Defaults

Recently we have heard a lot on defaults and I have also written that default is a possible solution to a financial crisis for a country. But as Ryan commented on the previous post my description was quite short. In this post I will expand on the the principles of defaults.

As I described before, defaults can be divided up in two kinds orderly and disorderly: an orderly default is simply the country agreeing with the owners of its bonds not to pay them in full or on time or both. In contrast a disorderly default is a country unilaterally giving the finger to its bondholders and not paying its bonds at all.

Why can a state actually disorderly default? If it does, won't it violate its contracts? The answers to this problem is that if the bonds are hosted under the law from that same state, the state can alter the law so that it won't really violate its contracts. To default disorderly a state just declares the bond contracts void. In the case of an orderly default the country offers bondholders the ability to exchange their old bonds onto new ones(with less principal or more maturity or both) which are treated differently. It will then still declare the old bonds void. There are some entities (appropriately named vultures) which buy up these void bonds and try to get money out from the issuing state, some times that works, some times it doesn't (Cuba is the main case here)

As I described in the previous post, the state is usually more interested in the orderly default since that will still retain some credibility on the financial markets. Since the country is usually in a crisis when defaults occur it could be of a great value to retain the possibility to borrow money (be it against usually extortionate rates). The second reason is that orderly defaults prevent creditors from seizing the assets of the state that are abroad. Finally disorderly default usually create all kinds of chaos that will seriously harm what's left of the economy and society (see Argentina in 2001, another episode from the Dutch show tegenlicht deals with it).

You could wonder why bondholders would agree to an orderly default, after all they have a contract with the state to receive the full amount on the bonds. The reason for this is the possibility of the disorderly default.They agree to be paid less with more certainty, than being paid in full with almost no certainty. The increased certainty can come from another country/entity guaranteeing the payments (as happens in the Greek case, it is not the bond holders but that entity that is demanding the reforms) or by putting the bonds outside of the countries borders. Often countries with less credibility opt to host their binds in New York or London so that the bonds are hosted under the law from the USA/UK.

The situation that then appears is similar to that of the battle of the sexes ( a game similar to the prisoners dilemma). The real question in these games is the preparedness of one player to wreak havoc, the more likely you are to drive of the cliff, the more likely it is that the other party will settle with you on favorable terms. Therefore a state should negotiate with absolute disregard for the economic consequences of disorderly default. I know it sounds strange but that's the world we live in.

Another problematic thing with defaults and negotiations to prevent them is the shear amount of actors involved in them. Here is a list of likely actors involved in any deal: The state, large social actors within that state (unions, employers, state companies etc.), the banks with bonds (most likely also within the country), other bond holders (pension funds, hedge funds etc.), foreign governments whose banks and funds hold bonds, trading partners, maybe courts that are abroad and of course the citizens of the the defaulting state. A Reuters blogger has a nice video on the main actors involved in Greece ( It has also a pirate boat :-)).

Finally, throughout history people and governments have made two big mistakes when it came to defaults. The first was that it doesn't happen to us/ the people we lend money to. And the second one was that a default means the destruction of a country. Both of which are almost always untrue: In the book this time it's different the authors describe how almost all countries (and yes that includes the US in the 1970s by some measures) have defaulted one way or another in the last 200 years. The second thing is that defaults even disorderly ones can be better on the long term than muttering along in a bad situation that is not going to improve with a large debt burden (see also my previous post). It seems that the Europeans have finally understood that with Greece.

Saving Portugal and Spain: Solutions (1)

After all the negative messages from this series, it is time to finally start working on the possible solutions. In this first post I will address the more financial solutions. Some have been discussed by European leaders, others should be.

The first solution is to lend a lot of money to these countries to help them cope with their deficit and debt payments. This policy can work to stem the problem of loss of trust on the side of the bondholders. It is quite simple to see why: if you know that you will get your money back one way or another, it is very safe to lend your money (in this case buy bonds). But in here there is the immediate problem: to give this trust to bond holders, one needs to be able to lend enough so that whatever happens, the country can pay its debt obligations. That means that you need to have very big reserves ready for lending (a job well suited for a central bank, which has virtually infinite reserves). But even if you're willing to do this you need to be sure that the treasure country is inherently sound (or force it to make policies to ensure this). If this is not the case you need to lend until the end of days and you're effectively subsidizing. In the Euro zone this is far from reality, and politicians more liked to pretend it was true rather than knowing it. This is why the policy has been branded: extend (the loans) and pretend (everything is OK) by some bloggers.

