with imperfectly flexible capital structures will only prove successful ex post for some fraction the firms that pursue it, which helps to explain why reductions of nominal demand tend to provoke consolidations in industries rather than mere rescalings of all the firms that contested the market in good times. When nominal demand collapses, prices fall less than naive economists would guess, some firms sustain quantities sold at the “too high” prices offered, others do not and start to experience large deadweight costs of insolvency. The winners can then buy the losers for a song and quickly dispell those costs.

Precisely the same dynamic accounts for adjustment to changes in labor demand on the extrinsic rather than on the intrinsic margin, for why we see unemployment rather than wage reductions in a recession. In the US (more, perhaps, than in other countries), workers’ lives tend to be leveraged against anticipated, uninsured, market incomes. Accepting a significant wage cut may imply selling a home into a bad market. (Here again, correlations between wage pressures and financial market developments are unhelpful.) It may imply pulling ones kids from schools, excision from civic and social communities, loss of difficult to replace health coverage, loss of ones automobile, and in extremis the humiliations and deadweight costs of personal bankruptcy. The operating and sometimes financial leverage of households sharply magnifies the loss associated with a wage cut, and the discontinuity of the bundles in which crucial amenities are offered magnifies that yet again. Even without invoking a Dunning-Krueger effect, these costs may be large enough that workers rationally prefer to gamble on staying employed at their anticipated wage rather than accept a very painful adjustment with certainty. Firms rationally accommodate this preference among workers, since grateful survivors make better employees on an ongoing basis than people bitterly distracted by their own insolvencies. By firing the workers on whom labor cost adjustment will fall, firms rationally externalize insolvency costs that they would be forced to partially bear if they retained those workers. Even among fired workers, it may be rational to hold out for wages high enough to restore solvency rather than quickly accept work at wages that render inevitable a disruptive adjustment. If they hold out and fail, they face a similar adjustment. But they might not fail. Holding out to search yields a valuable lottery ticket, for a while.

I said at the start that nominal price stickiness is a coordination problem, and it is. If nominal price reductions and nominal wage cuts were accompanied by simultaneous reductions in the nominal burden of each unit’s capital structures, the difficulty of downward price reduction would disappear. For a given household with no financial debt, if it were certain that existing housing, food, education, transportation, and health outflows would scale downward with a wage reduction, the household would rationally accept the wage reduction rather than risk unemployment. But even in a world where households don’t bear financial debts, even during a general depression, there is no assurance that prices will scale down with wage reductions. (On recent historical experience, there’s little evidence at all prices will scale down, that’s the equilibrium we’re in.) So it is rational for many households to resist wage reductions. The prevalence of nominal debt, which bears the stickiest price, renders resistance to downward price and wage adjustments more rational and more likely.

For both firms and individuals, resistance to downward price adjustment is often rational, even when at a macroeconomic level universal downward adjustment would be desirable (perhaps because the central bank and/or state have failed to accommodate the expected path of nominal incomes, perhaps because nominal exchange rates are rigidly misaligned). If we could wave a magic wand and have wages, prices, and especially debts all simultaneously scale downward, that might be awesome. But, unfortunately, we can’t.

If this sounds like some left-wing apologia of unreasonable wage demands (really? does it sound like that?), I’d note that the person who most famously made this argument was one Milton Friedman:

The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so.

Note: I’ve written about this once before, see also an objection by the excellent RSJ.

Update: Nick Rowe generously discusses the ideas (and interacts with me in comments) in three new posts.

If you are sympathetic to Greece and therefore mad at Germany, you are a sucker. If you think the Greeks are lazier and more dishonest than is usual in the human species, you are also a sucker, and have let a political framing cajole you into bigotry. If you think Germans are unusually cruel, you have also let politics make a bigot of you. If you are taking sides in a conflict framed as nation versus nation, you have already taken the wrong side. You’ve made a basic error, like picking a day when a tricky prosecutor asks whether you committed the murder yesterday or last Thursday. (I presume your innocence.)

