Original URL: http://www.theregister.co.uk/2011/11/10/were_all_doomed/

Eurozone crisis: We're all dooomed! Here's why

Imagine someone on £10K with a £50K credit card bill

By Tim Worstall

Posted in Government, 10th November 2011 16:39 GMT

Analysis Quite what is actually happening over the Eurozone I can't actually tell you: it's not that things change too fast to write about them, it's that things change to fast to read about them. Berlusconi still PM? Italian bond yields over or under 7 per cent? That changes as often and as fast as Berlusconi does condoms. France to go bust or not? Greece still bust?

However, what I can give you is a quick guide to what will solve the problem.

Nothing.

Well, nothing that's actually possible or legal, anyway.

We've two different things going on here: insolvency and illiquidity. Insolvency is Greece: they're bust, that's all there is to it. It just doesn't matter how much austerity (read, firing people) Greece does, how heavy they get with tax evaders and the structural changes they make. They simply cannot pay the debts they already have. They're as bust as someone on £10k a year with a £50k credit card bill.

People who are bust should default, pay back a bit but not all of what they owe, and start again. Finally, 18 months after this was obvious to the financial markets, the politicians have deigned to notice. So Greece will default: unfortunately, the deal isn't good enough. Only the private sector is going to take the 50 per cent “haircut” and most of the debt is now owned by various public sectors that won't. So Greece will still be bust and will have to default again in the future. Better to do it once and do it right but the politicians haven't come around to that yet.

But insolvency is nothing new: Greece has been in default on its foreign debts for 50 per cent of the time since it declared its independence in 1822. It's also not a large default, we're talking about the entire financial system losing £100bn or so: sure, real money but it doesn't bankrupt everyone or melt all the banks. Painful and tiresome but it can be done.

The other problem is illiquidity: this is Italy's big problem. They've a huge debt, like Greece. However, as long as the interest they have to pay on it stays low enough, they can manage to deal with it. Most Italian government debt is owed to Italian households anyway. However, if those interest rates rise then they can't pay the interest on the debt and thus they'll go the Greek way.

You expect me to default? No bonds, I expect you to die

This doesn't happen overnight of course. For the debt is bonds, bonds that were issued years ago. The interest that must be paid was set when the bonds were issued, the current market price of the bonds doesn't change that. Except for one little thing. Governments almost never pay off debt (the UK has done so three times since 1945, a couple of years each time, under Atlee, Lawson/Thatcher and Blair/Brown when they were still following the previous Tory budget plans), when an old debt becomes due they issue new bonds and pay off the old with the new. And, of course, the new bonds have to be issued with the interest rate set by the market.

That's the problem Italy has: their old bonds might be paying 3 per cent or 4 per cent, they've €300bn they must refinance this coming year and the new interest rate is 6.9 per cent (7, 7.4, 7.1, erm, take your pick by the nanosecond) and if all of their outstanding €1.9 trillion in debt has to be refinanced at these higher rates over the years then they're all Greek. But they're not bust yet: they're only bust if they do have to pay those higher interest rates. Thus they're not insolvent, they're illiquid.

Our problem is that they've got to refinance debt each week or so, with some coming up that must be financed. And each week that they've got to pay these higher rates makes the move to insolvency more likely. So of course, each week that the high interest rates persist means more people sell the old bonds and the higher the interest rates go (bond prices and bond yields move inversely) and so we have a horrible positive feedback. Note that this is nothing to do with short sales, speculation, CDS or even bankers being bastards. It's very simply people saying: “I'm not buying that shit, they're going to go bust.”

We all thought that it was going to be Spain that went this way next but no, Italy it is.

Surely there's something we can do?

So, what can we do about it? We could try what is being tried. A rescue fund: let us go and buy lots of Italian debt, drive the price up, the yields down and we're dandy. Great, OK, let's do that. So, now we've got this money pot called the EFSF (don't worry, boring acronym) which is to do just that. Except, in some fit of absentmindedness, no one actually put any money into the EFSF. There's a few billion in there but that's just the spare change of the beggar priming the collection cup. The EFSF is to go and borrow the trillion to buy the Italian debt. Everyone promises, cross my heart, to guarantee the EFSF but no one has been willing to cough up the cash.

This causes the occasional problem: it didn't take long to work out that the guarantees France has made would, if they ever had to make good on them, drive France into being Greece. The other problem is that having primed the collection plate they went off to ask people to lend the EFSF money. Err, no, said China, Brazil, the US and Russia. They did manage to borrow 3 billion this week: but the interest rate on the EFSF bonds is now rising just like it is on the bonds of France, Italy, Spain and so on. In part because it is France, Italy and Spain, among others, actually guaranteeing the EFSF and in part because the Japanese, who bought 20 per cent of the last EFSF bond issue, have already lost money on it.

This whole process has been called “The Mother of all CDOs”: yup, CDOs being those things that tanked the American financial system as they went down with the housing market. That system worked for a decade but the attempt to recreate it in Europe seems to be failing after a few weeks.

We're mad as hell and we're not taking any more

So, we could do what is being done but it's not going to work. Could we actually do something that would work? Sure we could.

We could just make new money. The European Central Bank (ECB) can do that, just like the Fed in the US and the BoE in the UK. This is very much what quantitative easing (QE) is. Print new money, buy government debt with it, prices of govt debt rise, yields on govt debt fall. Exactly what we want to happen. ECB prints up a trillion euro (creates it on a computer actually but...) buys Italian bonds and we're done.

Sure, we get a bit of inflation out of this: but that's actually good at this point. It makes all the other adjustments much easier, like grease on an axle. We're not in fact doing this though: this simple and obvious thing that could and should be done. The reason we're not is because it's illegal. This would be the ECB acting as a “lender of last resort” and the ECB isn't allowed to act as a lender of last resort. This is, believe me, from an economic point of view, really a quite remarkable fuck up.

It isn't just that cramming 17 wildly disparate countries into one currency for entirely political reasons was a bad idea (the “optimal currency area” argument) it's that when they did it, they set it up so that the central bank couldn't perform the most important task of a central bank: be the lender of last resort. The ECB just isn't allowed to print money and bail Italy (or whoever) out.

Sadly, this means that there isn't actually any solution to what is going on. Waffling about on the subject of austerity, of working back into competitiveness, this doesn't work because it won't work quickly enough. Faffing around about treaty changes and more Europe and joint economic monitoring won't work because it won't work fast enough. The EFSF won't work because no one will lend it the money to make it work. And finally, the one thing that would work and would work fast (within a week if it was actually done), the ECB printing money and buying bonds, is illegal.

I'm afraid we're all stuffed. ®

Bootnote

As a UKIP supporter, I've been saying it will all end in tears for at least a decade. I can find a Usenet post of that vintage saying exactly that. Being right is quite wonderful, but I think given the human pain about to come I'd rather have been wrong.