Rob Parenteau: Revisiting the PIIGS Led to Slaughter Perspective – Implications of a Greek Default

By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute

Last year we provided an analysis (on the Naked Capitalism blog and elsewhere, including the Levy Economics Institute Annual Minsky Conference, and CBC interviews), based on the financial balances approach that suggested a number of problems could arise with the eurozone’s pursuit of what are called “expansionary fiscal consolidations”. Without a large and sustained swing into a current account surplus, the financial balance approach revealed that the pursuit of fiscal consolidation would undermine the ability of the private sector to service the debt loads it had built up during the prior decade of currency union. Simply put, higher taxes and lower government spending drain cash flow from households and firms, and that increases the financial fragility of economies.

For a number of reasons, there appears to be a glaring blind spot with regard to private debt as investors and policy makers remain focused on reducing public debt growth. There is little or no recognition of how changes in fiscal policy may influence the sustainable paths available for the private sector to manage its financial obligations. For example, with regard to the case of Greece, the household debt to GDP ratio soared during the past decade, and is now on par with the rest of the eurozone. However, private sector nonfinancial debt stopped growing in 2008 as the Global Financial Crisis hit, and we have since witnessed the onset of a nominal income contraction since 2009, when fiscal policy became hamstrung by what amounts to a bond investor capital strike.

We currently have in hand an extreme case of this interaction of public and private financial conditions. Investor and policy maker attention is now focused squarely on the prospect of an imminent Greek public debt default. But the issue of a Greek government debt default immediately raises the issue of Greek bank solvency (since much of the Greek public debt is held on their books), and hence provokes the question of how the necessary bank recapitalization could proceed. I doubt the EFSF or ECB (or Qatari investors, for that matter, who must feel like Prince Alwaleed with his Citi holdings) will be in the mood for subsidizing a Greek bank recapitalization if Greece has defaulted on its public debt.

Oddly enough, the level of Greek bank write-offs has been falling since the turn of the year, and private loan growth is once again contracting on a year/year rate as of June. This makes no sense given that nominal GDP growth was contracting at more than a 5% year/year rate through mid year 2011. So what happens if Greek private debt outstanding starts shrinking because Greek banks not only have stopped making new loans, but they can no longer roll the old loans, and in fact, have to shrink their loan books through distress sales of existing assets because they are a) insolvent and b) unable to be recapitalized by the public sector? With regard to the latter, remember that in all likelihood, the Greek government will have to reduce expenditures to match the level of incoming tax revenues if it adopts the default option. Accordingly, there will be little room for them to bootstrap their own bank recapitalization. Possibly if they went completely AWOL, they could reconfigure the Greek central bank to somehow recapitalize the banks, but by then we are on to the new drachma.

I submit with Greece, the world is in all likelihood about to witness yet another case study in Irving Fisher’s debt deflation dynamics, which he described a lifetime ago after losing his shirt in the Great Depression – an experience that led him to rethink his conviction that markets are generally self-stabilizing in a general equilibrium fashion. The attempt to move toward zero public debt growth can have very destabilizing results on economies in which the private sector has spent the prior decade leveraging up. This follows from the simple application of double entry book keeping to macroeconomics. As policy authorities who work with the financial balance approach must know, it is a conclusion that depends on no high macroeconomic theory, Keynesian or otherwise. Whether German PM Schauble will be able to recognize that, even as the Greek debt deflation plays out in front of his own eyes, is debatable. Whether the Reinhart and Rogoff Bible will be re-examined for errors or omissions is also debatable. Whether we are about to see “failed nation states” emerge in the eurozone as a result of blithely ignoring these simple principles of double entry book keeping remains to be seen.

Faith based economics is a funny thing that way – although at the moment, it does not look like Zorba is about to get the last laugh, at least not until the debt deflation sewage from the periphery backs up all the way to German banks and German exporters. A Greek public debt default will place the question of the necessary eurozone wide bank recapitalization at the head of the line, which is where the IMF’s Lagarde was trying to place it a week ago before EU officials reeled her back in this week. Even if governments are able to swiftly execute publicly assisted bank recapitalizations in the wake of Greek default, it is high time to recognize that attempting a multi-year, multi-country fiscal consolidation against the backdrop of high private debt to income ratios is bound to produce rising private debt distress, with all that means for the ability of the private sector to generate the income growth necessary to service existing private debt load and higher taxes, and with all that means for the ability of financial institutions to remain solvent. Perhaps this is a lesson best relearned sooner, rather than later. It cost Irving Fisher his fortune, and then his house, before he was prepared to learn that lesson. We need not be so stubborn this time around.

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  1. chris

    As it appears that Germany is already preparing contingency plans to recapitalize their banks in the event of a Greek default (which means that their banks like America’s banks are lying about the values of the assets they carry on their books ala Enron) why don’t we skip to the chase and get on with making banks disappear?

    Or is the preference of the economic theorists to pretend this can be papered over and that there will never be a Creditanstalt event?

  2. Feta Tomatoes

    It cost them their savings, and then their houses, before they were prepared to learn the lesson, that the so-called “private sector industry” is bailed out with their tax dollars, their jobs and some of their lives. We need not be so delusionally stubborn this time around.

