The events of the preceding week, leading to the present memorandum agreement, have surfaced a particularly reptilian approach on the part of the “troika” (the collective term referencing the Commission of the EU, the European Bank, and the IMF) for Greece’s possibly receiving its next much-needed loan.  If one accepts the central thesis statement that the lion’s share of Greece’s contemporary economic difficulties can be traced back to the original nefarious circumstances by which Greece was initially inducted into the Euro-zone, it is perhaps instructive to review the economic reality that was Greece circa 1999-2002, when it was implementing its monetary conversion from the Drachma to the Euro.

To frame the discussion, in George Tsebelis’ recent and most insightful blog entry, he correctly points out that there have been recent failings on both sides (the Greeks’ failure to realize the prior budgetary restructuring goals set with the prior plan and the troika’s failure to incorporate any meaningful strategy for Greece’s economic recovery), with rather, the totality of the immediate discussion centering on bondholders simply being able to extract their maximum pound of flesh, with the revised qualifying conditions.  Tsebelis also correctly points out the issue of “the impossible request” contained in this set of revised assurances;  namely that Greece must “certify” its compliance with the plan in categorical fashion, independent of any possible revised governing will, derived from anticipated national elections.  As this is a terrible mandate that runs counter to the very underpinnings of democratic principles, there yet remains a sizable chance that the tentatively approved bailout package will prove to be a “bridge too far” in terms of its incursion into Greek sovereignty for the Greek populous to accept, with a default still occurring in the not-too-distant future.

So, from the above context of remaining uncertainty, it is germane to bring up an inconvenient truth from the past.  This truth is, specifically, that this latest melee is not the first, but rather, the second pass for the troika (whether it be intentionally or unintentionally) in mortally wounding Greece’s economy.

Turn the clock back to 1999 and we find a Greek economy that was generally consistent in running with a modest annual budgetary deficit, resulting in predicable inflationary dynamics.  However, with Greece being able to control the minting of its own currency at this time, it was able to essentially “self-medicate” in compensation for its recurrent trade deficit.  Moreover, contrary to what was largely extolled by German economists at that time, Greece’s internal economy of both durable goods and consumables was largely met by a diverse internal production capacity for at least 65% of its economy, and it was thus largely able to buffer its domestic goods pricing from external factors.

However, the intrinsic fundamentals of Greece’s economy were quite brittle at this time. Foremost was the reality that an excessive number in the workforce were federal employees, with this reality negatively impacting on the size and exuberance of any possible growth in the private sector.  Additionally, the expected revenue stream from both income and property taxes was far less than it should have been for an economy of Greece’s size, owing to chronic and widespread tax evasion. Together, these factors predisposed Greece to being highly susceptible to any changes in its macroeconomic climate.  Although Greece failed to meet the convergence criteria for entry into the Euro-zone in 1998, the then-recently reelected Pasok party Prime Minister, Costas Simitis, who narrowly won in April 2000, was ultimately successful in re-bidding for Greece’s entry to the Euro-zone in a staged transition between 2001 and January 1, 2002.  It can be seen that with Greece’s initial entry, the “perfect storm” of economic contraction was triggered, although few initially recognized it as such.

The first pound of flesh…

There is no playbook or single text that describes the optimal pathway to valuate and dynamically readjust one nation’s currency during the interesting transition period of adopting an external common currency, such as was the case with the transition from the Drachma to the Euro.  However, the process does have elements that call out to game theory and in this light, both Germany and France clearly had home court advantage.  The initially negotiated exchange rate of 340.75 to 1 was tied to an historically inaccurate conversion rate, with the European Bank being subsequently unmoved by supplemental Pasok party evidence of economic indicators forwarded as evidence of an improper valuation.  Additionally, Germany and France made a number of arguments late in the equitization process that further diminished Greece’s ability to correct the final locked-in conversion rate, with no amount of legerdemain on Simitis’ part in the 11th hour being able to rectify the imbalance.  Within several days (not even weeks) of the currency cross-over, Greeks were quick to point out that the cost of most domestic goods “jumped” inexplicably by 65-80%.   In petitioning the European Central Bank for a review of this anomaly, the Pasok cabinet was met with merely platitudes and obfuscation that this apparent temporal discontinuity in the average Greek’s earning power would soon be rectified by “market forces.”  It is an historic fact that such a rectification never took place.

