Planet Ponzi

by Mitch Feierstein

  Actually, that’s the wrong way of putting it. If a company is bankrupt, it’s bankrupt. It’s not a question of what the accounts do or don’t say, it’s a question of whether the company’s assets are worth more than its liabilities. In effect, the head of the world’s second largest bank is confirming that ‘many European banks’ are bankrupt and are presenting fantasy accounts in an attempt to keep reality at bay for that little bit longer. That’s scary in two ways. It’s scary because the world can’t afford another colossal financial crisis. And it’s even more scary because of the Ponzi-ish assumptions underlying Ackermann’s comments. On Planet Sane, if a bank were bankrupt, you’d either seek to wind it up, or merge it with a stronger competitor, or seek to attract additional capital. One way or another, you’d aim to fix the problem. On Planet Ponzi, however, none of these options are among the ones that come to mind first. You’d much rather present accounts which you know to be misleading. And you’d seek ways to defer the sovereign defaults which you know are coming (Greece for sure; Ireland, Spain, and Portugal quite likely), even though deferring the problem will make it bigger and worse. And you persuade the European Central Bank to lend yet more cheap money to weak banks against rotten collateral. And you put pressure on the ratings agencies to avoid telling the truth. And you deny that the crisis is anything like as bad as it quite obviously is. And so on.

  Ackermann (whose bank is probably not at risk) is prey to this kind of thinking himself. He is hostile to an IMF proposal for a mandatory recapitalization of the banks, a proposal which might actually fix the problem. He also dismisses the threat to the global economy. One report of Ackermann’s speech stated: ‘The Deutsche Bank chief said he doesn’t expect the global economy to slip into a recession. Germany and most other European countries will have “stable growth and I believe we also won’t slip back into recession in the U.S.,” he said. “So this spreading of panic and fear-mongering is simply mistaken.”’23 Really, Josef? Simply mistaken? So the dreadful employment figures in the US are simply irrelevant? The collapses in British services output make no difference? The Europe-wide fall in business confidence and the one-third decline in European equity prices, all that is ‘simply mistaken’?

  The trouble with avoiding reality is that sometimes reality comes to seek you out whether you like it or not. In 2008, total disaster was arrested because of the willingness of governments around the world to halt the crisis in its tracks by borrowing vast amounts and by printing trillions of dollars out of thin air. This time around, the potential problem may be on a far larger scale, and the ability of governments to take firm action is acutely limited. Indeed, that phrasing doesn’t quite capture what happened. It sounds so positive‌—‌‘firm action,’ ‘halt the crisis’‌—‌but what actually happened was the opposite. Firm action would have involved facing up to the crisis. Forcing creditors to take losses. Making shareholders lose everything. Telling Wall Street and the City of London and the financial sector generally: ‘We’re sorry to hear about your problems, guys, but we didn’t cause them: you did. We don’t think ordinary taxpayers should help retrieve your mistakes and we certainly don’t think that ordinary taxpayers should end up funding your bonuses or your unsafe lending practices.’ There would unquestionably have been huge economic fallout if governments had adopted this courageous position, but instead they took what everyone born on Planet Ponzi does: they kicked the can down the road. And because Ponzi schemes only survive by expanding, every time you kick the can down the road, you create a bigger problem than you had before.

