Monday, 10 May 2010

An atom bomb goes off

An atom bomb was set off yesterday. Only nobody noticed it. Because it was high economics that nobody but the geeks understand. But an atom bomb, it surely was. I am referring to the nearly € 1 trillion “bailout” package for the Euro zone members that was announced yesterday.

Even if you have only a passing interest in economics, you would have heard of the travails of Greece over the last few months. This was snowballing into a crisis that was threatening to spread to the other vulnerable members of the Euro zone - the so called PIGS – Portugal, Italy, Greece and Spain. Hence the shock and awe tactics of detonating an atom bomb. € 1 trillion rescue package. Wow !

Greece started it all. For a long time it was fudging figures that, if done in the corporate world, would have surely sent the Chairman to jail. But it is, of course, perfectly acceptable to do so in politics. Truth will always out, and when tougher financial markets laid bare who was naked and who was not, Greece got caught out. The interest rates on Greek bonds started to rise rapidly. Without the ability to borrow, Greece was in danger of default.

Because Greece is locked into the Euro zone, the traditional route of massive devaluation of the currency was not possible. Everybody assumed that the 1000 pound gorilla in the room – Germany – would rescue Greece out. But Germany these days is in no mood to rescue anybody. Everybody for themselves in tough times. How on earth do you convince the average German voter that he is penalised for being responsible and must stump up the money to rescue the irresponsible Greeks. This was Angela Merkel’s problem, especially with a crucial regional election that was held yesterday. She tried to postpone any decision till after the elections. She couldn’t do so. The result ? A stinging defeat for her party yesterday.

The announcement has huge implications. Firstly it admits that any Euro zone country, however small, is too big to fail. As each weak country is attacked, they have to step in to save them. Secondly, the European Central Bank has to intervene directly to shore up the bond markets; something which it was explicitly prevented from doing when it was set up. Thirdly, it calls into very question the basis on which the Euro came into being. Countries were left free to manage their own economies, but subscribing to basic disciplines of fiscal policy. No country was required to “bail out” another. This is all shot to the wind now. Every country now is bound to be responsible for every other ; how do you do it when each of them still wants to be a sovereign nation ? Fourthly what happens when this malaise spreads. Greece is not alone as a beacon of indiscipline. To varying degrees the others in the PIGS grouping have problems. Greece is small. Spain is big. What happens when bigger countries get into trouble. And perish the thought – if the much bigger Italy, another star in the indiscipline firmament is targeted; we don’t even want to think of the consequences of that. Fifthly, there will be very very painful cuts in Greece and whichever country needs to be bailed out. There are already massive strikes in Greece. How’s the population which has been hooked on to spending without a care going to take the chemotherapy ?

If that was not enough, there’s more worry coming. What about the countries in the European Union which are not in the Euro zone. What about the UK ?? It has run up an incredible deficit, faces political uncertainty, and is in a fair mess.

When bailouts were about banks, it was easy to get all steamed up, hurl invective at them and castrate executives. When its about whole countries, what do you do ??

It’s a gloomy world out there today morning. The skies are darkening over Europe.


zeno said...

Few naive questions!

Is there any possibility that these european countries will do away from Euro[common currency]?

When you talk about countries outside eurozone, you mean they are in danger, cause there is no one to save them?

Will the dark skies spread across to other parts of the world?

If yes,What will be the impact for the common joe? Will we see stock market crash? recession, job cuts?

Durga said...

There was a lot of commotion when Euro was proposed to be the common currency for European countries. One of the many discussions were impact on economies at a later date relating to the currency uniformity. Meagre fiscal policies were laid down for the Euro zone countries to convert their then currency to euros, more so to speed up the process of having a common currency. Curency conversions entail a whole lot of economic considerations on paper and in practice. These were apparently relegated to the backseat or given a go-by and we see its effect now. Yes, its a mess alright, which everyone saw it coming, but no one was willing to admit it or even think about it. The question is, how will this now be set right? What's done, is done. What are they going to do now? Obviously something more than wait for your neighbor to bail you out of your misery. What could that be?

ambulisamma said...

