21 March 2010

More on the international financial system

In this weekend’s edition of The Weekend Australian Financial Review, 20-21 March 2010, there is an opinion piece on the debt crisis by Simon Johnson (a professor at MIT’s Sloan School of Management and former chief economist of the International Monetary Fund) and Peter Boone (Chairman of Effective Intervention at the London School of Economics) which resonates strongly with the piece contributed by Professor Ross Buckley on Friday 12 February (see Negative resilience in the global financial system).

In his piece Professor Buckley identified feedback loops in the international finance system that reward international commercial banks and the elites within nations, at the expense of the common people in those countries.  The principal mechanism for this is the pressure which is placed on the governments of highly indebted countries to assume the obligations of local banks to foreign lenders, so that the foreign lenders are repaid in full, and the locals wear most of the cost of the repayment – essentially a massive socialisation of private sector debt.

Writing in a similar vein, Johnson and Boone contrast favourably the recent actions of the Kazakhstan Government with the behaviour within the Euro zone.

 In relation to Kazakhstan:

For most of the last decade, Kazakhstan gorged on profligate lending, courtesy of global banks – just like much of southern Europe. The foreign borrowing of Kazakh banks amounted to about 50 per cent of gross domestic product, with many of these funds used for construction projects. As the money rolled in, wages rose, real estate prices reached near-Parisian levels, and people fooled themselves into thinking that Kazakhstan had become Asia’s latest tiger.

The party came to a crashing halt last year, when two sharp-elbowed global investment banks accelerated loan repayments – hoping to get their money back. The Kazakh government, which had been scrambling to support its overextended private banks with capital injections and nationalisations, gave up and decided to pull the plug. The banks defaulted on their loans, and creditors took large “haircuts”(reductions in principal value).

But – and here’s the point – with its debts written off, the banking system is now recapitalised and able to support economic growth.

By contrast, in Ireland, where the banking system’s external borrowing reached roughly 100 per cent of GDP (twice the level of Kazakhstan):

Instead of making the creditors of private banks take haircuts, the Irish government chose to transfer the entire debt burden onto taxpayers. The government is running budget deficits of 10 per cent of GDP, despite having cut public sector wages, and now plans further cuts to service failed banks’ debt.

For Greece, with its government debt approaching 150 per cent of GDP, the outlook is much worse:

If Greece is to start paying just the interest on its debt – rather than rolling it into new loans – by 2011 the government would need to run a primary budget surplus (that is, excluding interest payments) of nearly 10 per cent of GDP. This would require another 14 per cent of GDP in spending cuts and revenue measures, ranking it among the largest fiscal adjustments yet attempted.

Johnson and Boone argue that, in Greece’s poisonous political climate the level of adjustment required is a sure route to dangerous levels of civil strife and violence; Greece simply cannot afford to repay its debt at interest rates that reflect the inherent risk.

The alternative they propose is for Greece to manage an orderly default:

Reckless lending to the Greek state was based on European creditors’ terrible decision making. Default teaches creditors – and their governments – a lesson, just as it does the debtors: mistakes cost money, and the mistakes are your own.

A default would be painful, but so would any other solution.

A default would ... appropriately place part of the costs of Greece’s borrowing spree on creditors...

Ultimately, by teaching creditors a necessary lesson, a default within the euro zone might actually be a key step towards creating a healthier European – and global – financial system.

Many will disagree no doubt, and there is an argument that there is nothing wrong (in the Greek case) with the taxpayer being asked to foot the bill for the recklessness of the governments they elected – by contrast with the Irish case, and the Indonesian case cited by Ross Buckley, where the punters are picking up the bill for the recklessness of the private banks. The fact is, however, that Greek society simply cannot deal with this matter on its own. If Greece does default, it will be the Germans and the French who take the biggest haircuts.  This will be an interesting space to watch.

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