Greek Citizens Vote "No" on a Bailout Offer that no Longer Exists

An exercise in futility has just ended in Greece, with its population voting down an offer that has expired almost a week ago already. Given the futility of the referendum, its outcome was actually irrelevant from a formal perspective – once the verdict was in, Greece and its creditors would be exactly back where they were half a year ago already: at square one.

In one sense the referendum’s outcome was of course not futile: It has solidified the current Greek political leadership’s grip on power. It merely hasn’t brought it any closer to a solution. Greek voters want Greece to retain the euro, but they cannot vote on how much money governments (or rather, taxpayers) of other countries should hand to Greece or under what conditions. They can also not vote on whether the ECB should resume lending to technically insolvent banks.

Futile exercise

Cartoon by Ilias Makri

There are of course powerful reasons why the EU is indeed interested in implementing another can-kicking agreement. For instance, as Carl Weinberg has pointed out in Barron’s, a Greek default is a very costly affair, as what were hitherto contingent liabilities will have to be reflected in government budgets:

"Greece is on the verge of defaulting on 490 billion euros ($540 billion) in loans, bond obligations, central-bank liquidity assistance, and interbank balances. Who will bear those losses? Greece’s creditors, which are all public entities across the euro zone, and that are on the hook for some €335 billion in loan guarantees. How will those losses be covered? Bonds will have to be sold that will roughly equal the increase in annual debt purchases by the European Central Bank announced last January.

[….]

Consider the ESM, Greece’s biggest creditor. Under its previous name, the European Financial Stability Facility, it loaned Greece €145 billion. If Greece defaults, the ESM, a Luxembourg corporation owned by the 19 European Monetary Union governments, will have to declare loans to Greece as nonperforming within 120 days. Accounting rules and regulators insist that financial institutions write off nonperforming assets in full, charging losses against reserves and hitting capital.

Here’s the rub: The ESM has no loan-loss contingency reserves. Its only assets—other than loans to Greece—are loans to Ireland and Portugal. Its liabilities are triple A-rated bonds sold to the public. How do you get a triple-A rating on a bond backed entirely by loans to junk-rated sovereign borrowers? Well, the governments guarantee the bonds, and because they are unfunded off-balance-sheet liabilities, they aren’t counted in their debt burdens—unless borrowers default.

If Greece defaults hard, governments will be on the hook for €145 billion in guarantees on those loans to the ESM. We expect credit-rating agencies to insist that these unfunded guarantees be funded. After all, unfunded guarantees are worthless guarantees.

[…]

A hard default would produce other losses to be covered. The ECB would have to be recapitalized after it writes off the €89 billion it has loaned the Greek banks to keep them liquid. The ECB would need to call for a capital contribution from its shareholders—the governments.

And don’t forget that Greek banks owe the Target2 bank clearinghouse, a key link in the interbank payment system, an estimated €100 billion. The governments are on the hook to make good that shortfall, too. The cash required to cover these contingencies would have to be funded with new bond sales."

This in short are the major reasons why the euro-group is undoubtedly prepared to bend over backwards to keep Greece aboard. Naturally there are other reasons as well, such as the fact that a Grexit would disprove the alleged "irreversibility of the euro". The IMF seems to want to approach things differently though, as it has no doubt become extremely wary of ever having agreed to take part in the bailout. Evidently, it wants to improve its chances of getting paid back.

In the week before the referendum, it published a paper on the sustainability of Greece’s debt (pdf) that came to the conclusion that all previous calculations were no longer applicable in the face of the Greek economy’s downturn this year. Ironically, the paper seems to have strengthened Syriza’s hand in the referendum, but perhaps that is what the IMF wanted. While the paper publicly declared what everybody knew already (namely that the debt can’t be paid back, and yet another aid program will be necessary to keep the charade going), one point it makes seems to have been overlooked.

The IMF points out that significant concessions by the euro-group are necessary to make a new aid program at least theoretically viable, but also notes that if agreements regarding Greek budget surpluses are loosened or certain reform measures are not imposed, these concessions will have to be even greater. If Greece applies to the ESM for a new bailout program (this appears to be the plan), the European Commission and the ECB must certify the recipient’s debt sustainability before any new aid can be granted.

Not only that, the lenders and Greece would have to come to an agreement before Greece has to repay bonds held by the ECB on July 20. Before a new agreement can result in funds being made available, national parliaments in the EU have to approve the new package. There are less than two weeks to do all of this, as it is hard to see how the ECB can keep maintaining ELA funding even at the current level if Greece defaults on its debt to the central bank as well. Greek savers and depositors who have left their money at the banks may well end up deprived of a significant percentage of their deposit money.

