Sunday, October 16, 2011

Neither a borrower nor a lender be

"Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry."
Hamlet Act 1, scene 3, 75–77

Those of you follow me on twitter know that I got a little upset earlier this week over a blog post by @. If you follow the link, you will see that the post is about an article by Kash Mansori in the New Republic.

Now, I am a big fan of Mansori, and love his blog. But stuff like this
"In particular, it misses the fact that the very design of Europe’s common currency area not only caused, but was meant to cause the eurozone’s periphery to incur large amounts of international debt. Further, there was little that the governments of those countries could do to stop it. Far from causing the crisis, the peripheral eurozone countries were up against powerful forces outside their control, forces that probably made this crisis inevitable no matter how responsibly they behaved."
is crap.

Yes, the Euro was meant to encourage capital flows from the capital-rich core to the capital-poor periphery. And yes, such capital flows frequently lead to crises when they are reversed. But thats a far cry from saying that the governments of peripheral countries are blame-free in the current Euro crisis. Essentially Mansori claims that the peripheral governments got a once-in-a lifetime windfall, and couldn't help but squander it. What Mansori misses is that the sovereign governments of those peripheral countries had a choice on what they could do with those capital flows. Instead of productively investing their capital bounty, the countries of the periphery squandered it on a consumption binge that lead directly to the problems those countries face today.

Lets look at the countries that Mansori mentions in his article:
  • Greece: Greece has had a history of being a serial defaulter ever since it became independent from the Ottoman empire in the early 19th century. Its no surprise that faced with a massive influx of capital, successive Greek governments choose to squander it on a massively bloated public administration, pension promises, and whatever else they needed to do to get themselves re-elected, including fudging official statistics. The Greek government choose to run a fiscal deficit in good times; its no wonder that in bad times they find themselves in a crisis.
  • Spain: Spain actually ran a small budget surplus during the boom, and even today its overall government debt-to-GDP ratio is pretty low. But Spain had a massive housing boom, among the largest in the developing world. The Spanish Central Bank tried its darndest to ensure that local banks followed safe lending practices, but they inevitably ended up with massive exposures to local households and builders. 
  • But the real reason that investors have turned away from Spain is because of the parlous state of its economy. Unemployment currently runs at over 21%, and even the meager growth forecast of 1.3% for 2011 looks optimistic. You don't have to look far to find the reasons - permanent employees get 6 weeks of severance for every year they have worked. Once you've worked at a company for a few years, you can pretty much stop working, because firing you is now impossible. Younger employees are limited to temporary contracts of 1 year or less. They are always the first to be fired, and employees have no incentives to invest in training them. As if that wasn't bad enough, bureaucratic red-tape means that incumbents in many industries are entrenched and entrepreneurship practically non-existent. Even MBA students from the best universities dream of getting a bureaucratic job - those are the only good jobs still available to the young. For most of the last decade, wages grew rapidly and productivity growth was flat to negative. 

    Massive reform will be needed before Spain can return to growth, and that sort of reform looks politically impossible at the moment. With 9% fiscal deficit, no way to devalue the currency, and no hope of growth, even Spain's relatively light debt burden begins to look heavy. Small wonder that capital (and mobile labour) is fleeing the country. 
  • Ireland: In some ways, Ireland is the poster child for Mansori's argument. It has one of the most flexible and business friendly economies in Europe, with famously low corporate taxes. It enjoyed rapid productivity growth and attracted large numbers of skilled immigrants for most of the period leading up to the crisis. True, it had a huge real-estate bubble, but arguably the government could do little about it in such a lightly regulated economy.
  • In fact, all of Ireland's problems stem from one decision made in late 2008 - the decision to guarantee the debts of all the Irish banks. These banks had borrowed heavily in the global markets to finance a wave of expansion as well as the domestic housing bubble. Banks like Anglo-Irish were effectively bankrupt in 2008, and the government stepped in to guarantee all their debts. In doing so, they instituted a massive transfer of wealth from Irish taxpayers to foreign creditors. The joke at Davos in early 2009 went something like this "What's the difference between Iceland and Ireland? One letter and about six months". It was to avoid precisely that situation that the Irish government guaranteed bank debt. But today, the Icelanders look like the smart ones - their crisis cost them 13% of GDP, while re-capitalizing its banks will cost Ireland 36% of GDP.  With Irish debt-to-GDP set to hit 123% by 2014, investors are rightly concerned.
Ultimately, a freely functioning market exerts control on both borrowers and lenders through the fear of default. Borrowers fearful of being cut-off from credit invest their borrowings wisely instead of spending them, and lenders fearful of losing their money scrutinize borrowers and monitor their behavior. When the Irish bailed out the (European) creditors of their banks, they undermined this system, and it backfired on them spectacularly. In essence, the Irish wasted a decade and a half of good governance in a show of pride over the strength of their banking system. Germany and the Nordic countries who are being pressurized to bail out the rest of Europe should take note. 

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