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Thursday, 11 February 2010

COMING SOON: THE MERKELON

As plans for a Greek bailout, led by Germany and possibly France, begin to coalesce,  I cannot help but draw analogies with the situation in Dubai.

I have heard it said on many occasions that the opulent emirate, the spark that started the conflagration Greece is now in the centre of, had nothing to do with us. They were actually in default, and we weren't. They were a surprise, and we weren't. They were ill-equipped to deal with the fallout, while we had the combined economic and political muscle of the Eurozone behind (or against) us. We had no exposure to them anyway.

The analogy was indeed false, but it never needed to be valid in the first place. There is a simple mechanism to how this kind of contagion spreads, and it's worth noting that the facts (as damning as they are) don't really come into it:
  1. A sovereign (Dubai) finds itself in unexpected and fully warranted trouble.
  2. People exposed to the sovereign (Banks) lose money
  3. Memos go round offices saying: find out where the next shitstorm is most likely to come from and get us the hell out of those positions. 
  4. Staff fall back on conventional wisdom to identify a weakest link (Greece).
  5. Investors short everything that smells vaguely weakest-link-ish (Greek).
  6. Speculators smell panic and reason that, since everyone's only just woken up to the risk posed by the sovereign, they are bound to dig up more dirt. They short and are rewarded when bad news which no one had bothered with previously inevitably do start to emerge.
  7. The offending sovereign, playing for time, blames speculators for everything, and in so doing signals that it is unable, or unwilling, to rectify its shortcomings. Everyone shorts like there's no tomorrow.
  8. As creditors' positions start looking particularly iffy, potential guarantors of the sovereign's debt (Eurozone countries) are sought. They come under pressure to state their positions.
  9. Potential guarantors resist being identified as such or demand commitments from the offending sovereign in return for their guarantee. Either response prompts further panic selling, as well as speculation.
  10. Endgame. Either the offending sovereign sends an unequivocal message that creditors will be paid, or defaults, or the guarantors assume their role formally. 
  11. Guarantors (should they be needed) claim their pound of flesh, prompting intense protests from the offending party.
Modify this only slightly and you can see the same thing happened with subprime mortgages in 2007, with off-balance sheet vehicles in early 2008 and with banks in late 2008. Now it's the sovereigns' turn. Note that at each stage, the bad debts of the previous culprits were taken on by the latter. [Broadly speaking, of course; Greece was quite restrained in bailing out its reasonably healthy banks, although it did perform a miguided implicit bailout of our cash-strapped consumers by hiring everyone within sight into the civil service in 2008-9 and casually abandoning tax collection].

Dubai went through this in short succession and, hey presto, the Burj Dubai is now called Burj Khalifa in honour of Abu Dhabi's ruler and guarantor-in-chief. Now, do we in Greece have any elevated, iconic structures to name after Angela Merkel? Hmmmm....



On a serious note, the bailout appears to involve German, France, or both standing in as guarantors for our debt. Presumably this will come with strings attached, but such is life.

But I have a better idea, and one that European governments have touted before: just advance our EU funding for the next 5-10 years, paid for by our would-be guarantors, who will get an equivalent discount off their EU contributions for the years in question. This of course on the condition that we use all of it to pay off debt.

Assuming constant levels of EU support, this leaves us with an extra EUR42.5 to 85bn, which would put a very nice dent into our public sector debt and shut everyone up for good without actually being a bailout in NPV terms.

But the plan has a host of other amazing advantages:

  • It leaves the EU with a smaller budget, encouraging it to spend more wisely.
  • It leaves us, in time, with no reliable EU funding for the near future, breaking the cycle of poor governance and dependency that has helped exacerbate our already abysmal record of public management.
  • It forces us to retract the damaging EU subsidies destroying our agriculture
  • It won't force us to take procyclical fiscal measures right on year one, in the teeth of a bad recession.
  • Its success does not depend on our partners, or markets, believing our commitments are sincere.
  • It doesn't come with political strings attached, and does not set a precedent of direct EU intervention into member states' fiscal policy.
  • It will have less of an impact on France and Germany's borrowing costs, as they will borrow only against their own fiscal record, not ours.

Of course, the fiscal adjustment will have to come at some point. Under the advance plan, we get a year's grace period, and then lose 16% of our government budget (the retracted EU funds). This is in fact harsher than the current SGP, but, I think, politically more palatable.

So who's with me?

[Citations coming soon]

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