Europe on the Brink: Debt Crisis and Dissent in the European Periphery 9781350219960, 9781783602131

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FIGURES

3.1 Current account balances as a percentage of GDP in Germany

and Portugal, 1994–2010 . . . . . . . . . . . . . . . . . .

120

3.2 Financial accounts as a percentage of GDP in Germany and

Portugal, 1995–2011 . . . . . . . . . . . . . . . . . . . . . 121 3.3 Interest rates versus GDP growth during the process of nominal

convergence, 1992–99 . . . . . . . . . . . . . . . . . . . . 123 3.4 Average gross annual earnings, 1996–2008 . . . . . . . . . .

126

3.5 Official unemployment rate in Portugal, 1998–2013 . . . . . . . 126 3.6 Evolution of real unit labour costs, 1995–2008 . . . . . . . . . 127 3.7 Inflation rate, 1997–2008 . . . . . . . . . . . . . . . . . .

128

3.8 Evolution of the growth in productivity, 1995–2008 . . . . . . . 129 3.9 Gross public debt in the euro area as a whole and in Germany

and Portugal, 2000–13 . . . . . . . . . . . . . . . . . . . . 131 3.10 Expenditure on social protection in the euro area as a whole

and in Germany and Portugal, 2000–11 . . . . . . . . . . . . 132 3.11 Total Portuguese individual debt as a percentage of disposable

income and as a percentage of GDP, 1997–2010 . . . . . . . . 133 3.12 Real estate loans and total loans to individuals, 1997–2011 . . . 134 3.13 Unit labour costs in the euro area and in Portugal, 1995–2013 .

138

3.14 Portugal’s exports versus imports and GDP, 2008–13 . . . . . 138 3.15 Percentage yields on Portuguese ten-year bonds, 2010–12 . .

140

3.16 Government bond yields plotted against ECB bond purchases . 141 4.1 Changes in forecasts for GDP and employment outlooks for

Greece . . . . . . . . . . . . . . . . . . . . . . . . .

167

ACKNOWLEDGEMENTS

Many, who shall for now remain anonymous, have committed their time to investigating, understanding, distilling and imparting their knowledge of the boundaries between virtual finance (the so-called derivatives sector), the traditional global financial sector itself, national and regional economic systems and, most importantly, that system which underlies all three economic layers, nature itself. While this book focuses primarily on the dynamics of regional finance, and the interplay between the private and public sectors, I think it is worth mentioning that, in conventional economics, nature, which is synonymous with life on this planet, is typically reduced to the role of ‘natural resources’. The dismal ­science still ­reverberates with an unnatural, disconnected and abstract discourse, a death economy rather than a life economy, which is an unhealthy state of affairs for humanity and for the rest of the planet. There are still too few economists who profess to care; we need to change that. Others shall be named because they provided their ideas, their time and their encouragement to bringing this book project to press. The idea for this book would never have occurred were I not invited to participate in an Irish book entitled What if Ireland Defaults?, so thanks are due to editors Brian Lucey, Constantin Gurdgiev and Charles Larkin, along with the publishing staff at Orpen Press in Dublin. Thanks to María Julia Goyena for sustaining my energy in this project and to my family for teaching me to try to make a difference. Thanks also to Eduardo, Ken, Tom, Annette, Miren, Ailín, Roberto and Alejandra, Aimee, Gemma, Lourdes, Bríd, Nick, Hector, Alex, Pat, Edgar, Aixa and Aldo, and so many more translators, ideas people, proof writers, educators and others, for their help and encouragement. Thanks also to the editing, publishing and marketing staff who

viii  |  acknowledgements

believe in this book project. Finally, thanks to my six co-writers – Christina, Mariana, Anzhela, Diana, Roberto and Joseph – and also to Eamon and Lucy. I know I’ve forgotten many more names but I haven’t forgotten your help. Thank you anyway. Buenos Aires, 3 February 2014