You can usually find evidence in support of lots of different narratives. Hypotheses of human affairs are not in general mutually exclusive. Many different stories can in some sense be true. Among those in-some-sense-true narratives, we should choose to emphasize those whose application will lead to better social outcomes over other potentially defensible narratives. That’s why I frequently argue that we should emphasize the role of creditors rather than debtors when lending arrangements go bad. I am not making a claim about God’s view of the subject. Perhaps Hell is a debtors’ prison, and there is truly no greater evil than failing to repay a loan. Perhaps Hell is full of creditors who failed to fit through the eye of a needle. These questions are, I think, beyond the sort of knowledge that should inform policy. What is clear is that unserviceable debt arrangements, when they accumulate, are enormously costly in human and economic terms, and so we need norms and institutions to regulate credit extension. My view, which I think almost anyone with a passing familiarity with the human species would have to concede, is that people under financial stress make decisions with a view to a shorter-term time horizon and with less capacity to be fastidious than people who have already financed their own immediate term. That is why I argue that we should emphasize norms that hold creditors accountable more than norms that hold debtors accountable. Creditors as a class are capable of regulating the initiation of debt arrangements at lower cost and with greater effectiveness that debtors are. If we want societies that yield good outcomes, then, we should impose a heavy regulatory burden on creditors, and we must choose moral narratives consistent with that.

Perhaps the very worst moral narratives in all of human history are those that allocate blame on the basis of tribal, ethnic, or national groups. There is just never, ever, any sufficient reason to go there in my view. It is perfectly reasonable to hold leaders and governments accountable, as well as the institutional embodiments of interest groups. This is not because leaders individually are worse people than members of the public who may agree with their decisions. I carry no water for fairy tales about the inherent virtue of ordinary folk. The reason we hold people and institutions that act consequentially within the political sphere accountable is because those entities are points of leverage on whom relatively humane forms of accountability — career impairment and financial loss, shame or loss of reputation, in extremis imprisonment — may powerfully regulate the behavior of the polity. To impose accountability at the level of “the people” is the logic of Dresden, barely fit even for warfare, to be avoided at all costs. (I hope in this context the World War II analogy will not further inflame national passions.) “Collective punishment” — regulating the behavior of a polity or nation by imposing consequences on all of its members — is inefficient in terms of human suffering provoked. It is also risks being much worse than counterproductive unless it lives down to the Machiavelli’s dictum that “If an injury has to be done to a man it should be so severe that his vengeance need not be feared.”

Civilized people do not blame nations, even when publics of those nations are holding mass rallies in the street supporting bad actions. Civilized people hold leaders and institutions to account for the conditions under which their constituents’ passions got that way, if the passions are misplaced. This is not to assert, as a positive claim, that political leaders and elite institutions “control” the will of their populations. Like most causal arrows, this one runs both ways. As with creditors and debtors, where we impose the accountability is a function of which choice leads to better outcomes. However hollow it may ring (and however hypocritical in the face of what people who use this rhetoric have sometimes done) claiming that “we have no argument with the people of Oceania, only its government” is a healthy impulse. [1] As civilized people, we ought to try to define political, economic, and social institutions that make good decisions on behalf of polities. Those institutions should both genuinely represent the diverse interests and views of their publics, and also constrain and shape those views so that the democratic will of the polity is consistent with high quality outcomes in both a functional and ethical sense. When things go awry, it is those institutions we must hold to account. To hold institutions to account effectively we must hold people to account, but we focus our scrutiny on people in roles of disproportionate authority rather than extending it to nations as a whole.

By all means blame Schäuble or Merkel or Varoufakis or Tsipiras. I have my views about who is more blameworthy, your views may differ. You may blame people like me, if you like, members of “the press” generally, and hold us accountable by reputation and career. My view is that banks and securities underwriters on both side of the Atlantic, as well as many individuals who worked in that sector, ought to have been held to much greater account for events of the financial crisis (but I also think it is too late for punitive accountability to make much of a difference now). You may disagree. These are all fine arguments to have.

But do not blame “France” or “Germany” or “Greece”, do not blame the “United States” or “Iran” or “North Korea”, tribes and nations cannot be held to account, only institutions and leaders can be.

I have not visited Germany, but I very much want to, and admire very much about its culture and economic arrangements. My own family’s difficult experiences 75 years ago do not temper my affection for Germany. It is, I think, a wonderful country. I have visited Finland, and despite the fact that I think its government’s role was less-than-constructive with respect to the Greece crisis, it remains one of my favorite places in the world. As a student of political and economic systems, I admire the Scandinavian countries above all others, regardless of their role in this crisis.

The European crisis is a crisis of bad framing. Characterizing Europe-wide credit problems in terms of national actors, then fixing that characterization into place via intersovereign lending, were deeply pernicious, deeply destructive, errors. I don’t doubt these errors arose more from increments than ill intentions. There were pressures and interests and paths of less resistance — no need for any vast conspiracy. [2] The international framing was convenient to domestic constituencies throughout Europe. In every country, elites find it convenient to deflect passions to an external bad actor rather than take responsibility for mistakes at home. Sometimes on the merits they have a case, sometimes not. Regardless, inflaming passions against another nation is always a terrible choice. Even when a dispute really is a zero-sum conflict of interest between two nations, great diplomacy is called for. That may be a lot to ask for, but it is what civilized countries do. I wish my own country lived up to it more often.