  In short, Europe’s problems today are scary. In Spain, there is a huge problem with bad debt arising from bad real estate deals and it’s still unclear to what degree the second-tier Spanish banks will be able to survive those losses. My view is that many of these banks are grossly understating their exposures, but that the government will not be in a position to nationalize or recapitalize them‌—‌or, if they do, they will be using massive leverage and risking taxpayers’ funds only to prolong the inevitable and necessary defaults and subsequent painful process of deleveraging. In France, if politicians keep their cool and if their banks prove stronger than they appear, those banks may survive. I’d expect both countries to have a tough few years‌—‌slow growth, fiscal austerity‌—‌but nevertheless to come through OK. But that happy outcome is by no means assured. It’s not even possible to ascertain the likelihood of disaster. Only the banks know how strong their balance sheets truly are‌—‌or do even they really know? As we saw earlier, Citigroup’s senior management did not understand how weak it was. Nor did the managements of Lehman or Bear Stearns. Nor did the management of Britain’s Lloyds Banking Group understand what a dog they’d bought when they took over HBOS. (It managed to lose £10 billion in a single year.24) There may well, in other words, be a large European bank, or several large European banks, that are even now sliding toward the waterfall, utterly oblivious of what’s about to happen. And if one large bank goes over the edge, there are countless more in danger of following. When and if the banks start to collapse, the fiscal consequences for governments will be horrendous, no matter how prudent they seek to be. A European banking crisis will therefore also be a European sovereign debt crisis‌—‌which in turn will make the banking crisis even worse.

  *

  This survey won’t have cheered up too many readers. It’s also raised countless questions. What about Germany? What about the current European bailout fund, the EFSF? What about the euro‌—‌can the European currency even survive?

  Those are big questions. Too big and too important for this chapter.

  17

  The aureus and the as

  For five hundred years around the birth of Christ, Europe had a single currency. The Roman republic and, later, the western Roman empire issued coins that ran from the golden aureus through the silver denarius and the brass sestertius and dupondius down to the copper as. The Roman coinage was universal across the empire, but it also had extensive sway beyond its formal boundaries. Because the Roman empire was potent, its currency too was potent. Although the coins were made of precious metals, their value was greater than the metal they contained.

  The system was beautifully simple. A Roman emperor didn’t need to worry too much about fiscally incontinent barbarians in Germany. There were no fiscal problems which a few thousand Roman legionaries couldn’t sort out. That’s the first kind of currency union you can have. One in which fiscal discipline is created and enforced from the center‌—‌with spears and siege machines as required.

  But that’s not the only way to build a currency system. The United States has a federal system, albeit one with a strong center. Although the Federal Reserve has responsibility for controlling monetary policy and is theoretically independent of government, its independence is purely notional. The US president appoints the Fed’s chairman and the US Senate approves the nomination. Nevertheless, despite the power of the center, the system remains genuinely federal.

  At the moment, there is no provision in US law for American states to go bankrupt. Although various US states defaulted on their debts in 1841–2 and 1873–4, those defaults did not trigger full-scale bankruptcy. (Though they did cause plenty of mayhem and led to the spread of balanced budget clauses in many state constitutions.1) At the moment, it feels like 1841 all over again. California has a $25 billion spending deficit and a hole in its unemployment insurance fund that’s expected to reach $13 billion this year.2 Though California is in the worst position among US states, there are plenty of others that are also in a bad way. But the way things stand at present, they can’t go bankrupt.

  Although bankruptcy is wrenching, it’s also cleansing. The whole point of the process is that, under the supervision of a court, you get to wipe out unpayable debts and leave yourself with a sustainable financial structure. Possessing a bankruptcy option could even help the negotiating position of individual states. At the moment, public sector unions can bargain hard against a st
ate that has no credible way out. If states could threaten bankruptcy there would be two credible parties at the negotiating table.3 Though it sounds weird to say it, a bankruptcy option would probably improve the fiscal position of the states in the long term, and serious legislative thought has gone into creating the option, Newt Gingrich being the most vocal proponent of the idea.4 The notion is hardly outlandish. After all, municipalities can already file for bankruptcy. Orange County famously did it recently.5 New York City came within a whisker of having to do it in 1975.6

  So let’s just assume this change had gone through. Let’s say there was a bankruptcy law that states could use. If California did file for bankruptcy, no one anywhere would think that had any implications for the dollar. When New York City almost went bankrupt, the papers weren’t printing panicky articles demanding ‘Where now for the dollar?’ The dollar would be totally unaffected. The bankruptcy would happen under court supervision. California would emerge with sustainable finances. Some creditors would lose money because they had lent money to an outfit that had mismanaged its finances. Which, you’d hope, would remind lenders that they need to think before handing over their cash.