INTRODUCTION: SOVEREIGN BONDS, BURDEN SHARING AND THE TROIKA’S RESCUES

Tony Phillips

Europe on the Brink is a critical investigation of the root causes of the European sovereign debt crisis, and the policy choices made to ‘resolve’ the crisis. In its five principal chapters, the book explores structural flaws – both financial and democratic – in the institutions of the European Union (EU) that reflect its neoliberal roots. We examine decisions made by sovereign European governments before – and in some cases after – they were intervened.1 The perspective we offer is that of the European and the global periphery. Three financial institutions – the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF) – together coordinate interventions in peripheral states within Europe. This three-headed hydra of European multilateralism is called the Troika. We examine the Troika’s attempts to resolve the European crisis in the context of other resolutions of regional sovereign debt crises from outside Europe. At the root of the European sovereign debt crisis, muddled by a haze of Eurostat2 statistics, is a global credit bubble gone horribly wrong. Our authors take a look at how this bubble grew and, more importantly, what has been done and what is yet to be done in Europe now that the credit bubble has burst. It might surprise many non-economists that some professors from orthodox schools of neoclassical economics refute the existence of bubbles altogether.3 This blinkered viewpoint emanates from the ground zero of neoliberal­ ism, the Chicago School of Economics, where the late Milton Friedman (1912–2006) taught for three decades, and from fellow market fundamentalist Friedrich Hayek (1899–1992). Surprisingly, this same opinion prevails in various economics faculties at European and Third World universities. Bubbles, it seems, cannot exist in ‘free and

2  |  introduction

efficient markets’. We take this and many other neoliberal ideas to task in this book. While there is no one school of economics advocated as an alternative to the current orthodoxy, this book provides an explicit critique of certain aspects of orthodox economics. Financial markets are both good and bad; they are also innately undemocratic, as those without money or credit cannot participate. In particular, investing in innovative finance – such as hedge funds, investment banking or private capital – is a privilege afforded only to the very rich. Regardless of market access, what has become evident in this crisis is that self-regulated or explicitly deregulated ‘free’ markets – especially combined with unproven financial innovation – are a recipe for disaster. Our authors deconstruct free market theories, comparing them with today’s financial reality. Alternatives are presented that consist of healthy mixes of local savvy, unorthodox4 and orthodox economics. In his New York Times column in April 2013, Paul Krugman ­attempted to explain how the idea of austerity became so orthodox, even though the two main academic studies supporting it had been revised, or had been found to be based on faulty data. Krugman summed up orthodox economics with the phrase ‘What the top 1  percent wants becomes what economic science says we must do’ (Krugman 2013). Rather than espousing a purely orthodox viewpoint, this book advocates reality-based economic policies that could work for the majority of the European population, not just for a small minority. Bubbles and financial lobbies Credit bubbles are not new. When credit is scarce, investors compete for debt; during credit bubbles, banks compete for investors, lowering the bar on loan criteria and divesting risk (if financial rules allow them to do so). The European credit glut in first part of decade from 2000 to 2009 resulted from banking deregulation. This gave banks more ways to increase their notional leverage, generating more loans and more exposure to risk. Some estimates of the notional leverage of Lehman Brothers, just before the bank collapsed, are close to forty-four times, but the formula used to calculate bank leverage is

phillips  |  3 not standardised – not even by the Bank for International Settlements (BIS)5 – and leverage estimates often fail to take shadow banking6 into account. Credit availability can also be increased by new ways of cre­ ating or repackaging credit7 – part of what is currently called financial innovation. New money can also be the result of what economists like to call quantitative easing’ (QE),8 but this is typically a central bank decision. The inflation-averse ECB did not begin QE in the early 2000s, so this was not the cause of the European crisis. Instead, the ECB tried, somewhat belatedly, to use QE as a partial resolution of the problem. That too proved to be just another gift to the banks. In Europe, the new debt fuelling the credit bubble was primarily private: loans from, and between, banks. In certain European nations, government (sovereign) bonds were also important. In both cases, bonds are primarily bought and sold by the private sector. If this doesn’t sound like a sovereign debt crisis it is because in many cases it wasn’t one. Rescue policies have meant that nations – many with previously low sovereign debt to gross domestic product (GDP) ratios – have taken on board excessive sovereign debt while the same policies have tended to depress GDP. Sample ratios before and after the ‘rescues’ include Ireland (25% in 2007, 125% in 2013), Spain (36% in 2007, 88% in 2013) and Portugal (62% in 2007, 127% in 2013).9 Contagious deregulation from the United States The latest global credit bubble began to inflate real estate prices in the early 2000s, especially in the US after the previous bubble (dot-com) collapsed in 2001. Alan Greenspan, then Chairman of the US  Federal Reserve, placed his confidence in the growth engine of the US real estate market. Hot money was channelled out of techno­ logy speculation and into real estate speculation, chasing tax advantages and easy credit, but this didn’t only happen in the US. Paulo de Morais, the Portuguese econometric mathematician, estimates that 70% of private debt expansion in Portugal was due to real estate speculation (de Morais 2013a, 2013b); in Ireland, business lending in construction and real estate rose 800% between 2000 and 2007 (O’Hearn 2009); and in Spain the situation was similar, if not worse. Aggressive financial lobbying in the US succeeded in diluting,