The credit crisis that has writhed and recrudesced into a Greece crisis never needed to become a conflict between nations. I believe Europe’s current crop of leaders must be held to account for having made it that, and I repeat my admonition. Shame. I hope (against the odds perhaps) that a less narrow and compromised set of leaders replaces the current generation, that Eurofinance is reformed much more deeply than it has been, and that as passions fade the European project can resume. I even hope that the Euro survives, although I think the economic case against it is powerful and correct. Fixing the Euro is possible. It just requires institutional innovation that at the moment seems unthinkable. But, in the recent cliché, the unthinkable has an odd habit of becoming inevitable in politics. There is still room to hope.

Greece’s 2010 assistance program was largely a bailout of European banks, initiated to prevent a wider banking crisis. I didn’t expect this claim, from the previous post, to be very contentious. But apparently it is, so I’ll overdocument below. Certainly a bank bailout was not the program’s sole purpose — fear of contagion to other indebted Eurosovereigns was also concentrating people’s minds. But the operation was not a huge help to Greece except in the sense replacing private creditors with more generously scheduled official creditors gave the country breathing space.

Commenters have brought up the 2012 program, which is more complicated. It included “private sector involvement”, Eurospeak for getting private creditors to take a haircut on their holdings of Greek debt. That’s a more ambiguous case, and we’ll discuss it below. My view was and remains that the “cramdown” was made possible precisely because the first program helped European banks to reduce their exposures to Greece, both directly by getting paid in full on near-maturity debt, and indirectly by creating time and a window of optimism during which positions could be offloaded without too much impairment. Below, I link some data and and work through an exercise that supports my view, but I certainly don’t claim it is definitive.

Most of this post is going to be documenting stuff. But I want to correct a misperception I fear I may have left with the previous post.

I am not criticizing Europe’s handling of Greece because banks deserved to take a hit and were treated too lightly. It is not the absence of pain and blame that troubles me, but its asymmetry. What was required was a Europe-wide solution to a European problem. What occurred, in my opinion, was the quarantining of a scapegoat. I blame Europe’s leaders for not framing the crisis in a different way, for acting as though it was about alms to Southern miscreants rather than explaining its roots in EU-wide regulatory errors and poor credit allocation incentives, Europe-wide problems that threatened many states. Framed this way, solutions would have looked very different. They would have addressed Germany’s problems and France’s problems as well as those of Greece, Spain, Portugal, Italy, Ireland, and Cyprus. Framed this way, solutions would have been conducive to “ever closer union” one crisis at a time. Instead, leaders chose to inflame national stereotypes. They pretended that there were villains and angels, and that they (and their own constituents, of course) were the angels.

I understand that life happens in real time, people are human, and politicians face pressures and constraints. But if we can admit that of politicians in Brussels, perhaps we might extend the courtesy to politicians in Athens as well. They too inherited their imperfect institutions, and followed paths of less resistance that perhaps were not so virtuous.

2010 Program

The 2010 assistance program was widely understood at the time to be motivated by the need to prevent disruptive write downs at non-Greek banks. The Guardian reported in February 2010 that France and Switzerland had exposures to Greece of €55B each ($119B @ 1.4266 $/€), and Germany €30B ($43B @ 1.4266 $/€), based on BIS data. The Wall Street Journal reported similar values, as does CRS. [1]

In early 2010, it was not the case that the majority of Greek debt was held by Greek banks, as people seem fond of saying. From the same Guardian piece:

Analysts…dismissed as misplaced concerns that Greek banks might be holding all the €300bn of debt in issuance. “Greek banks own around €40bn of the total…implying most Greek debt is sitting on the balance sheets of non-domestic banks,” said Jagdeep Kalsi, an analyst at Credit Suisse.

From Swiss Daily Tagesanzeiger as translated by Ed Harrison:

According to the International Monetary Fund (IMF), about two thirds of the debt of Greece is held by foreign creditors — an above average value.

After the program was announced, European economists (but not politicians) frequently explained it as intended to shore up non-Greek banks. Here’s former IMF staffer Gary O’Callaghan, writing in 2011:

The new Portuguese programme is set to be launched in the context of a continuing lack of market credibility in the other two — the Greek and Irish…

[W]hy are [Eurozone finance ministers] supporting these financial assistance programmes? Because, if they are not implemented, the non-payment of debt — including bank debt — by the nations on the periphery would lead to severe banking crises and a return to recession in the core of the eurozone.