In the aftermath of Greece’s cross-over to the Euro, the average Greek found their salary significantly diminished in purchasing strength, with this contributing to two run-away processes:  1) increased borrowing and 2) increased involution of the domestic economy, owing to a new reality of cash-starved government and banking sectors.  And of course, with a constricting economy came the usual vicious circle of reduced personal and business income leading to reduced tax revenue, ultimately leading to the government’s reduced capability to pay its disproportionally vast workforce.

Unable to print its own (even inflated) currency, Greece became further strapped in debt, leading to the contemporary reality that it is now unable to meet its dept obligations. This finally brings us to the immediate present.  Now after the troika’s having inflicted a mortal wound to Greece a first time, the blood-letting continues…

The Second Pound…

Now, in making its associated set of revised qualifying conditions for the latest loan, the troika has lost (or chosen to ignore) all institutional memory of the initial conditions that brought Greece to is current unsustainable dept burden in the first place.  Moreover, it’s conditions make no attempt to concurrently provide relief for the exponentially constricting Greek economy, which threatens to further compound the Greek national deficit.  The so-called proposed “haircut” on the balance owed to French and German financial institutional holders, as well as private holders of Greek debt will do precious little to decelerate the involution of what little Greek economy currently remains.

Notwithstanding the above legacy of poor choices on Greece’s part (initially entering the Euro zone, not correcting its flawed tax base and not exiting the Euro zone soon enough), there is still a very glaring provenance of bad-faith actions, on the part of the European Central Bank.  Hence, it is not hard to see a certain elegance in Greece now simply choosing to divorce itself completely from the Euro as quickly as it can and rather, return to a difficult but time-proven strategy of rebuilding its economy from the inside.  Yes, other economies may falter as a result of such a decision on Greece’s part.  But to be very clear, Greece doesn’t own this nearly as much as does the Central European Bank, that was perfectly willing to see Greece suffer in the aftermath of its falling to usurious practices.  Greece is unambiguously the victim here;  perhaps a most financially-unsophisticated victim of sorts, but a victim nonetheless.  Given that the default is essentially now a fait accompli,  the real economic discussion should center on cogent strategies that Greece can adopt to re-start its economy, from the inside out, in the most expeditious fashion possible.

At this juncture, distributing blame is neither useful nor will it generate any consensus. Rather, we must focus on the future, in order to avoid a collapse of the negotiations, a disorderly default, and the world wide consequences (which despite claims that they will be less significant than two years ago) will be felt throughout the EU as well as in the US, China, and obviously the rest of the world.

The two negotiating parties have reached the following stage: On February 12 the Greek Parliament by a 2/3 vote accepted the new memorandum agreement. The meeting of the Financial ministers of European countries was planned for February 14, and it was replaced by a video call and postponed until February 20. In the conference call, issues regarding the lack of confidence in the Greek commitment were raised, and assurances about post-election Greek compliance to the agreement were sought.

The requirement of “post-election compliance assurance” is a terrible idea that by itself has the potential to derail immediately the entire package and send Greece into disorderly bankruptcy, and the EU and the world into a financial tailspin. Here is why: First, the request is impossible to satisfy in ANY democracy. Second, Greece is now in a much better state politically to fulfill its obligations than it was a week ago, or for that matter, since 2009.

1. The impossible request. The reason that we have elections in democracies is so that the people will decide the composition of their ruling bodies (Parliaments, or Congresses and Presidents). All parties accept the fundamental uncertainty of the electoral process, and all incumbents promise that they will accept their replacement if the people chose to decide this way. One can ask people to postpone an election, but not to cancel it. And one can certainly not ask people to guarantee what will happen after the election.

Let me use an example from recent EU history to make this point clearer to the people who request assurances. When the Greek Prime Minister George Papandreou unilaterally announced a referendum for the approval of the agreement between Greece and the Troika, the leaders of EU countries (particularly Merkel and Sarkozy) were outraged: One day they thought that they had a firm agreement while the next they discovered they had only a chance of an agreement. (Actually, the probabilities in their eyes were very low, because they knew from the French and Dutch referendums on EU institutions (which derailed for years the process of EU integration) that referendums do not get answered on the basis of the question asked but on the basis of the identity of the questioner.) All observers sided with their analysis, the referendum was aborted and Mr. Papandreou had to resign.

Now the roles have been reversed. The same people who objected to the Greek referendum want to proceed to make outcomes conditional on electoral results. The most likely outcome of such a process would be the polar opposite of what they actually want: the elections would give a majority to anti-EU parties; the bailout will not be signed, and Greece will go into disorderly bankruptcy.

