Italy

Vivek Kaul

I’ve long said that capitalism without bankruptcy is like Christianity without hell. – Frank Borman
If you have been following the business newspapers lately, you would have probably come to the conclusion by now that a break-up of the euro will lead to a huge catastrophe in Europe as well as the rest of the world.
Yes, there will be problems. But the world will be a much better place if the countries like Portugal, Ireland, Italy, Greece and Spain opt out of the euro. To know why read on.
How it all started
The European Coal and Steel Community was an economic organisation formed by six European nations in 1958. This gradually evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The EU introduced the euro on 1 January 1999. On this day, 11 member countries of the EU started using euro as their currency. Before the euro came into being the German currency deutschemark used to be the premier currency of Europe. The euro inherited the strength of the deutschemark. The world looked at the euro as the new deutschemark.
The move to euro benefitted countries such as Portugal, Italy , Ireland , Greece and Spain (together now known as the PIIGS). Before these countries started to use euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the Euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU.
Easy money and the borrowing binge
With interest rates being low, the PIIGS countries as well as their citizens went on a borrowing binge. Greece took the lead among these countries. The Greek politicians launched a large social spending programme which subsidised most of the key public services. In fact a few years back, the finance minister of Greece claimed that he could save more money shutting down the Railways and driving people around in taxies. In 2009, Greece railways revenues were at around $250 million and the losses of around $1.36billion. All this extravagance has was financed through borrowing.
Greece was not the only country indulging in this extravagance, other PIIGS nations had also joined in. Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest being charged on loans.
As John Mauldin and Jonathan Tepper write in Endgame – The End of the Debt Supercycle and How it Changes Everything “In plain English, that means that if the borrowing rate is 3 percent while inflation is 4 percent you’re effectively borrowing for 1 percent less than inflation. You’re being paid to borrow. And borrow they did. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros.”
This was because loans were being made by German, French and British banks who were able to raise deposits at much lower interest rates in their respective countries and offer it at a slightly higher rate in the PIIGS countries.
The citizens of Spain borrowed big time to speculate in real estate. All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. Currently Spain has as many homes unsold as the United States (US), though the US is six times bigger than Spain. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP, are in trouble.
The accumulated debt in Spain is largely in the private sector. On the other hand the Italian government debt stands at $2.6trillion, the fourth largest in the world. The debt works out to around 125% of the Italian gross domestic product (GDP). As a recent report titled A Primer on Euro Breakup brought out by Variant Perception points out “Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level.” Debt as we all know needs to be repaid, and that’s where all the problems are. But before we come to that we need to understand the German role in the entire crisis.
The German connection
Germany became the largest exporter in the world on the strength of the euro. Before euro became a common currency across Europe, German exports stood at around €487billion in 1995. In 1999, the first year of euro being used as a currency the exports were at €469billion euros. Next year they increased to €548billion euros. And now they stand at more than a trillion euros. Germany is the biggest exporter in the world even bigger than China.
With euro as a common currency took away the cost of dealing with multiple currencies and thus helped Germany expand its exports to its European neighbours big time. Also with a common currency at play exchange rate fluctuations which play an important part in the export game no longer mattered and what really mattered was the cost of production.
Germany was more productive than the other members of the European Union given it an edge when it came to exports. As Mauldin and Tepper point out “since the beginning of the Euro in 1999, Germany has become some 30 per cent more productive than Greece. Very roughly, that means it costs 30 per cent more to produce the same amount of goods in Greece than in Germany. That is why Greece imports $64 billion and exports only $21 billion.”
German banks also had a role to play in helping increasing German exports. They were more than happy to lend to citizens, governments and firms in PIIGS countries. So the way it worked was that German banks lent to other countries in Europe at low interest rates, and they in turn bought German goods and services which are extremely competitively priced as well as of good quality. Hence German exports went up.
The PIIGS countries owe a lot of money to German banks. Greece needs to repay $45billion. Spain owes around $238billion to Germany. Italy, Ireland and Portugal owe $190billion, $184 billion and $47billion respectively.
Inability to repay
When the going is good and everything is looking good there is a tendency to borrow more than one has the ability to repay, in the hope that things will continue to remain good in the days to come. But good times do not last forever and when that happens the borrower is in no position to repay the loan taken on.
Greece tops this list. It has been rescued several times and the private foreign creditors have already taken a haircut on their debt i.e. they have agreed to the Greek government not returning the full amount of the loan. Between Spain and Italy around €1.5trillion of money needs to be repaid over the next three years. The countries are in no position to repay the debt. It has to be financed by taking on more debt. It remains to be seen whether investors remain ready to continue lending to these countries.
In the past countries which have come under such heavy debt have done one of the following things: a) default on the debt b) inflate the debt c) devalue the currency.