Former Bundesbank head Karl Otto Pöhl, just after the 2010 program for Greece was approved:

Pöhl: …a small, indeed a tiny, country like Greece, one with no industrial base, would never be in a position to pay back €300 billion worth of debt.

SPIEGEL: According to the rescue plan, it’s actually €350 billion …

Pöhl: … which that country has even less chance of paying back. Without a “haircut,” a partial debt waiver, it cannot and will not ever happen. So why not immediately? That would have been one alternative. The European Union should have declared half a year ago — or even earlier — that Greek debt needed restructuring.

SPIEGEL: But according to Chancellor Angela Merkel, that would have led to a domino effect, with repercussions for other European states facing debt crises of their own.

Pöhl: I do not believe that. I think it was about something altogether different… It was about protecting German banks, but especially the French banks, from debt write offs. On the day that the rescue package was agreed on, shares of French banks rose by up to 24 percent. Looking at that, you can see what this was really about — namely, rescuing the banks and the rich Greeks.

Pöhl, by the way, agreed with the now-(in)famous Yanis Varoufakis that from Greece’s perspective, a partial default would have been superior to the 2010 package. Here’s Pöhl again:

Pöhl: …They could have slashed the debts by one-third. The banks would then have had to write off a third of their securities.

SPIEGEL: There was fear that investors would not have touched Greek government bonds for years, nor would they have touched the bonds of any other southern European countries.

Pöhl: I believe the opposite would have happened. Investors would quickly have seen that Greece could get a handle on its debt problems. And for that reason, trust would quickly have been restored. But that moment has passed. Now we have this mess.

Strange bedfellows, perhaps.

If this is all nonsense (as a correspondent alleges) because of errors in the BIS exposures data widely known four years ago, I’m not the only one who’s missed the memo. I’m in pretty good company. Here’s banking scholar Anil Kashyap writing just a few days ago:

By the spring of 2010 the excessive debt problem became unbearable and there was open speculation that Greece would default. The country had done this on four occasions previously since 1800. Much of the government debt was owed to banks outside of Greece, with the largest amounts in France and Germany. So if Greece had stopped paying, the French and German banks would have suffered substantial losses.

Greece was lent new money in 2010, but as Karl Otto Pohl former head of the German central bank observed at the time much of that money was used to repay the obligations owned by the French and German banks. The new lending was advertised by the politicians across Europe as a rescue for Greece. But it was at least as much a deal to buy time for the banks and other owners of Greek debt to avoid a default.

2012 Private Sector Involvement (PSI)

In 2012, private sector creditors were indeed asked to take a hit. As I mentioned in the intro, my view is that “PSI” was undertaken in deference to the politics of creditor moral hazard only when, thanks to the 2010 intervention, non-Greek banks were able to reduce their exposure. I’m hardly alone in that view. Again, Anil Kashyap:

By continuing to allow banks everywhere to use Greek debt as collateral, the ECB also created conditions that supported the trading of Greek debt. By this time the French and German banks had shed their exposure to Greece so that they would no longer be directly harmed if there was a default. So the stealth rescue of the non-Greek banks was completed with little public attention and the narrative that all the problems were self-inflicted by the Greeks became more pronounced.

By June 2011, Greek banks did hold the majority of Greek debt, and other banks’ exposure was small enough that large write-downs would be manageable. (Here’s a spreadsheet, published by the Guardian, with data apparently from UBS.)

According to the best discussion of PSI I’ve found, by Jeromin Zettelmeyer, Christoph Trebesch, and Mitu Gulati, the debt exchange was large, affecting €199B of debt at face-value, with a present value of roughly €130B at the time of the exchange (using a discount rate of 15.3%, see Table 4, p. 23). The authors estimate the total debt relief to Greece from the operation to be €98B. Of that €98B, €15.8B are accounted for by subsidies embedded in two below-market loans from official lenders: €8.2B in underpriced borrowing to buy notes from the EFSF (to be distributed as a “sweetener” to encourage creditors to make the exchange), and €7.6B in the form of an underpriced loan to partially recapitalize Greece’s banks (which would be impaired following their own participation in the write-down). That left a subsidy of €98B – €15.8B = €82.2B which had to have been provided by surrendering €130B in debt, for an average write down of 63.2%.