  3. Appian Way

    The average Greek could learn a thing or two from their American brothers. This is the proper response to financial aggression:

    “Washington State Longshore Workers ”
    AP: Before dawn today, 500 people broke down terminal gates, prevented security guards from interfering, and cut the train’s brake lines.

  4. Dice Rollers

    “to swiftly execute publicly assisted bank recapitalizations”

    Does Al Qeada take over if Banks aren’t quickly paid off?

    1. chris

      only if Al’s handlers and enablers in the Western democracies see that as an appropriate use of their “assets”.

  5. Hugh

    “Even if governments are able to swiftly execute publicly assisted bank recapitalizations in the wake of Greek default”

    That’s a big “if”. Before you can recapitalize European banks, you need to know how much they are in the hole. Greece is only the beginning of their losses. European governments would need to examine and audit their books and then revalue their assets according to the real world of mark to market. I can’t see this as a “swift” operation.

    And if these governments wish to avoid this kind of the thing in the future they need to throw out the current management of these banks, and that means a long ways below the CEOs. They need to limit the scope of future operations. And following the Swedish model, they need to attach personal liability to bank managers that don’t report bank problems until they have festered and grown out of control.

    Oh yes, and they need to find the money to do this. How does one do this exactly if you are say France and living under the constraints of the euro? How do you do it even if you are Germany?

    Given that European political and financial leadership is as bad and kleptocratic as our own, does anyone see an orderly resolution to this euro mess?

  6. mario

    “The attempt to move toward zero public debt growth can have very destabilizing results on economies”

    IMO, rather an attempt to move toward reduction of public income. Debt is unsustainable without income. Prime issue is income not reduction indebt.

  7. Jim Haygood

    No worries, mates — the G7 is ‘flexibly inflexible’ and will put Humpty Dumpty back together again by Monday morning:

    We are taking strong actions to maintain financial stability, restore confidence and support growth.

    Euro area countries are implementing the decisions taken on July 21 to address financial tensions, notably through the flexibilisation of the EFSF, reaffirming their inflexible determination to honor fully their own individual sovereign signatures and their commitments to sustainable fiscal conditions and structural reforms.

    Funny, 21st July is when it all started going to hell, as best I can recall.

    But the eurocrats seem to cherish the memories of 21 July. Maybe Berlusconi provided coke and hookers for all.

    It’s Friday night — bunga bunga!

  8. Sulu Shimojuju

    Do we really accept that Big Money—through intimidation, bribery, or some other coercion, including the truncheon of information technology —can shove us out of our homes and obliterate our communities?

  9. steve from virginia

    Wow, Rob Parenteau sounds seriously depressed. “The banks, the banks …” I feel so sorry: Rob! It’s not your fault. The various money authorities are trapped, there is nothing they can do (except Eurobonds/fiscal reform which would buy more time … but what would the money authorities do with that time, anyway but waste it?)

    Ah, the Greek banks … triage is required (but, the same thing can be said for all the Euro-banks). Essentially, they have borrowed from themselves, how to get out of that hole? They can’t, all must be restructured. How … embarrassing!

    Why not skip the ‘Greek central bank’ part and have the government issue its local currency to put people back to work? Greek- only, call them Drachmas or Enrons or whatever, don’t borrow, issue against mortgage value of Greek real estate as in rentenmark in Weimar. Borrowing is the problem: out of the frying pan … into another frying pan.

    Make the new enrons demurrage money and there is no inflation or hoarding. Keep the euro as a true reserve currency w/ the Greek central bank remitting enough euros from its tourist trade — on a schedule — to retire some small bit of euro debt. This would be self-correcting — Parenteau is right about ‘lenders’ strike’: not a Greek vacation strike, however. The more Germans go to Greece and spend euros the more ‘confidence’ the euro gains in the money marketplace and the world gains in Greece.

    It’s all advertising, anyway. Equate in people’s minds the euro with farm animals and there are problems. Equate euros w/ fun and drunkenness in Santorini and the euro becomes gold …

    Oh yeah, don’t forget that energy conservation. Cut energy use in half or all else is ruin.

    Not kiddin’

    1. Crazy Horse

      I like your thought process Steve.
      Euros & dollars are mere illusionary fabrications. Sun and sex are the real objects of desire and value, and will always find a market.

  10. Daniel de Paris

    We need not be so stubborn this time around.

    You are afraid for BMW and Mercedes sales in Greece. I’m not.

    Who said Greece need German imports to-day? Germany may take advantage of some bargain prices on offer in the short run. And yes, in the longer term, may-be those roads to Athens may start to be useful the other way round…

    When asset price levels are getting ridiculously high, and that’s what happened in the South of Europe, you just cannot avoid a full-blown crisis. This crisis will get the insane price levels downwards. Putting home prices in line with revenue flows.

    The Zapatero government and Spanish banks just tried every trick to avoid asset price discovery. Saving the banks was the word. It work up to up a point…

    Italy is possibly able to draw into its household money. But when it comes to Greece and Spain, there is clearly absolutely no way of out without a full-blown banking crisis.