4  |  introduction

removing, or creating outright bans on, government regulations on banks and on their creative financial innovation in particular. New laws deregulated what banks could do with loans (credit) and insurance; it also allowed banks to invest for themselves as well as for their clients. Competition between nations to host their own lucrative financial services sectors spread competitive deregulation to the UK, to other G-20 nations, all across the EU and beyond. Credit bubbles, deregulation and cross-border transactions can cause negative side effects far from where risk is created. Financial regulators in the US and Europe forgot the cautionary lessons of the Great Depression in the interwar years. In the 1930s, financial regulation was put in place to prevent a recurrence of another global financial disaster, but in 1999 President Clinton signed the Gramm– Leach–Bliley Act, which repealed the provisions of one such law called the Glass–Steagall Act (1933)10 that served to separate commercial banks from investment firms. Moreover, in 2000 President Clinton signed the Commodity Futures Modernization Act, handing over regulation of over-the-counter derivatives to the fifteen-year-old International Swaps and Derivatives Association (ISDA).11 In a letter from the Executive Director and Chief Executive Officer of the ISDA, Robert G. Pickel, addressed to members and published in the ISDA report A Retrospective of ISDA’s Activities in 2000, an ebullient Mr Pickel announced: In the area of public policy, we are pleased to report a major victory in the passage of key legislation: the U.S. Commodity Futures Modernization Act has finally become law, ending more than a decade of debate concerning the status of swaps transactions under the U.S. Commodity Exchange Act. We have won our fight for the enactment of legal certainty legislation, which ensures that over-the-counter derivatives transactions will continue to be enforceable in accordance with their terms … The European Union Commission has issued a draft directive promising a thorough rationalization of collateral law within the 15 member states of the EU by 2005 (ISDA 2001).

Derivatives deregulation12 was going global. Mr Pickel was invited

phillips  |  5 to give testimony on the role of derivatives in the current financial crisis by the Senate Committee on Agriculture in 2008.13 The banks run the ISDA; in effect, this left the banks self-regulating their own swaps and derivatives trades. Increased flexibility in finance ushered in a period of mergers between commercial banks and securities firms, adding to ‘too big to fail’ issues. Banking became more global­ ised. There was an enormous boom in financial services, giving rise to the credit bubble mentioned earlier. Financial innovation14 gave banks new mechanisms to vastly increase leverage. Self-regulated innovation had supercharged the credit bubble. It proliferated across the planet,15 laundering its toxic collateral as it spread. In this brave new deregulated world, mortgages and other forms of credit were securitised, then often insured against risk of default (using credit default swaps or CDSs), and then sold on to other banks and funds. Investment banks offloaded the risk of ‘toxic’ (or bad) credit – including bad sub-prime mortgages – to other banks and funds. In many cases the risk crossed national borders to investors in Europe. One extreme illustration of direct contagion from the US  sub-prime crisis16 to Europe was illustrated by a Goldman Sachs & Co. sub-prime bond deal. The US Securities and Exchange Commission (SEC) prosecuted Goldman Sachs & Co.17 for secur­ ities fraud, alleging that they provided misleading information to European clients.18 Goldman Sachs had sold $150 million of the Abacus 2007-AC119 bond to Industriekreditbank (IKB) in Dusseldorf, Germany. The value of the bond was tied to the performance of US sub-prime residential mortgage-backed securities. The Dutch bank ABN Amro provided $909 million in unregulated default insurance (CDS).20 Goldman charged about $15 million in fees. The litigation describes what Goldman Sachs failed to tell either IKB or ABN Amro: ‘unbeknownst to investors, Paulson & Co. Inc. [a hedge fund] … played a significant role in the portfolio selection process’ (the term portfolio refers to the ‘financial assets’ in the Abacus 2007-AC1 fund). Paulson & Co., with its inside knowledge of the fund,21 then proceeded to short22 the fund. IKB lost most of its $150 million investment. Royal Bank of Scotland bought the global markets arm of ABN Amro. They later unwound their position, paying