If we assume that the Guardian/UBS exposures linked above are valued at comparable discount rates, we can compute the distribution of the incidence of this cost-to-debt-holders / subsidy-to-Greece. According to that data, Greek banks would have accounted for 45.3% of the €130B debt exchanged, non-Greek banks would have accounted for 25.3%, and unknown non-European-bank holders would account for an additional 29.4%. In absolute € terms, then, Greek banks representing €58.9B of exposure would have transfered €37.3B; non-Greek banks representing €32.9B of exposure would have transfered €20.8B; and unknown non-European-bank holders representing €38.2B of exposure would have transfered €24.2B.

I’d say that non-Greek European banks got off pretty easy in this exercise. If you believe the Credit Suisse analyst cited by The Guardian above, Greek banks held only 13% of Greece’s debt when the 2010 bailout began. Yet in the 2012 exchange, Greek banks were responsible for substantially more of the debt relief than non-Greek banks, even net of the recapitalization subsidy. (€29.7B vs €20.8B)

There’s lots you can quibble with here. Maybe the Guardian/UBS exposures are valued at a very different discount than our 15.3%. Maybe that data’s no good (it’s just the only data I could find). I’m treating all debt as incurring the same write-down. In fact, the size of the write-downs were maturity sensitive, with short maturities incurring larger haircuts than longer maturities, and there’s no reason to think the maturity profile of our three subgroups was identical. Maybe the assumptions beneath the pieces I’m borrowing from Zettelmeyer, Trebesch, and Gulati are wrong. Maybe I’m just screwing something up. (Let me know! Trashy spreadsheet!) But this is about the best I can do on the evidence we actually have. And, tentatively, it doesn’t look like Greece’s pre-2010 bank creditors had it very rough at all, especially when compared to 2010 BIS exposures.

Profile of Greece’s overall finance, 2010 – 2012

There’s a wonderful analysis at Greek Default Watch of Greece’s sources and uses of external finance from 2010 – 2012. It seems like a good way to conclude this piece:

The Greek government needed €247 billion in the period from 2010—2012. Of that, a mere 7.7% went to finance the government’s deficit—the rest went for other purposes. Around 15.4% went to pay interest on debt—this money went to both domestic and foreign investors. Another 12.3% went to repay Greek investors who held government bonds that were expiring in that period. A full 24.3%, the largest item, went to repay foreign holders of Greek government bonds—in sum, almost €60 billion. Around 18% went to recapitalize banks, 14% went to support the PSI (such as buying back debt) and 8.6% went for other operations.

In other words, more than 50% of the money that Greece needed in that period was to deal with the country’s excessive debt burden (interest on debt and repaying residents and non-residents). Given that the bank recapitalization and PSI were both, ultimately, linked to the country’s debt, almost 84%, or €206 billion, was ultimately devoted to Greece’s debt—which, at year-end 2009, was €299 billion. Importantly, however, a large sum (€60 billion) went to bailout foreign banks and other investors. So this operation was minimally about covering the current profligacy of the Greek state—it was mostly about covering its pass excesses.

I think that covers it.

Notes

[1] By Twitter, Dave Rabinowitz disputes these values, citing 2011 data and some earlier not-so-accessible investment bank research. It’s not disputed, I think, that exposures were much lower by 2011. That’s much of what buying time with a bailout would be intended to enable. (If Rabinowitz does have better information than the BIS on exposures at the time of the program, and what policymakers at the time would have understood those exposures to be, I hope that he’ll provide it. I’d be glad to offer links in an update.)

Greece is a remarkable country full of wonderful people, but along dimensions of development and governance, the place is plainly pretty fucked up. It has been fucked up that way for a long time, for decades at least. This has never been secret. Anyone who has visited Athens knows it has far more in common with Bucharest or Istanbul than with orderly Western European capitals. In the run up to Greece’s joining the Euro, everyone who wanted to know knew that Greece’s qualifications to join the Eurozone were, shall we say, ambitious. Mainstream establishment banks “helped” Greece and other Southern European countries with accounting fudges that, while perhaps obscure, were not secret even at the time. Despite protestations when these deals hit the news in 2010 that officials were “shocked, shocked”, they were explicitly blessed by the agency that compiles the statistics on which Eurozone entrance was based in 2002 and Greece’s gaming was extensively reported in 2003 (ht Heidi Moore, both cites). The Euro was and ought to be primarily a political enterprise. In order to sell the common currency to Northern European elites, its architects required Eurozone members to meet strict “convergence criteria” and especially the requirements of the Stability and Growth Pact. But in practice, those criteria have always been interpreted flexibly. Most Eurozone members have broken their promises at one point or another, including both Germany and France. The Euro was a unification project, and erred (not unreasonably, I think) on the side of building a big tent.