If the countries are in more than just a liquidity issues and I believe they are then it is time for more drastic measures. One of the proposed measures (and already kinda enforced on Greece) is the orderly default on its debts. An orderly default is simply the country agreeing with the owners of its bonds not to pay them in full or on time or both. In contrast a disorderly default is a country unilaterally giving the finger to its bondholders and not paying its bonds at all. The disadvantages of a default, either kind, is the loss of trust on the side of the bondholders and a disastrous rating from the rating agencies. Furthermore, since often a significant portion of the owners of sovereign bonds are domestic actors (banks, pensionfunds, etc.) the effects for the economy are likely to be bad as well. The main advantage is that the country is relieved of its debt burden and it can move forward, and if a country defaults orderly many of the bond holders will eventually return (be it that you borrow at higher rates). If a default is disorderly the country will be shunned from the financial markets and that is in this age very very bad. Therefore an orderly default is always better than a disorderly one.

However if the underlying economy is not sound, a default will not solve most problems (and could be even worse than a large debt burden). In fact the only way to move out of the mess is to get the economy running again. This can be by external factors such as, increased trade. But this is unlikely to happen since most of the world is still struck by the financial and euro-crisis. Structural reforms like cuts usually take too much time as I mentioned in a previous post. Therefore the only way forward is to invest in the country. Since this is usually impossible by the state, it needs to either borrow money using bonds with such a long maturity that it can use the money to grow or with foreign investment. If the money is well spend it could be the only way out of a debt and economic crisis that Portugal and Spain are now in.

Saving Portugal and Spain:The situation (3)

This post will be the final post about the situation of Portugal and Spain. In this post I will address some of broader the issues facing Europe as a whole and the Iberian peninsula in particular.

The first real problem is energy: Europe is increasingly dependent on increasingly unstable countries for its energy needs. Some examples: as a recurrent winter tradition Russia is threatening to cut gas to certain or all European states. Iran has just announced (or maybe announced, it is a bit unclear), that it will cut its oil deliveries to at leas 6 European countries. Other countries with substantial oil and gas reserves are in turmoil because of the Arab spring (Libya, Egypt, etc.) . In Europe we do not want more coal plants because of the CO2 and other environmental issues. Nuclear power is not a feasible political option since the disaster in Japan, even though Europe is a bit divided on this issue with France and Germany being on both sides of the debate. At this moment, so called green energy (in order of importance: water, wind, sun and .... biomass) does not seem to be able to cope with the ever increasing demand.

The other problem, which is a bit more local, is water. In the northern countries there is to much of it and in the southern countries there is to little. The too much part can be mitigated by building better structures to deal with water (levies, dikes, dams, preemptive flooding areas etc.). In the south the problems are harder to solve. Spain and Portugal have already entered an argument on the use of a Spanish dam on one of the larger rivers flowing into Portugal. Here the main culprit is the agricultural sector (even though some industries are also large water consumers). It just takes an extraordinary amount of water to use modern large scale agricultural techniques.

Finally there is the problem of indecisiveness. In Europe, and in specific European countries it seems harder and harder to make quick decisions. This is fueling the uncertainty over the crisis and more importantly it is delaying the plans for a way of getting Europe out of the crisis and back in the lead. The indecisiveness is caused by the incomplete patchwork that is the European Union. Fact of the matter is that in many cases nobody seems to know which actor is responsible for what (European commission, European council, European parliament, European central bank, the parliaments...). This then invokes lots of political games, which only make the situation worse. Therefore it is necessary to create a more clear structure, one way (decentralization) or another (Federalization).

In my next series of posts on this subject I will be discussing a more cheerfull subject of solutions to this situation. So if you want to discuss more on the situation of Portugal and Spain, please react below.

Saving Portugal and Spain: The situation (2)

This post is a continuation of the earlyer post on the situation of Spain and Portugal. There some of the unitil problems were discussed, the problems here are results of the earlyer problems. These non-the-less represent a serious threat to recovery on the Iberian Peninsula.

First there is the drain of young talented people: as i discussed before, the lack of innovative and growing companies means that there are no positions for young people. The continuous corruption on the high levels of society and the large bureaucracy are also responsible for demotivating youth. This means that young people will flee the country and will move to countries, in Europe but also outside. This is very bad for the home country since it is precisely these people that the country needs to start new companies, renew existing ones, reconstitute the governance structure, in short to construct the countries future.

Then there is the problem with trust, which is also one of the reasons young people are leaving. At this moment people do not trust the country to leave the crisis. This leads to less investments and lower credit ratings not just of the country but also of all organizations (banks, municipalities, companies etc.). The lower ratings and fewer investments in turn lead to less trust and less economic growth. What I mean to say here is that once a country has turned a certain corner it will fall down a cliff. The only way to fix a situation like this is either to go broke, wait a long time in misery and slowly rebuild your economy on the wreckage of the old one. Or, a more preferable option, make a grand gesture on something econmic and rebuild trust.

