piigsty

I know, Part 1 was a bit intense. Your reward is some nice and simple diagrams.

First, on the clogs in the banking/financial sector and its effect on the wider economy

PIIGSty Printing Money Explanation 1.1

Second, on the what the government can do to free up the clogs

PIIGSty Printing Money Explanation 1.2

Pay attention ‘cause this is a tricky one. Former Chairman of the US Federal Reserve Alan Greenspan said something very interesting in a recent interview on MSNBC. When asked were US treasuries (US debt) still safe to invest in [coming after the US downgrade by Standard & Poors to AA+], Greenspan replied “ Very much so. This is not an issue of credit rating. The United States can pay any debt it has because it can always print money to do that so there is zero probability of default.”

Printing money (aka Quantitative Easing or QE1, QE2 etc in the US) conjures up images of ropey old monetary dinosaurs, eyes bulging as giant money presses spit out endless dollars, euros, yen , yuan or what have you. In the electronic age, luckily you don’t actually have to physically roll out legal tender paper and print away to your hearts content (at least, not in a civilised economy). Instead, you can use a trick of accounting to simply write in €10bn, €20bn, €100bn…onto the ‘asset’ side of the Central Bank balance sheet (or in the ECB case, the balance sheet for the eurozone-17).

The hope is that printing money will spark economic growth or inflation or both. Why? Well think of this. Every economy consists of goods and services – that’s what we produce. If that’s what we produce, then surely measuring money – what we spend on that stuff – is measuring how the economy is doing. Which it does.

Economic growth then (the change in output year on year) must = the amount of money in the economy (supply)  X  the speed its sloshing around (velocity).

Today, the speed (velocity) has dropped to a standstill. But, each Central Bank can increase the supply! How?

1. Lower interest rates (make existing money ‘cheaper’)
2. Print money (make more money)

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The borrowing rate on the European bail-out fund (the €440bn EFSF fund) is less than 3% . The reason is that If all 17 eurozone nations worked together and borrowed money as a group, then the weight of the larger and more creditworthy among them would mean a lower borrowing rate (interest rate). Six eurozone members have excellent AAA credit ratings (including the EU giants France and Germany) and they therefore borrow at a lower rate than the much smaller, high debt nations like Greece or Ireland.

These AAA eurozone nations represent a big chunk of the EZ-17 (in population and GDP terms) and a sizable chunk of the EU-27 too..

Of course, this means that smaller eurozone countries ‘piggyback’ on much bigger nations credit rating to solve their own problems which isn’t viewed as very fair if the bigger countries have to then pay a higher interest rate collectively than they would have on their own. This is why French President Sarkozy and German Chancellor Merkel constantly have to walk a politically delicate tightrope to get agreement on any united European effort.

One way to speed up the balancing of the PIIGS finances (to get some credibility back from the markets, remember!) is to reduce the value of your currency or break away from a bigger currency and set up a new one.  As euro-members, eurozone (EZ) countries can’t fiddle around with the value of their currencies which they could before i.e. making their currencies cheaper so others buy more of what you produce and drive up demand for your exports, businesses and jobs.

This means EZ countries can’t just break off from the euro and set up a new currency for themselves (or an old currency; i.e. bring back the Punt, Escudo, Drachma etc). Put simply, it would set alarm bells ringing for investors who suddenly realize that you’ve given up a currency anchored in ECB HQ (and politically in Berlin and Paris) for one anchored in Dublin, Athens, Lisbon, Madrid or Rome… places where the fantastic decisions were made that put the PIIGS in the giant mess in the first place. In any event, it mightn’t make any difference to the big problem – the national/sovereign debt piles. Lets say Ireland wants to restablish the Punt. Heres the pros and cons.

Like during any real disaster, some are more concerned with arguing that the eurozone led itself into this mess in the first place by having a lax attitude toward the entrance requirements (the Maastricht Criteria) and lax regulation (the Stability and Growth pact) rather than addressing how to fix the problem.  Current debt levels force countries to make the hard choices in other areas, such as the main government account deficit by cutting public spending and increasing debt. There is, obviously, a limit.

With so much uncertainty, the only real credible elemnt the PIIGS are clasping onto for dear life is the euro and ECB control of monetary policy. German leadership (of the euro) means shrewd German policies – and the markets like these. But it was never envisioned that we’d have a banking crisis on top of deep fiscal crises in previously sound economies. An obvious altternative solution would be to temporarily suspend debt repayment to certain parties (i.e. certain bondholders) and only pay those who need to be paid – but this brings challenges to those big Northern European banks who own PIIGS debt.

So, no. You can’t scrap the euro. It would put a gun to your own head and giving the ability to pull the trigger to millions of unknown people. Your debt pile remains – in Punts, in euros, in golden coins, in lumps of coal – whatever unit of value you want. You still owe it. The only correct action is to fix the pile – and this is Europes challenge. One way or another.

Fact: The European banking sector is sick. Once a vibrant area bursting with credit, now you’d be lucky to get your credit card application approved. The problem with banking is that the sector is the lubricant ‘oil’ that makes the economic ‘engine’ work. Without it, your economy is sunk. Across Europe, one of the most overused (and misunderstood) phrases these days is ‘burning the bondholders.’ What exactly does this mean?

In banks, there are three groups:

1. Shareholders – the ‘big wigs’ + guys usually throwing the eggs at AGMs/EGMs who own part of the bank
2. Bondholders (shareholders with less risk) – usually giant hedge funds or other big European banks, less likely to throw eggs
3. Depositors – the average Joe/Josephine with a bank account

Lets use Ireland as an example. Irish banks need investors. Since Ireland is so small, it needs international investors from across Europe, Asia, the US and beyond.  A bank is unique in that it has both shareholders (i.e. receive % of profits each year) and bondholders (which are like super-shareholders as they get paid interest payments and are paid first if the bank goes bust and is sold off).

As strange as it seems, bondholders are treated like depositors under Irish financial law (which is based on English law) meaning that you could have €1 in your bank account or own €1m of bank bonds and be protected under our big bank guarantee. BUT bondholders can’t run. They have to wait to be paid their €80bn+. Depositors can run, hence the long queues on TV of people trying to withdraw their cash. If Ireland doesn’t pay the bondholders, who are affected?

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