Germany and France may have missed their Stability and Growth commitments now and again, but they are not fucked up like Greece is. Greek governments — not the current, much maligned Syriza, but decades of its predecessors — treated the state like a teat from which clients and friends of electoral victors might suck. The Greek state has been a shady, opportunistic borrower, no doubt, the kind of character no one would lend money to with any great expectation of seeing it back.

And yet, that’s precisely what bankers in the relatively not-fucked-up Eurozone countries did! These people were not naïfs. They knew the Greek state was sketchy. But precisely because it was sketchy, prior to the financial crisis its debt paid slightly higher interest rates than that of safer Eurozone sovereigns. European banking regulations attached zero risk weights to all EU sovereigns, rendering it nearly costless for banks to simply manufacture deposits to purchase sovereign debt. Eurozone sovereigns were default-risk-free as a regulatory matter and currency-risk-free from the perspective of Eurozone banks. The European financial system was architected to make lending to Greece — and Spain and Portugal and Italy — a money machine for bankers with little career risk over a medium term. Sketchy credits tend to punch above their weight in terms of volume of issuance, so there was a lot of nice paper to buy. The bankers who lent to these states understood perfectly well that there was in fact a long-term risk, an uncertainty, a constructive ambiguity. They lent anyway, and took home very nice salaries and bonuses for doing so. It was conventional to lend, the mainstream consensus was that credit risk was over and worry warts were old-fashioned, Europe was strong and would work this out. If the worry warts turned out to be right, it was likely years away, IBGYBG.

When the game was up, when the global house of credit cards collapsed in the late Aughts, European leaders had a choice. They had knowingly and purposefully brought weak states into the Eurozone, because they genuinely, even nobly, wished to build a large, strong, United Europe. When they did so, they understood there would be crises. A unified Europe, they had always claimed, would be forged one crisis at a time. The right thing to have done for Europe at this point would have been to point out the regulatory errors and misaligned incentives that encouraged profligate lending and enabled corruption and waste among borrowers, and fix those. Banks that had made bad loans would acknowledge losses. The banks themselves would have to be restructured or bailed out.

But “bank restructuring” is a euphemism for imposing losses on wealthy creditors. And explicit bank bailouts are humiliations of elites, moments when the mask comes off and the usually tacit means by which states preserve and enhance the comfort of the comfortable must give way to very visible, very unpopular, direct cash flows.

The choice Europe’s leaders faced was to preserve the union or preserve the wealth, prestige, and status of the community of people who were their acquaintances and friends and selves but who are entirely unrepresentative of the European public. They chose themselves. The formal institutions of the EU endure, but European community is now failing fast.

It is difficult to overstate how deeply Europe’s leaders betrayed the ideals of European integration in their handing of the Greek crisis. The first and most fundamental goal of European integration was to blur the lines of national feeling and interest through commerce and interdependence, in order to prevent the fractures along ethnonational lines that made a charnel house of the continent, twice. That is the first thing, the main rule, that anyone who claims to represent the European project must abide: We solve problems as Europeans together, not as nations in conflict. Note that in the tale as told so far, there really was no meaningful national dimension. Regulatory mistakes and agency issues within banks encouraged poor credit decisions. Spanish banks lent into overpriced real estate, and German banks lent to a state they knew to be weak. Current account imbalances within the Eurozone — persistent and unlikely to reverse without policy attention — implied as a matter of arithmetic that there would be loan flows on a scale that might encourage a certain indifference to credit quality. These were European problems, not national problems. But they were European problems that festered while the continent’s leaders gloated and took credit for a phantom prosperity. When the levee broke, instead of acknowledging errors and working to address them as a community, Europe’s elites — its politicians and civil servants, its bankers and financiers — deflected the blame in the worst possible way. They turned a systemic problem of financial architecture into a dispute between European nations. They brought back the very ghosts their predecessors spent half a century trying to dispell. Shame. Shame. Shame. Shame.