  So that’s the second model for a common currency. Everyone takes responsibility for their own finances. No one bails out anyone. No need for legionaries and siege machines. If California (in the US version of this scenario) or Greece (in the European one) files for bankruptcy, the bankruptcy process is handled in the ordinary way, with no implications for the currency whatsoever. The currency just continues.

  Bear in mind that bankruptcy does not mean the extinction of a nation. It does not mean that a fleet of trucks drives overland from Germany and Switzerland to Greece to start carting off ancient monuments and ripping up the national railroads for scrap. In fact, almost nothing visible would change. Countless US passengers have flown on the planes of bankrupt airlines, most recently American Airlines. Those planes were fueled, serviced, piloted, and cleaned. You couldn’t tell from the flight whether the airline was in the bankruptcy court or not. Same thing with GM when it went bust. Its cars didn’t stop working. Dealers still had cars to sell. Production lines stayed moving. The bankruptcy court has no interest in arresting ordinary productive labor or trashing ordinary productive assets, because its ultimate aim is the preservation of value. That requires those planes to fly, those cars to move. It’s the same thing with countries. Assets remain bolted to the floor, businesses continue to operate, private depositors remain entitled to their cash.

  The point is that bankruptcy is a financial problem which needs a financial solution. That solution is painfully simple. Creditors need to recognize that they are not going to get their money back in full. They need to acknowledge their losses. The debtor needs to commit to a new payment plan which will ensure that the new, lower level of debt will be properly serviced. And that’s it. Everyone moves on. Because sovereign default has been perfectly common over the years, there are well-established mechanisms for handling these things. The so-called ‘Paris Club’ handles debts owed by a sovereign borrower to sovereign lenders. (For example, if Greece owed money to the German Federal Republic, that debt would be renegotiated via the Paris Club.) The London Club does the same thing for sovereign debt owed to the private sector. The IMF supervises everything, supplying stopgap funding where necessary.

  If Greece had been left to go bankrupt, anyone holding Greek government debt would have taken a hit: they’d have been legally obliged to recognize their losses on their balance sheet. Outside Greece itself, relatively few banks would have been tipped over into insolvency as a result. Some might have taken a hit large enough to force them to seek new capital or merge with a stronger partner. The really mismanaged ones could have been left to fail. Which would have been good. Greece would still be in the euro. Germany and the other strong countries of Europe would not have had to bail out a small, reckless, improvident country. Some stupid lenders would have been taught an important lesson.

  On Planet Ponzi, however, the golden rule is: never, ever, acknowledge a financial loss. Because bankruptcy forces the recognition of losses, it’s the least favored solution on Planet Ponzi. So instead we have a chain of bailouts, which are extraordinarily costly to taxpayers in the provident countries and which cannot possibly fix the problem. They can’t fix the problem, because Greece isn’t like some fundamentally sound business with a temporary cashflow crisis. If that were the issue, loans from European taxpayers might make perfect sense. But it’s clearly not the issue. The country owes more than 152% of its annual income. Ratings agencies estimate that just 30–50% of that debt is collectable. That’s not a momentary embarrassment over cashflow; that’s bankrupt, bust, broke, insolvent, ruined. It’s kaput. Πτώχευση.

  Worse still, this reality denial makes everything worse for longer. Greece is forced into firesale privatizations in a scramble to raise funds. As a result those privatizations are poorly planned and raise far less than they should. The Greek government is compelled to cut spending so savagely that the country’s economic fabric is permanently impaired. Banks, which ought to be raising capital and fixing their businesses, are left pretending that things are OK.