The unfortunate part is that countries that are already in distress are usually not able to make these gestures, since they are already in distress. The only way to make a good gesture yourself is to either present a workable way out of economic decline and insolvency (usually nearly impossible, since most plans only revolve around budget cuts and increased taxes. Most economists, even at the IMF know that that doesn't work) or the other way: embellish and lie. Show a suddenly growing GDP, show more investments, show a cleaner government, fire some important heads of institutions. It surely wont help your economy or your situation directly but if Portugal and Spain manage to inspire trust back in them. They might be able to turn the situation around as quickly as it emerged.

In the next part of this series I will talk about the more international aspects of the crisis.

Rating the agencies

Credit ratings have gone from an obscure financial term to a report card on the behavior of governments. But what are these ratings, where do they come from and why should we care about them?

Credit ratings are an indication of the likelyhood that an financial instrument (bonds, securities etc.) will pay the promised returns. It is best understood when talking about bonds(corporate and country loans): it is the likelyhood that a company will pay the principal and interests on its loans. The ratings can range from AAA (No question, they will pay) to D(they won't pay). In the globalized world we live in ratings on credit are a necessity: how else would you as a small investor be able to know if it is save to buy bonds from a company around the world. Interestingly it is mainly large actors (pensionfunds etc. ) who actually do have the resources to investigate these questions, that mainly rely on credit ratings: they often even have the ratings enshrined in their statutes..

There are three major credit rating agencies: Moody's, S&P and Fitch and they are all from the USA. That means that ratings are likely to be biased to USA values, like a preference to a certain law-system(see this chapter on Fitch). It is hard to precisely understand where a rating actually comes from. To make a rating these agencies use all kinds of quantitative (e.g. amount of external debt), qualitative (e.g. willingness to pay on debts) and institutional parameters (e.g. enforceability of contracts). And out comes a single rating, which actually always means a gross oversimplification of the situation a country or company is in.

To make matters more complex: it is not the investors that pay the agencies but the issuer of the instrument. This means that the interests of the rating agencies are not fully aligned with the investors. It is rumored that during the boom of MBS (Mortgage Backed Securities), large investment banks made rating agencies put incredibly high ratings on their products, even though the chances of default where substantial. Some might say that this is one of the main reasons why the crisis began, but i will come back to that in another post.

The reason why we should care about these ratings is because other people do. Even though it is incredibly unlikely that France will default on its bonds, some large investors might be forced by their statutes to sell of their French bonds now that they are rated lower. Because of these kinds of reactions from large financial actors the ratings have a significant impact on the price of the thing that they are rating. In the case of a country it means that a lower rated country needs to pay more interest in its bonds than a higher rated country.

For all Dutch speakers: there is a very good documentary from VPRO Tegenlicht on rating agencies(about half of it is in English, so non-Dutch speakers can also watch it). I believe that the Inside Job also deals with them in understandable way.

Saving Portugal and Spain:The situation

For any successful attempt of solving a situation, it is important to make an overview of the problems that are there. And this is what I want to do in this post. I have gathered quite some data about Portugal and I believe that a lot of the problems are similar to the ones of Spain. As always please correct me if I'm wrong.

First an assessment of the situation right now. The government debt of Portugal is increasing at an alarming rate: depending on who's measures one uses it has reached over 100% of GDP already. In 2011 the deficit was around 6% (note that it may change because Eurostat hasn't published the official data yet) as also agreed in the bailout package with the Troika (EU,ECB, IMF). In general a government debt like this is unsustainable unless there is an economic boom or an unexpected increase in income. Both of which are unlikely.

This brings us to the second point: the Portuguese economy. For the last decade there hasn't been any real growth in GDP of Portugal. The Spanish GDP did experience a growth rate of about 3.5% but this is probably biased upwards due to the real estate boom in there. I believe that the reason for the low growth rate, mainly in Portugal, is the lack of innovative activity. Factories are closing instead of opening, and there is no adequate work for university graduates. In Spain the same situation seems to exist (If I have to believe the Dutch news stories).

Finally there is the problem nobody really wants to talk about: corruption. From what I have seen in Portugal this is not on lower levels (e.g. never seen corrupt police and I doubt that it would be accepted by the population). Rather, it is at higher levels of society. There are controversies surrounding the takeover of the bank BPN, there is operation face occulta, even the president Cavaco Silva has been accused of accepting bribes. At some point there was even an add campain by the Portuguese Licor Beirão making fun about how corrupt the government really was. The main point is that if even half of these stories are true it means that the most powerfull politicians are more busy getting rich and covering themselves than leading the country.

In the next post I will discuss more details about the situation in Portugal and Spain.

Saving Portugal and Spain: Introduction

For a while i would like to devote my time and the space on this blog on the quest to save these countries from the economic turmoil they are in. I chose Portugal and Spain because I think that even though the problems that they are facing and their economic structures, language and culture are quite different; the problems are similar enough to at least consider some form of similar approach. This I do not think about the three other EU countries in trouble: Ireland, Italy and Greece. But even for them there might be something in this blog.

