Monday, February 13, 2012

Creditor vs. Debtor

The breakup of the EU is definitely a foregone conclusion. The EU must get rid of its debt mountain first before it can get out of the morass. In zeroing on the highly indebted states, the EU leaders remain blind to the real crisis. They conveniently choose the easy way out by heaping pressure on the struggling states. The chance of those states ever repaying their debts even with tons of bailout money is as good as zero.

One of the rules of management is not to manage things that are beyond your control. If the EU leaders have some sense, they should confront the creditor banks instead of the struggling states. In a crisis of a massive debt overhang, it's the creditors that must bear the heavy burden of debt write-offs. After all, it's not just the debtors that are at fault, the creditors are equally guilty of indiscriminate lending. But the creditors hold the debt assets while the debtors have only debt liabilities. Writing off liabilities is virtually impossible when the asset owners are in no mood to play ball. However it's the asset owners that are actually in a weaker position.

We only need to recall Jean Paul Getty's quote on the relative strength between borrowers and their bankers, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem.", to remind ourselves as to who really should hold the upper hand in the debt negotiations between the opposing parties.

But the debtors don't know how to play their hands. They should've entered the negotiations in concert, all the PIIGS countries banding together. Only then can they force the bankers' hands. Note that with just a 30 percent write-off of the banks' debts, the bank owners would lose all their equity holdings. In time, practically all the eurozone banks will become wards of state. With the current economic conditions in the eurozone, debt write-offs of more than 50 percent are almost certain. There's no way that the eurozone banks with total loan exposure of $30 trillion could survive without nationalisation. To put it in perspective, the EU's GDP is only $12.6 trillion. This colossal hole is the thing that EU leaders are trying to prevent from an implosion that would wreak havoc on the German, French and British banks and, by implication, the three biggest economies in the EU.

Instead of calling the banks' bluff, the debtors are being picked off one by one by the banks. Next in the target sight after Greece is Portugal. To make matters worse, both Greece and Italy have picked former professors as their political leaders. Cocooned in the academic world, professors go by the book, never once willing to put up with unconventional approaches. At negotiations, they can easily play into the hands of the bankers. Lucas Papademos naively believes that failure to obtain bailout money would lead to chaos. Actually it's the austerity measures imposed by the bailout terms that would see Greece descend into anarchy.

Now how the PIIGS should have strategised? Before going to the negotiating table the PIIGS must countenance all the available means of countering the banks so that their negotiating position is stronger than that of the banks. Dumping the euro in favour of their former national currencies, bank holiday, capital controls and trade protectionism are in. Only then can they have the negotiating flexibility to arm-twist the banks. Instead the PIIGS are ludicrously sticking with the status quo, very much weakening their negotiating position. The EU project anyway is an anachronism in a world that's moving towards fracturing of states and societies.

These are desperate times. We are in the midst of the Grand Depression, that is, the 1930s Great Depression scaled up multifold. What the PIIGS are suffering from now is an extreme shortage of currency or liquidity. The only way out is a huge dollop of spending money which could only come about if they are in control of their own currencies. Only then can they export their way out of economic depression. Of course, they can no longer maintain the same lifestyle as in the past but at least they could get their jobs back instead of rioting in the streets. Initially, things would be very expensive but prices would soon stabilise after the initial spurt as the whole world is now suffering from excess capacity coupled with insufficient demand. For example, Iceland which has seen its krona value dropping by about 50 percent since 2008 no longer endures high inflation (see left chart from The Washington Post).

What if all other states also embark on money printing to depreciate their currencies? Don't worry, money printing without public spending won't cheapen the currency. Just ask Ben Bernanke and Mervyn King about their recent experiences. Apparently they still can't figure out why things don't turn out as predicted. Even if the other governments unleash their public spending and drive up inflation, that's well and good. That'll transfer the wealth from the creditors to the debtors and that's what we need to redress the extreme imbalance between creditors and debtors.

But all these can only happen if the PIIGS realise that they have a strong bargaining hand. The debt fight is theirs to lose. For the sake of the whole world, they'd better use their trump card.

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