  There’s another problem with the European bailout program, which is a tad technical, but bear with me as I explain it. The main European bailout tool is the European Financial Stability Facility, or EFSF. The EFSF has, in theory, the ability to issue bonds worth up to €440 billion. Because its bonds are guaranteed by eurozone member states, those bonds will carry a AAA rating.7 That’s the good news. The bad news is that the potential demands on its services vastly exceed its capacity. Take a look at figure 17.1. (And note, by the way, I haven’t even placed France on that chart, or Belgium, or any other countries that might get into trouble if the turmoil became too much.)

  Figure 17.1: The European Financial Stability Facility

  Source: IMF, World Economic Outlook, April 2011.

  In one way, I’ll admit that this graphic exaggerates the problem. Greece is bankrupt, but that doesn’t mean it can’t pay a proportion of its debts. Likewise, though Italy’s finances are ropey, any writedown on Italian sovereign bonds won’t need to be anything like the 50–70% writedowns anticipated in Greece. Yet it’s still the case that the EFSF is insufficient. It’s built to withstand a gale, when the radar is showing a hurricane. And it’s at its limits. The EFSF enjoys its AAA rating thanks to the financial capacity of its AAA-rated members, such as France, Germany, and the Netherlands. But the Netherlands is not a large country. If it incurs any more debt via the EFSF, it will be at risk of losing its AAA rating, which in turn would mean that the burden of maintaining that rating would fall on France and Germany. France would probably not be able to sustain that additional burden, so it too would lose its rating. Germany alone couldn’t swallow over €440 billion of additional debt (and, as a political matter, would almost certainly not want to), so the EFSF would lose its own rating and its ability to raise funds would be vastly diminished.8

  In short, not only is the bailout program utterly misconceived‌—‌because it’s about deferring a problem, not fixing it‌—‌it is woefully underpowered. Because financial markets recognize these facts, the entire European banking sector is aswirl with fear and uncertainty. That fear causes banks to restrict their lending and hoard their cash. It causes consumers to defer purchases. It prompts companies to avoid investment and refrain from hiring. The uncertainty itself is like a tax charged on the entire economy, destroying jobs and preventing growth.

  There is one last option, not yet discussed. Greece could ditch the euro, reintroduce the drachma, leave behind the experiment with a common currency. It’s a real option, but not necessarily a good one. In the first instance, the country has euro-denominated debts. If Greece returned to the drachma, that new currency would trade at a very low level against the euro. Taxing in drachmas to repay debt in euros would not be remotely credible, so in effect to return to the drachma would be to admi
t insolvency. Since Greece’s problems don’t in fact arise from the common currency at all‌—‌they arise from mismanaged public finances‌—‌a return to the drachma would accomplish almost nothing that simply declaring bankruptcy could achieve. What’s more, since Greece has a bizarrely small export sector, a return to the drachma wouldn’t do much to boost the overall economy‌—‌indeed, it would simply inflict on the country all the costs of possessing a small, pointless currency on the edge of a huge common-currency area.

  Naturally, the same kind of question arises in the opposite direction. At a certain point, will the north European economies not get fed up being bound to their untidy and reckless southern neighbors? Will there not come a point where exit from the euro, for all its cost and grief, will not be preferable to the status quo? Some economists at the Swiss bank UBS attempted to quantify the pain of leaving. They reckoned that if Greece were to go, it would suffer costs equal to around 40–50% of GDP the first year and around 15% in each subsequent year. If Germany were to leave, they reckoned that first-year costs would be 20–25% of GDP, and subsequent-year costs about 10%.9 Even to my mind, those costs seem pessimistic in the extreme, but the exercise serves to make a point. The euro as it stands today has a central bank but no central treasury; the countries who use it have politicians who won’t lead and governments with no room for maneuver, and include bankrupt nations that deny their bankruptcy; the system suffers from countless banks that are insolvent but in denial, and an almost complete lack of transparency or accountability. Such a currency must surely implode. It cannot last. At the same time, because the alternatives are awful, the present system will endure‌—‌and propagate its own version of awfulness‌—‌for some time to come. It’s not a pretty picture, however you care to look at it.