This first post( in a long line) is about why it is important to care about the problems on the Iberian peninsula. For me it is quite simple, after living in Portugal for half a year: então parte da minha alma é português :-). Furthermore my girlfriend and here family as well as mine and her friends still live in Portugal. Also in Spain I have quite some friends, so I guess I'm quite biased here... But also for somebody that has no direct connection it is important that these countries do not sink further in economic crisis.

First there are the costs for the people in there themselves. A lot of people that are like us are facing a deep recession, unemployment (yes even more than we do), sharp increases in prices, sharp decreases in the services that you expect from a government in Europe and a lot more.

But also for other European countries there are problems. there is the economic perspective, a lot of the exports from northern Europe go to southern Europe. I might be mistaken but i think that the crisis is starting to hit German exports (e.g. cars) to these countries. Then there is the financial world: for a country to be seriously indebted there needed to be banks willing to lend it money, in the case of Greece those were French banks (which are now mysteriously at the brink of bankruptcy). In the case of Portugal and Spain i am quite sure that other North-European banks have the most exposure again.

Finally, I see this also as a test for Europe. If we can make it through this crisis together, Europe will be stronger regardless of the exact configuration of power. If we fail to make it trough we are back to where we started with the ECSC. So my message is that it is in the interest for all Europeans to solve this crisis.

Economics at a turning point(3)

After the previous 2 posts on my view on the economics science, it is time to present my view on propelling it forward. I will present a far more humble and empiric science of economy rather than the abstract science that it has become. My ideas are still in a very early stage so they may lack a full and thourough basis and therefore i would like to invite the readers of this blog to comment on the concept.

My general idea is to approach the economy as a set of different sectors (production consumption government etc.) as is common within economics. Here is where the twist is: instead of theorizing how the interaction between these blocks is and fitting the data to such an interaction, i would like to compute response functions between them. The response function, as borrowed from electrical enginering, does not need to be a neat mathematical sound function as all to often happens in classical economics. It would be a function that has probably lags and maybe even cases in which a system responds before the signal actually was given. This could happen with consumption when people, worry that a crisis might occur, adjust their spending accordingly.

This does not mean that the theory of economy would go to the trash, rather it could explain and smooth en the function. This will be very necessary because it is impossible to observe an economic impulse in abstraction, rather we will have to get it from observing the entire system. This means that there will be a lot of noise, that economic theory of all branches, be it classical evolutionary or something else, could help over come.

When the response functions of all important components from the economic system are know, we could use simulation (which we probably need because the system will be far to complex to analyze only analytically) to answer questions on all sorts of economic questions. Interestingly we could use a system like this also to test the robustness of our predictions by varying the initial conditions slightly (an approach commonly used in simulation). This means that we can predict the likelihood of major events like another financial crisis much better.

As I've said before, this idea is still in the early stages so i would like everybody to comment and expand on it.

Cuts and Crisis

As many of us are experiencing: Europe and other large economies are in a great economic crisis. One of the consequences of a crisis of this magnitude is the high deficits that many governments are now running, threatening their solvency. An obvious answer to this threat is reducing deficits by cutting costs, reducing benefits and increasing taxes.

In this post I will deal with the first method of cutting: cost reductions. In most government programs this is simply firing civil servants or 'reducing bureacracy'. This seems a good idea: reducing a deficit by getting rid of unproductive labor. Unfortunately things are (almost) never as easy as what they seem. What happens with cutting programs is that civil servants get fired, but because they can't find another job they need to be supported by the state. This means in effect that you, instead of paying a salary to a working person, pay a benefit to a not working person. This effect greatly reduces the effects of cutting programs even when they cut only unproductive civil servants.

But wait, it gets even worse: cost cutting programs take specialists to asses and implement the programs, especially when they involve larger scales. Many governments do not have these specialists amongst their own staff so they will need to hire them from the private sectors. These specialists (now called consultants) do not come cheap. An ironic situation now occurs: the government is paying high costs to get rid of low salaries. And this, of course, leads to even less cost reductions.

The final problem with cutting personell in time of crisis is that large reorganizations often reduce productivity temporarily(lets assume, contrary to reality, that it is not a permanent reduction). The reduction comes from the fact that people and therefore organizations learn to act within an organization. When that organization rapidly changes people need time to adjust to the new organization, leading to less productivity temporarily. This is bad, especially in a crisis. In crises people need to be able to trust the government and are relying on its stability. Therefore a reorganization of crucial sectors is precisely the opposite of what a government should do.

In conclusion: even though cutting civil servants seems to be a good idea to reduce the governments deficit, it probably is better to get money from somewhere else if you are in a crisis.