2. The current political landscape. The Parliamentary meeting of February 12 produced a monumental change in the Greek political landscape. The main political axis of division is no longer Left-Right ; rather, it is the long-time latent euro-drachma divide (or what we can alternatively call the modern vs. old Greece divide or the pro-anti memorandum divide. Right now, three quarters of Greeks say they want to remain in the Euro despite the very onerous implications of this choice on their welfare.

The re-alignement of the political system to shift from traditional left-right divisions to the central question of the Greek alignement with the EU (which is in agreement with the will of the people) had not happened during the PASOK government. The party of New Democracy had a significant component (including its own leader) with the populist right and was opposed to the memorandum. This is what the EU has wanted for years during the previous phase of the crisis. Even PASOK had a strong component of “deep PASOK” which was supporting Mr Papanderou but was against reform.

The vote of February 12 transformed the situation, and forced the leaders of the two parties to dismiss those members who voted “no” not only from the parliament but from the parties themselves. Some of these members say that they had not realized that they would be dismissed for voting “no”, others that they will participate in the forthcoming election with new anti-memorandum parties. Be that as it may, the Greek electoral law gives a significant bonus to the first party (of the order of 50 out of 300 seats). This bonus was sufficient in the past to create single party governments, but right now, it is unlikely. New Democracy will be the first party (according to all polls) but its own percentage will be so low that a second party will be required for a government coalition. With the anti-memorandum elements (or most of them) gone, the only viable government coalition is New Democracy and PASOK. Indeed, if the first receives 25% of the vote and the second some 15%, they can then form a government with around 155 (out of 300) seats. Significantly, the political game and the pressure from the EU has produced impressive political results. But untimely continuing pressure from the EU side may well reverse them!

Time is of essence. The Greeks understand this. Indeed, they forced a Parliamentary vote on a Sunday before the Euro group Finance ministers meeting. All of us have seen videos of Athens burning on Sunday night during the voting procedure. These acts were committed by a very small group of people, with hoods who systematically went from one salient place to the next. Yet, immense forces of police were surrounding the Parliament and did not move. Why? Because they were afraid that the real goal was to attack the Parliament and postpone the vote, which under the circumstances would have led Greece to miss the EU deadline.

The window of opportunity for Greece, for the EU, and for their partners (US) and creditors (China) will close if, on Monday, Eurogroup meeting decisions are made conditional on the outcome of Greek elections. Athens burned but the vote was salvaged. The major parties split and a new party system is emerging with a coalition between them in support of the memorandum. Doesn’t this show commitment?

This decision is good news, news that the vast majority of Italians wholeheartedly approve, news that signals a considerable shift in the mindset of the Italian public administration toward public money and the public good.

Some background may help. Over the last year, local and national politicians, as well as sports bureaucrats, vociferously proposed Rome’s candidacy to the 2020 Summer Olympics, undeterred by the negative business and financial climate and the woes of the Italian government. Interestingly, because of a series of circumstances (including a less than exciting field of competitors), Rome’s candidacy appeared to have a good shot at succeeding.

This candidacy had the unsurprising support of (nearly) all of the Italian political parties, from left to right. What marvellous opportunity for political patronage, they must have thought! After setting up a Rome 2020 committee (at the cost of $1.6 million a year for Rome’s City Hall) and collecting approvals from sports figures and corporate sponsors, the Olympics machine passed each obstacle toward the goal line. Last step, the necessary signature of the Italian government, for the CIO (the International Olympics Committee) requires national governments to provide written insurance that financial obligations will be fulfilled and cost overruns will be paid for were it to assign the event to the candidate city.

In the past, this approval would have been a sure thing. Italy has most recently hosted the FIFA World Cup in 1990 (a financial and logistical failure), the 2006 Winter Olympics (a great event but a financial failure nevertheless), and the 2009 Swimming World Championships (on which the italian courts are still laboring). Yet, once again the Monti government displayed the pragmatism and enlightening transparency that has earned it the praise of most. The government cabinet examined the finances of the most recent Olympic events around the world. What did it discover? All of them ended up costing way more than promised, making it nearly certain that the government would have to step in later to the rescue. For instance, this summer’s Olympic games in London overran their initial budget by nearly 100%; the Olympics in Athens in 2004 are likely to have accelerated Greece’s dramatic path toward insolvency; and the list goes on and on. As importantly, it found that most of the facilities built for these events end up accumulating dust and rust while being un-(or under-)utilized, at further cost for the taxpayers.