    Please do not get into the political argument. We are not in 1930 any more. This no repeat of the Depression. Of course Europe can and will help and support Greece and Spain again as it did in the past.

    Sure Banking industry has run amok. So have quite a number of economic agents. But check aggregate EU and eurozone aggregates. Europe is certainly not broke.

    IMHO there is no escape. A full-blown crisis is the only way to get into an acceptable sharing of the pain among participants.

    Do not expect those North of Europe savers (some of them never bought a home in their life and saved in DM…) and/or fixed-income voters to expense the crisis on their sole shoulders.

    Banks were among those who took advantage of this “grande bouffe”. The market needs to get read of the active participants into these massive mis-allocations of capital.

    Who really want the current banking industry to survive in its current form. Wall Street, I suppose?

    1. Diego Méndez

      Letting asset prices to be “discovered” (downwards) and letting Spanish banks go bankrupt is just another way of putting the losses (rightly) on creditors. (If you don’t involve creditors, there is no real debt relief, since the state would then guarantee creditor’s claims on natinoalized Spanish banks).

      Unfortunately, creditors happen to be Germans & Co. So letting banks default, it’s just another way of putting losses (rightly) on Germany & Co. Since continued euro membership is only viable if Spain only does whatever Merkel may want, I am doubtful that the euro periphery may get real debt relief without a euro breakup.

  11. LRT

    Debt deflation does eventually solve a debt problem. The debt problem is that it becomes impossible for the state or for companies to keep up payments on interest and principal, so they default. After that, the debt sells at some discounted level in the hope of eventual settlement, but the burden is over.

    Of course, what happens is large scale redistribution of assets. There never has been a way out of this, the only possibility always has been postponement.

    1. joebhed

      And if we fail to recognize that this is the ‘righting” movement of the debt-based system of money, the grandkids will be doing it again.
      The solution for the debt-based money system’s debt-deflation cycle is not a debt jubilee, but a new money system where having a means of exchange does not require the issuance of debt.

  12. Diego Méndez

    Well, Rob, we had a passionate discussion about this over a year ago:

    Unfortunately, you were right. The political system has underperformed, both in Spain and Germany (which is just another way of saying the problems were much harder than I anticipated).

    I am afraid we are heading towards an uncoordinated euro area breakup, a.k.a. the mother of all financial crises.

  13. aeolius


    From Reuters a few days ago:
    Greece’s dramatic rise in living standards to a 2008 GDP per capita of $30,400, almost the EU average, was caused not by an exceptional surge in Greek productivity, but mostly by massive subsidization and borrowing. Greece’s continuing current account deficit, estimated by the Economist at 8.3 percent of GDP in 2011 in spite of deep recession, indicates that the country remains deeply uncompetitive. In comparison, Greece’s neighbors Bulgaria and Macedonia had 2008 GDP per capita of $14,000 and $10,700 respectively, yet it is now 20 years since communism fell and market forces are dominant in both economies. Another comparison is Portugal, which joined the EU shortly after Greece. Its GDP per capita is somewhat less inflated at $24,900.”

    Perhaps we should learn the Greek word for “Schnorrer”

    What we see in Greece is a dependency rage

  14. Ming

    There is a subtle danger with all debt based money systems, the user of the currency will eventually be unable to payback the debt…Consider, that the hard money (i.e. paper or electronic cash) in the system does not grow on its own; it is created or destroyed by only issuing authority. (in the US, this is the Federal reserve). This is counter to our individual experience, but even the interest a person may gain on their GIC or bank deposit is paid from the revenues of the bank that issued the paper. Only debt has the capacity to self grow via interest payable (or compounded) on the debt. So in a economic system where 100% of all hard cash and deposits are counterbalanced against debt, the debt will increase in size relative to the money supply by the interest rate. From a system level view (macroeconomic view), this is always the case. Either the interest is paid via the existing cash or deposits, which would shrink the existing money supply relative to the outstanding debt(inherently deflationary); or new debt is constantly issued to pay for the interest due, (which still leaves the borrower owing more debt); the interest is not collected but added to the outstanding debt (Money stays the same, but the debt grows by the interest payments); or the borrower defaults, the debt situation becomes immediately unstable. Only the injection of money that is debt free, or an injection of money that is backed by debt that will always be rolled over (i.e.the present situation between the Treasury and the Federal Reserve), or debt forgiveness can prolong the operation of a debt based money system.

    1. joebhed

      The only real solution is to end the debt-based money system.
      The natural, mathematical and mechanical flaw of the debt-based money system has been clearly explained by Dr.Bernd Senf of the Berlin School, in his only English language lecture here:

      Dr. Senf has been promoting the replacement of today’s debt-based money system,joining Joseph Huber as a proponent of the Monetative movement. Here is their Mission Statement:

      Taking Money Creation back into Public Hands

      It is equivalent in purpose and method to the NEED Act of Congressman Dennis Kucinich.

  15. Eric

    countries like Greece will survive whatever happens because they have a large black economy. So all these economic numbers don’t represent reality. People in for example the UK will get a much harder time.

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