Scores of countries in the past have defaulted on their debt when they have been unable to repay it. A very famous example is that of Russia in 1998. It defaulted both on its national as well as international debt. Oil prices had crashed to $11 per barrel. Oil revenue was the premier source of income for the Russian government and once that fell, there was no way it could continue to repay its debts.
If the country’s debt is in its own currency, all the government needs to do is to print more of it in order to repay it. This has happened time and again over the years all over the world. Every leading developing and developed country has resorted to this at some point of time. The third option is to devalue the currency and export one’s way out of trouble.
Exit the euro
The PIIGS countries cannot print euros and repay their debt. Since they are in a common currency area there is no way that they can devalue the euro. A straight default is ruled out because German and French banks will face huge losses, and Germany being driving force behind the euro, wouldn’t allow that to happen.
So what option do the PIIGS then have? One option that they have is to exit the euro, redominate the foreign debt in their own currency, devalue their currency and hope to export their way out of trouble.
A lot has been written about how you can only enter the euro and not exit it. The situation as is oft repeated is like a line from an old Eagles number Hotel California “You can checkout any time you like / But you can never leave.” A case has also been made as to how it would be disaster for any country leaving the euro.
Let’s try and understand why the situation will not be as bad as it is made out to be. A report titled A Primer on Euro Breakup, about which I briefly talked about a little earlier explains this situation very well.
The first thing to do as per the report is to exit the euro by surprise over a weekend when the markets are closed. Many countries have stopped using one currency and started using another currency in the past. A good example was the division of India and Pakistan. As the report points out “ One example of a currency breakup that went smoothly despite major civil unrest is the separation of India and Pakistan in August 1947. Before the partition of India, the two countries agreed that the Reserve Bank of India (the RBI) would act as the central bank of Pakistan until September 1948….Indian notes overprinted with the inscription “Government of Pakistan” were legal tender. At the end of the transition period, the Government of Pakistan exchanged the non-overprinted Indian notes circulating in Pakistan at par and returned them to India in order to de-monetize them. The overprinted notes would become the liabilities of Pakistan.”
Any country looking to exit Euro could work in a similar way. It will need to have provisions in place to overprint euros and deem them to be their own currency. Then it will have quickly issue new currency and exchange the overprinted notes for the new currency. Capital controls will also have to be put in place for sometime so that the currency does not leave the country.
Despite the fact that there are no exit provisions from the euro, after the creation of the European Central Bank, the individual central banks of countries were not disbanded. And they are still around. “All the euro countries still have fully functioning national central banks, which should greatly facilitate the distribution of bank notes, monetary policy, management of currency reserves, exchange-rate policy, foreign currency exchange, and payment. The mechanics for each central bank remain firmly in place,” the report points out.
Technical default
By applying the legal principle of lex monetae – that a country determines its own currency, the PIIGS countries can re-dominate their debt which they had issued under their local laws into the new currency. As the report points out “Countries may use the principle of lex monetae without problems if the debt contracts were contracted in its territory or under its law. But private and public bonds issued in foreign countries would be ruled on by foreign courts, who would most likely decide that repayment must be in euros.”
The good thing is that in case of Greece, Spain and Portugal, nearly 90% of the bonds issued are governed by local law. While redomination of currencies in their own currencies will legally not be a default, it will be categorized as a default by ratings agencies and international bodies.
Another problem that has brought out is the possibility of bank runs if countries leave the euro. Well bank runs are already happening even when countries are on the euro. (The entire report can be accessed here: http://www.johnmauldin.com/images/uploads/pdf/mwo022712.pdf).
The PIIGS coutnries can devalue their new currencies make themselves export competitive and hope to export their way out of trouble. This is precisely what the countries of South East Asia after the financial crisis of the late 1990s. As the report points out “history shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The best way to promote growth in the periphery, then, is to exit the euro, default and devalue.”
The German export machinery
A breakup of the euro will create problems for the highly competitive export sector that Germany has built up. The PIIGS countries would start competiting with it when it came to exports. Given this they will not let the euro break so easily. As the bestselling author Michael Lewis said in an interview sometime back “German leadership does not want to be labeled as the people who destroyed the euro.”
But as Lewis also said “If you put Germany together with Greece in a single currency, it’s a little like watching an Olympic sprinter and a fat old man running a three-legged race. The Greeks will never be as productive as the Germans, and the Germans will never be as unproductive as the Greeks.” So it’s best for PIIGS countries to exit the euro.
In the end let me quote my favourite economist John Kenneth Galbraith as a disclaimer: “The only function of economic forecasting is to make astrology look respectable.”
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/world/if-piigs-have-to-fly-they-will-need-to-exit-the-euro-314589.html)
(Vivek Kaul is a writer and can be reached at [email protected])