Thus, Monti said NO, an unequivocal NO, a mature NO, lucidly explained to the approving citizenry of Italy. Basically Monti said that he refused to burden Italy’s future generations (including its future politicians) with this massive expense. How refreshingly mature! If ratings agencies were doing their job, rather than recycling old information in their ratings, they would have waited for this decision before pronouncing their latest verdicts.

euro

Amid crisis in Greece that brought about days of social unrest and paralyzed Athens, the European Union celebrated 20th anniversary of the Maastricht Treaty last week. The Maastricht Treaty enabled the creation of the euro and was designed to ensure that member states follow a common baseline: price stability, sound public finances, sustainable public finances, durability of convergence and exchange rate stability. It instituted convergence criteria: low inflation, low long-term interest rates, government deficit not above 3% of GDP, and accumulated public debt not above 60% of GDP.  Many believe that if Eurozone countries implemented the Maastricht criteria in the first place the current financial crisis could have been avoided. The EU is now preparing for a new treaty to ensure tighter fiscal cooperation. Two countries out of 27 member states, UK and the Czech Republic, will not sign the treaty.

2. Everything you think about who is up and who is down was wrong eighteen months ago and will be wrong again. Germany’s unemployment rate is dropping- but so is its GDP growth. Does anybody really think we will be listening to, lectures from the German government in mid-2013?

Vincenzo Consolo, a great writer and a passionate chronicler of his native Sicily, has died at age 78. Leoluca Orlando – ex-mayor of Palermo; he visited UM in 2009 to talk about his own struggles against the mafia – wrote: “The death of Vincenzo Consolo is a major loss for the culture, the literature, and the conscience of Italy. His book The Smile of the Unknown Sailor is a true masterpiece, in continuity with the paintings of Antonello da Messina and with the theatrical writings of Luigi Pirandello: all profoundly Sicilian, all authentically universal. Vincenzo Consolo has been, for so many of us, an almost-transcendent point of reference, like a spiritual father, a priest, a lay pastor. He leaves, for our nation’s historical record, a number of splendid books and the witness of a man of intransigent ethical focus.”

Consolo was representative of a generation of writers who walked the tightrope between regionalism and universal values. It remains to be seen – in a new era of federalism without a true sense of confederation – whether the writers of the new millennium will follow their path. The universal values, though debated, remain; will writers of the next generation recognize the importance of linguistic and geographical distinction, and maintain the strong sense of place as the rosette at the center of the moral compass, that informed the fiction and poetry of regional writers like Consolo?

It is recent news that S&P downgraded several EU member countries, by one to two notches, setting off a storm of panic and accusations across the continent. In particular, and not for the first time, France, Italy, and Spain found themselves at the center of much negative attention. Yet, the storm was short-lived. Today, the spread between Italian BTPs and German Bunds is hovering around 460 basis points (i.e., the Italian government pays about 4.6% greater interest than the German one when borrowing for ten years). This is about 70 basis points lower than prior to the negative announcement by S&P. Thus, as it has happened several times before, the markets shrugged off the negative judgement of the rating agencies.

What is happening here? Rating agencies exist to provide for-fee, better-informed, unbiased assessment of the creditworthiness of borrowers. In the aftermath of the bursting of the real estate bubble in the United States, the deficiencies of these agencies have been put sharply into focus. The dubious usefulness of the rating system, the agencies’ blatant conflict of interest, and self-evident biases in their assessments have long been discussed.

There is, however, one issue that has not received much attention in this debate, namely the simple observation that very rarely, especially when assessing the creditworthiness of governments, rating agencies are better-informed than the market. In the past, rating agencies played a very important role by

1) aggregating information that was unavailable to most investors,

2) interpreting it in a uniquely sophisticated manner, and

3) disseminating it in a coarse, yet easy to interpret fashion: letter ratings.

Acknowledging this role, national regulatory bodies and commonly accepted practices gave these ratings special treatment. For instance, many institutional investors (mutual funds and pension funds) cannot hold (sovereign or corporate) bonds rated below investment grade, and in most cases borrowers cannot issue bonds without a rating. The special treatment, in turn, contributed to making the ratings necessary, and the consequences of downgradings severe, regardless of their actual information content.