You article sounds scares to average's like me.When you say gloomy world today morning,wish its only today.

Emma said...

I am glad I am out of there....

Ramesh said...

@Zeno - Not naive at all. The breaking up of the Euro is economically feasible, though a huge pain, but politically suicide for Europe. Therefore it is unlikely to happen, although countries like Greece carry the danger of being "expelled". The problem outside the Euro zone (like the UK), is that the European ideal and wanting to keep European integration going will pull towards bailout, while the sheer economics and the distaste after the Eurozone activity will pull away. In any case, the UK is too big to be intervened by anybody else ; very likely the pound will devalue significantly.

There is every danger of this causing financial problems everywhere. Already markets around the world have been jittery. There are structural imbalances in both the US and Europe. I don;t think the financial crisis of the last two years is by any means over. The wild optimism of the recent times, is I think much misplaced.

Ramesh said...

@Durga - Very right. There were lots of flaws in the original design. Achieving currency unification without political and economic unification is fundamentally flawed. It is unlikely to survive for long without trouble. Europe is in considerable trouble, I think.

@ambulisamma - It is scary and politicians have been hugely guilty of not explaining the economics in simple language. We cannot ignore these in today's times when economics rules much of life.

@Emma - Ha Ha ! But you were in the nice part of Europe, with not that much trouble !!

kiwibloke said...

PIGS morphed into PIIGS (Ireland/Iceland one of the two?) and the latest is PIIGSUK. Acronyms apart, all these Ponzi schemes had to go bust somewhere. I have always had this interesting question on economics - If every company grows revenue/profits year on year (and in many countries services are much bigger than Manufacturing/Agriculture) are we buying/selling stuff we never needed/wanted in the first place? BTW, what is news on the real estate bubble in China? I believe banks are now asked to refuse a mortgage for a third house? Is it true?

Sandhya Sriram said...

I have always felt that something like a EU was a very positive step to keep giants off the economies of smaller countries.

But running a powerful economy and keeping fiscal policy out of scope is like running a vehicle with engine outside which was fine for initial consolidation and proving a radical concept but eventually will have to subsume.

What would be a positive turn to the piece will be if the EU wake up to the reality that they need to have some form of a check on the financial health of a nation in the EU (something like a SAS 70), impartially lay down guidelines for keeping a tab on the key economic indicators and ensure that no political need takes dominance over the economic need

unfortunately, that will never happen. while the countries have committed their body to the EU, they have not committed their hearts to it and therefore as you rightly said, it is a gloomy morning out there.

thanks to you for this eye opening perspective!!

Ravi Rajagopalan said...

For all his faults, Gordon Brown deserves a round of thanks from British taxpayers for keeping Britain out of the euro. In retrospect, the test he applied seemed fuzzy at that time, but it is exactly those tests that have kept Britain out of this zone. we have full control over all levers of financial management, and a reasonably open system with a free press, a sceptical population, and open financial markets. Britain will have short-term pain but long-term, I am bullish. Already the downward adjustment of input costs has resulted in a mini-boom of British industry helped no doubt by the gentle lowering of the pound.

I think all european countries benefitted from the Euro, in greater or lesser degree. And while I sympathise with the German taxpayer, lets not forget that Germany actually lowered wage costs after it went into the Euro, helped no doubt by the increased labour and manufacturing mobility enabled by the common currency and by savings in transaction costs. The issue is that some nations chose to behave irresponsibly. I remember 1500 Lira cab rides to the airport (ok, Milan to Linate) become 10euro cabrides (a five fold inflation) in no time at all. This increase in costs, plus the free flow of money raised through eurobonds were like catnip before the cat. It was bound to encourage irresponsibility.

Without a binding political framework there was no way the ECB could render effective policing action.

RamMmm said...

I just can't help smiling at those acronym generators and the possible headlines generated out of them.

PIGS don't fly
BRIC hits the wall
BASIC blocks to emission cuts

Anonymous said...

en kament kaanam pooduchu :(

Anonymous said...