Until the financial crisis, people like, well, me, were of two minds about the EU’s famous “democracy deficit”. On the one hand, I believe that good governance requires accountability to and participation of the broad public. On the other hand, before the crisis, I was willing to cut the Euro-elite a lot of slack. I’m an American born in 1970, but my life is largely framed and circumscribed by events in Europe during the Second World War. I grew up on a diet of “never again”. I am writing these words from my grandfather’s villa on the Romanian Black Sea, which my mother worked doggedly to recover in an act of sheer vengeance for what this continent’s history did to her father. I was inclined to support Europe’s democratic fudges when they were about diminishing and diffusing the still palpable possibility here of reversion to ethnonational conflict. To see European institutions deployed precisely and with great force in the service polarization across national borders has radicalized and made a populist of me (as have analogous betrayals among the political leadership of my own country). If I were Greek, I would surely be a nationalist now.

With respect to Greece, the precise thing that European elites did to set the current chain of events in motion was to replace private debt with public during the 2010 first “bailout of Greece”. Prior to that event, it was obvious that blame was multipolar. Here are the banks, in France, in Germany, that foolishly lent. Not just to Greece, but to Goldman’s synthetic CDOs and every other piece of idiot paper they could carry with low risk-weights. In 2010, the EU, ECB, and IMF laundered a bailout of mostly French and German banks through the Greek fisc. Cash flowed into Greece only so it could flow out to rickety banks. Now, suddenly, the banks were absolved. There were very few bad loans left on the books of European lenders, everyone was clean, no bad actors at all. Except one. There were the institutions, the “troika”, clearly the good guys, so “helpful” with their generous offer of funds. And then there was Greece. What had been a mudwrestling match, everybody dirty, was transformed into mass of powdered wigs accusing a single filthy penitent (or, when the people with their savings in just-rescued banks decide to be generous, a petulant misbehaving child). [antidote]

Among creditors, a big catchphrase now is “moral hazard”. We cannot be too kind to Greece, we cannot forgive their debt with few string attached, because what kind of precedent would that set? If bad borrowers, other sovereigns, got the idea that they can overborrow without consequence, if Spanish and Portuguese populists perceive perhaps a better deal is on offer, they might demand that. They might continue to borrow and expect forgiveness, and where would it end except for the bankruptcy of the good Europeans who actually produce and save?

The nerve. The fucking nerve. Lenders, having been made nearly whole on their ill-conceived, profit-motivated punts, now fear that if anybody is nice to somebody who doesn’t deserve it, where will it end? I’d resort to that cliché about chutspa, the kid who murders his parents then seeks leniency ‘cuz he’s an orphan. But it’s really too cute for the occasion.

For the record, my sophisticated hard-working elite European interlocutors, the term moral hazard traditionally applies to creditors. It describes the hazard to the real economy that might result if investors fail to discriminate between valuable and not-so-valuable projects when they allocate society’s scarce resources as proxied by money claims. Lending to a corrupt, clientelist Greek state that squanders resources on activities unlikely to yield growth from which the debt could be serviced? That is precisely, exactly, what the term “moral hazard” exists to discourage. You did that. Yes, the Greek state was an unworthy and sometimes unscrupulous debtor. Newsflash: The world is full of unworthy and unscrupulous entities willing to take your money and call the transaction a “loan”. It always will be. That is why responsibility for, and the consequences of, extending credit badly must fall upon creditors, not debtors. There is one morality tale that says the debtor must repay, or she has sinned and must be punished. There is another morality tale that says the creditor must invest wisely, or she has stewarded resources poorly and must be punished. We get to choose which morality tale we most use to make sense of the world. We do, and surely should, use both to some degree. But if we emphasize the first story, we end up in a world full of bad loans, wasted resources, and people trapped in debtors’ prison, metaphorical or literal. If we emphasize the second story, we end up in a world where dumb expenditures are never financed in the first place.

But don’t the Greeks want to borrow more? Isn’t that what all the fuss is about right now? No. The Greeks need to borrow money now only because old loans are coming due that they have to pay, and they have been trying to come to an agreement about that, rather than raise a middle finger and walk away. The Greek state itself is not trying to expand its borrowing. Greece’s citizens and businesses would like to expand the country’s borrowing indirectly, by withdrawing Euros from Greek banks that the Greek banks won’t be able to come up with unless they are allowed to expand their borrowing from the ECB. That is, Greece’s citizens are in precisely the place France’s citizens and Germany’s citizens were in 2010, at risk that personal savings maintained as bank deposits will not be repaid. Something was worked out for French and German citizens. Other than resorting to the ethnonational stereotypes that European elites have now revived in polite company, what is the justification for a Greek schoolteacher losing her savings that wouldn’t have applied just as strongly to a French schoolteacher five years ago? Because Greeks are responsible, as individuals, for what the governments they elect do? Well, then I deserve to be killed for what my government has done in Iraq and elsewhere. Is that where we want to go?