As in many past occurrences, however, financial markets have evolved at much greater speed than their regulations. In today’s global, interconnected financial markets, information is widely available and almost instantaneously disseminated. This is especially true for macroeconomic, country-wide information. Thirty or forty years ago, the rating agencies were among the few sophisticated players able to collect and interpret information on GDP, CPI, trade balances, or government expenditures. Today, that is not the case. Government reports on each aspect of a country’s economy are avidly read and interpreted by countless small and large traders, hedge funds, mutual funds, and the like. Most governments, having embraced transparency, release information in well-defined formats at regular dates to as many market participants as possible. These market participants have the same or better models than the rating agencies to interpret the available information.

In short, I do not believe sovereign ratings have any novel information content. The information rating agencies use to produce their coarse judgements has already been received, examined, and digested by the markets weeks and months in advance. So, why do we still pay so much attention to them? Two reasons. First, the regulations I mentioned above have not been revised (yet) to account for the seismic shift in the markets’ information environment, and continue to assign these ratings a special role. In other words, the importance of rating changes is “built in” the system, regardless of their information content, e.g., forcing mutual funds to liquidate positions in government bonds downgraded below certain thresholds. Second, rating changes may act as coordinating devices leading markets to a downward spiral of distress selling and collapsing prices. As I discussed in a previous blog post, financial markets are inherently fragile, and a rating change may quickly and painfully lead to a run to a company, a bank, or a government, in absence of lenders of last resort.

The current debate on reforming the rating system is likely to lead to changes in these anacronystic rules and regulations. New such rules may then attenuate the extent to which market participants follow rating changes and react to them. When this happens, rating agencies will be the most likely financial market participants to be downgraded.

So, why care about Europe? Let’s start with two traditional arguments, which are wearing thin: that Europe is culturally important; or that Europe is geopolitically potent.

Start with cultural. Paris is lovely, and Rome is a very good holiday destination. Europe is where a lot of our culture came from. Europe is where a lot of Americans came from- though the recency of Europe in their heritage is diminishing, and the number of Americans whose relatives migrated from Europe is also diminishing. If you buy the case for the humanities, and the study of culture and history in general, you probably buy the case for studying Europe…but maybe you don’t.

Another is geopolitical: that Europe has the power to influence our lives and what we can do (invade, impose, induce, cajole) as a country. This makes up most of the American debate about Europe. The implicit assumption is that we should focus our attention on rising powers so we can play great games of power politics and strategies. Europe is neither much of a threat nor much of an ally. So first we get Donald Rumsfeld gleefully dividing “old” and “new” Europe, followed by a national “pivot” to India and China. The hideous performance of European elites in the financial crisis, coming after decades of failure to develop a musclebound foreign policy, hardly draws our admiration from Beijing to Brussels.

Neither culture nor military capacity demand our attention, and so American elite discourse disparages or disregards the whole continent. It’s a museum.

This shows you the poverty of American elite discourse about the rest of the world. There are two more reasons to care about Europe even if you aren’t interested in cultural history or convinced of its geopolitical importance. They happen to explain why a much more diverse range of American elites seem to live on transatlantic flights, regardless of whether they work in policing, financial reform, comparative federalism, health finance or chemistry.

First, Europe is where we find our peers. It is where we find the overwhelming majority of countries with our problems and ideas. Most statistics show the US to be quite comparable to the United States, as shown by Peter Baldwin and our visitor at CES in a few weeks, Jens Alber [pdf]. It is with Europe, not China or South Africa, that we share problems of aging populations, or immigration, or active labor market policy, or health care cost containment. That’s why the most common degree of top Obama administration officials isn’t in the US at all- it’s the LSE, about as far as Asia’s rising powers as you can get. The excitement of exchanging health care ideas with China or India or Africa is undeniable, but how much can we really learn from countries that spend as little as 1/100th of what the US spends on health care?

That shared fund of problems, debates, and ideas, is the second reason to care because it gives rise to solutions Europe shapes. Europeans, with their huge markets and established policy community, still shape international regulations as diverse as chemicals regulation, mobile phone standards and bank capital adequacy requirements. China might be developing impressive naval force projection, but Europeans are big players in the ISO, and the ISO shapes many American businesses and lives. That might be a kind of geopolitical power; it certainly means understanding Europe is a good idea for budding smartphone designers or chemical engineers.

So why care about Europe? I won’t try to convince you of its geopolitical or cultural importance if you aren’t already convinced. If wars are what interest you, Europe will disappoint. Its nationalisms once caused huge wars but now amount to bickering about the ECB. But even if Europe produces no wars, crises, or BRICs in 2012, it will remain our peer, and that’s why we will continue to go there for policy debate and discussion. Geopolitics is a very narrow guide to interests, and so is tourism; real policy debate with peers does actually matter.