IMF pathi unga postla padichena ila newspaperlaya therila..asian countries wanted to increase IMF that avanga sikkalla maatina use agumnu yosikka..kudutha extra kaasulaam is now going to developed countries like greece apdinu irunthichi.

Thala..aana unga rango range. Asin gong li pathi rasichi rasichi post podra athey flowla economics patiyum post podreenga parunga..anga nikareenga neenga :)

Ramesh said...

@Kiwi - Yes, everybody is inventing acronyms these days. There's a huge property bubble in China.Its been building over a long time and has gone absolutely crazy recently because of free lending. Its easy to think that China is somehow "different" and not vulnerable to the usual laws of economics. For sure, a lot of people are going to get hurt. The short termism here is unbelievable.

@Sandhya - You've hit on the exact reason why the EU stutters all the time. In reality the proponents want a United States of Europe. Neither the people nor the individual countries want this. hence the classic fudge. Any political body that selects Herman von Rompuy as its head, needs to say no more. Imagine a G3 summit between Obama, Hu Jintao and von Rompuy !

Ramesh said...

@Dada - Brown deserves more than a round of thanks. But for the massive splurge on NHS in the good days, I actually think he was one of the best Chancellors the UK had. He may be a poor Prime Minister, but he certainly was a top drawer Chancellor. The UK is in deep trouble, I think, but has the best capacity to come out of it for the very reasons you have mentioned.

I don't think the Euro really benefited anybody. The Euro is just another way of trying the Gold Standard. Take the case of the UK and Switzerland - two countries that stayed out of the Euro. Did they lose out on any count. No. Who really gained that they would not have had they kept their old currency ??

@RamMmm - Ha Ha. See my post on acronyms here

@Gilsu - The only Asian country that has significantly increased its contribution is China. They are the only ones with excess money around.

Economics , I know a little. But the fair ladies , I know nothing at all. Thanks to you and the others, I am being educated !!

Deepa said...

A good discussion!

The Greece cookie is crumbling,
the punters are scrambling.
One hears a 'bailout' rumbling,
and the Germans are grumbling.

Sandhya's comment was a great read too.

adeshsidhu said...

With 25% budget deficit, I think Britain is next. I read somewhere that every new born child in Britain will owe 17,000 Euros to Government because of this deficit.

Cuts will be necessary but people who take things for granted will find extremely difficult to cope without it.

LEB said...

I could not believe when I read about Greece. For a common man like me who does not understand economics too well, it felt difficult to believe that a country can go short. And like you said, it did not grabe the headlines. Great post.

Ramesh said...

@Deepa - Ah a verse even on this dry topic ; very nice Deepa

@Adesh - No I don't think Britain is in the same league as some of the others. Britains debt is largely because of the huge stimulus of previous years coupled with massive increase in NHS spending in the good days. Theirs is a much more flexible economy. They'll cut back. Sure they are in trouble, but I would bet on them to come out allright. The real biggie in deeper trouble, I think, is Italy.

@LEB - Iceland was the worst example and they did go bust. The Greeks thought they could be in the big league by doing a Ramalinga Raju. Got caught out.

Srivats said...

Dearest Ramesh

THis is why I had to come and read ur posts, for it helps me understand the world better. And as such I am not seeing any news these days, not that I am proud of it, it has become so.

That was very informative writeup :)

Vishal said...

Insightful post, Ramesh!

Left me wondering how such fudging could happen at the national level without being addressed in due course. If the political system supports this, then where else would one go?

As for EZ members, it is shocking to know that there are fundamental flaws in the operating principles. I would watch out for the wider consequences for sure!

Ramesh said...

@Sri - Hey welcome back. Nice to see you back in blogosphere. Your art is much better than this boring economic stuff !!

@Vishal - Unfortunately every country fudges figures to varying degrees. Countries still practice single entry accounting; there's no concept of independent audit; their accounting systems are ancient .....

raghavendra kotla said...

Hi Ramesh, do you want write about carbon credit trading ? :-)


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