If citizens aren’t going to be held responsible for their governments’ bad debts, how will sovereigns borrow at all? Well, how do firms raise equity, when an equity claim makes no promise whatsoever that any cash will be returned? People invest in shares not because they have any sword of Damocles to hold over the enterprise, but because they believe the firm will engage in activities sufficiently productive that throwing some cash back to investors will not be burdensome, and because firms know repayment enhances access to continued finance. The same is true of sovereigns like the United States or the UK, which borrow easily in currencies they can print any time. Nothing prevents the US from conjuring $100T USD and handing it out to citizens, engineering a one-time inflation that leaves outstanding bonds nearly worthless. It wouldn’t even constitute a default. But the US has organized itself in ways that persuade creditors that their funds will be treated reasonably. Inflexible debt sows seeds of coercion and enmity between borrower and lender. Equity-like arrangements, including “debt” denominated in securities issuable at will by the debtor, require and encourage trust and collaboration. Sovereign debt in particular should always look like the latter, not the former, given the regularity with which government borrowings are disbursed into insiders’ bank accounts rather than used to aid the publics who might be pressured to foot the bill.

Greece should see its debts forgiven, pretty much wholesale. That forgiveness should be understood as a default, with future investors warned. Insured deposits in Greek bank accounts should be made whole, uninsured deposits should be “bailed in”, Greece’s banking system should be integrated into a much more carefully regulated European banking system that eschews investment in individual sovereigns entirely, Germany as much as Greece. Let sovereigns sell securities to the market, where incentives for careful credit allocation are sharper than they are within banks. Let European banks hold only claims against the ECB when they want a risk-free instrument. If Spain or Portugal or Italy wish to haircut or repudiate their existing debt, let them, at cost of future market access. Sovereigns have an option to default full stop. Investors in sovereign securities must price that. If perceived credit risk leaves public finance too expensive Europe-wide, then the EU should develop a mechanism whereunder states are permitted to sell equity securities to the ECB up to a fixed limit, set uniformly across Europe in per capita terms.

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

If it were 2009, I might have been persuaded that the corporate bankruptcy analogy is poor, that Europe’s interest in the development and cohesiveness of its empire would substitute for narrow economic incentives (which should in any case be blunted, since they are the incentives of 27 different fiscs). If the past five years had not happened, I might be open to the argument made here (ht platypus) that, having extended the maturity of a large quantity of debt far into the future, creditors’ position is more like equity, since the fraction of face value creditors eventually recover is dependent upon Greece’s long-term growth.

But we have had five years to observe creditors’ tender ministrations, under governments that complied with creditors’ every demand. This has been the result:

Euroelite apologists cite the small upturn at the very end of the graph to say, “See! Things were going swimmingly until the five-month old Syriza government screwed it all up. They just had to stick with the program! It was working! The darkest hour comes before the dawn!” These people, they are sophisticated highly educated people. You can trust them. Check out this track record:

The fact of the matter is no country, not Germany, not France, would voluntarily put up with the sort of “adjustment” that has been forced on Greece, for the good reason that gratuitous great depressions are not actually helpful to an economy. Creditors have had five years to mismanage Greece and they’ve done a startlingly effective job. Syriza has had five months to object. However much you may dislike their negotiating style, however little you think of their competence, Greece’s catastrophe was not Syriza’s work. If creditors respond to Syriza’s “intransigence” with maneuvers that cause yet more devastation, that will be on the creditors. Blaming victims for having insufficiently perfect leaders is standard fare for apologists of predation. Unfortunately, understanding this may be of little comfort to the disemboweled prey.

Europe’s creditors are behaving exactly as one might naively predict private creditors would behave, seeking to get as much blood from the stone as quickly as possible, indifferent to the cost in longer-term growth. And that, in fact, is a puzzle! Greece’s creditors are not nervous lenders panicked over their own financial situation, but public sector institutions representing primarily governments that are in no financial distress at all. They really shouldn’t be behaving like this.

I think the explanation is quite simple, though. Having recast a crisis caused by a combustible mix of regulatory failure and elite venality into a morality play about profligate Greeks who must be punished, Eurocrats are now engaged in what might be described as “loan-shark theater”. They are putting on a show for the electorates they inflamed in order to preserve their own prestige. The show must go on.

Throughout the crisis, European elites have faced a simple choice: Acknowledge and explain to electorates their own mistakes, which do not line up along national borders of virtue and vice, or revert to a much older playbook and manufacture scapegoats.

Such tiny, tiny people.