Greek two year government note yields decline in early trading on Monday (!), via investing.com

As noted above, the incentives to do something are great – after all, the EU would still have to at least provide emergency aid if the Greek banking system were to become entirely insolvent. Since the lenders need parliamentary approval, their leeway is limited though. Admittedly, we have no idea what they will end up doing; possibly they will decide on implementing another stop-gap measure, while leaving Greece weighed down with capital controls so as to put further pressure on the Greek government.

A boat in stormy seas …

Cartoon by Martin Rowson

The Canary in the Coal Mine

Frankly, we are a bit tired of writing about the seemingly never-ending Greek drama. However, Greece is an important test case in many ways, and can be seen as a kind of canary in the coal mine. Mises was of the opinion that while it might be legitimate to issue short term government debt in an emergency, long term government debt was alien to a market economy. He also noted that:

"The financial history of the last century shows a steady increase in the amount of public indebtedness. Nobody believes that the states will eternally drag the burden of these interest payments. It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract. A host of sophisticated writers are already busy elaborating the moral palliation for the day of final settlement."

As we can all see, these days massive attempts to simply inflate all sorts of debt away are underway (in the process expropriating savers). This is done under the cover of “economic necessity”, but we should call a spade a spade. When central banks like the Fed, the BoJ and the ECB create billions from thin air every month to buy up government debt, they are ultimately attempting to inflate debt away.

The debt-financed welfare/warfare state system is coming to an end. Greece’s inefficient and corrupt bureaucracy and political class and its insane economic policies have merely brought about its downfall somewhat earlier.  We should however expect that most governments of industrialized nations will be able to “muddle through” for a very long time, at least as long as some extent of net wealth creation is still taking place in the economy.

Consider that it took even the Bolsheviks seven decades to consume the last crumb of previously accumulated capital before they folded – and they had to make do with a stunted, very rudimentary system of economic calculation, based on prices they were able to observe in the surrounding market economies (without that possibility, their economy would have imploded much faster). The "middle of the road" system should survive a lot longer, but its problems should become more and more obvious as time passes.

There are two possibilities when the end game arrives, and it is unknowable which one governments will eventually opt for: outright default (which would have deflationary consequences), or default via inflating the currency into oblivion. Prior to that they may try to implement more blunt wealth confiscation schemes than the ones currently in train, such as grabbing 10% of all private savings overnight (as the IMF has proposed in a paper last year, see: Is a Large Wealth grab on its Way? for details).

The crappen has been released …

Cartoon by Nate Beeler

We all are creditors to the banking system and to governments , whether or not we have bought government bonds outright. Every bank depositor is de facto a creditor of banks, who in turn are major creditors to governments.Through their share in pension funds and investment funds, most people are creditors to governments as well (many are so unwittingly). In other words, debt haircuts and government defaults, regardless of which shape they take, will redound on a large part of society in some way. When the time comes, government creditors will lose the bulk of their claims. Historical experience unfortunately indicates that even such catastrophes routinely fail to invite systemic reform.

It becomes ever more difficult to fund the basic promises of welfare states in light of demographic effects and economies severely impaired by a succession of boom-bust cycles of ever greater amplitude. Generational conflict is a certainty, as fewer people are enjoined to pay for a rising number of dependents and at the same time, a shrinking population also means that the economy’s knowledge base contracts. The more people there are who are focused on discovering market imbalances and putting them to profitable use,  the more the economy’s inherent "information deficits" decline to the benefit of all. In short, ever larger costs must be funded, while the economy’s ability to create wealth (that can be partly confiscated by taxation to fund welfare state promises) is under attack from many sides at once.

 The demographic problem illustrated – via 9gag.com

Conclusion

The Greek problem remains unresolved – the referendum couldn’t resolve it, although it may have influenced the ultimate outcome. However, Greece’s situation is a good reminder. Neither banks nor welfare state government can keep up the pretense of solvency without the backstop provided by the printing press. As long as there is wealth that can be redirected this seemingly works, but there is a limit to this. The events surrounding Greece are in this sense also a strong reminder that faith in central banks and their power remains the central issue for financial markets.

Addendum:

Just as we finished writing this, it was reported that Greek finance minister Yanis Varoufakis has resigned, apparently because he doesn’t want to jeopardize further negotiations with his presence:

"In a statement Varoufakis said: "Soon after the announcement of the referendum results, I was made aware of a certain preference by some Eurogroup participants, and assorted ‘partners’, for my … ‘absence’ from its meetings; an idea that the Prime Minister judged to be potentially helpful to him in reaching an agreement. For this reason I am leaving the Ministry of Finance today."

 Slide show of Yanis Varoufakis’ career as Greece’s finance minister

Cartoon by Marian Kamenski