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Goldman Sachs & Co. over $840 million.23 Many thousands of poor Americans also lost their homes, defaulting on their mortgages. The Paulson hedge fund24 made about $1 billion from its short sale. Many similar deals occurred with CDO-issuing investment banks, hedge funds and European investors, providing a channel for risk transfer between the US and Europe, thereby globalising the US crisis. A small number of similar cases have also been investigated by the SEC, including JPMorgan Chase and Magnetar Capital (Eisinger and Bernstein 2010); the former agreed to pay $154 million to settle the SEC investigation. Europe’s toxic loans Orthodox economic theory is currently based on the neoclassical (neoliberal) economic model. Neoclassical economists are taught to have confidence in market self-regulation. This same economic theory was used to design the financial architecture of the EU and is highly influential in most European national financial regulatory frameworks. Laissez-faire national banking regulators in Europe, particularly in the periphery, cast a blind eye to financial shenanigans and to the occa­sional regulatory or liquidity breaches by their local banks.25 Banks in Europe also made toxic loans to both the private and the public sectors. In the early 2000s, many loans were in the real estate sector but, as the housing markets waned, ‘much of the fresh business for banks was provided by public debt. In 2008–09, states across the developed world arrived in financial markets seeking extraordinary volumes of fresh funds, perhaps close to a trillion euro’ (Lapavitsas 2012). The private financial crisis shifted to a public one and the banks cashed in again. In 2008, the US sub-prime bubble burst and the same deregulated channels globalised the problems to Europe. This happened directly, via losses on investments, and indirectly, due to a sharp reduction in short-term financing. European and US banks were forced to come to terms with their severe financial exposure. The banks in Europe were too interlinked to fail; they desperately needed a taxpayer rescue. In each of the intervened economies in the periphery, significant

phillips  |  7 quantities of taxpayer money have been ploughed into the rescue of defunct private financial sectors, but rescuing banks is not just a peripheral phenomenon – nor is it just a euro phenomenon. Bank rescues have already taken place in Germany, Belgium, France and the UK, and in many more European financial centres, mirroring the spectacular collapses on Wall Street. We all remember Lehman Brothers, but there are few reminders of the collapses of UK banks such as HBOS, Lloyds TSB or Royal Bank of Scotland, or Spain’s Grupo Santander, or the Benelux behemoth Fortis Bank and the often rescued Dexia, Iceland’s Kaupthing Bank, or Germany’s Hypo Real Estate bank (HRE), Commerzbank and many of its Landesbanks, not to mention the financial terrorism unleashed by Anglo Irish Bank or Spain’s still-born conglomerate with the curious name of Bankia. When Wall Street giant Lehman Brothers collapsed, the excessive leverage of many European banks was also exposed. One illustrative example was the Munich-based HRE, which, when it collapsed, required a special law in the German parliament to implement its rescue. Hannes Rehm had recently set up Germany’s Special Bank Rescue Fund.26 ‘I would go so far as to say that not to save this bank would have worse consequences than Lehman’s bankruptcy,’ said Rehm about the HRE rescue (Wilson 2009). HRE cost the German government in excess of €100,000 million. Some of this was due to the acquisition of a Dublin-based subsidiary, DEPFA, which operated out of the very loosely regulated onshore–offshore International Financial Services Centre (IFSC) in Ireland. For more on Irish specifics, see Chapter 1. In the US, the Federal Reserve did what it could to reconstruct Wall Street, but in Europe the new central bank for the euro, the ECB, was unable or unwilling to play the same role. The ECB joined forces with the European Commission and the IMF, forming the now infamous tripartite intervention group. As the European peripheral economies started to collapse, the Troika got to work. The EU in crisis While this crisis is a global one, this book is about its European consequences. Taking both a national and an EU perspective, we

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look at the policy choices made when this credit bubble burst. Both the Eurozone and the ECB were born on 1 January 1999. Just days before its tenth birthday, the ECB was sorely tested by the collapse of the US investment banking sector. With exclusive rights to issue euro banknotes and many similar powers, the proud ten-year-old set about handling its first serious crisis. As we shall show, it was hampered by its very own neoliberal regulatory system and its institutional immaturity. The EU as a free trade zone, and the Eurozone within it, has its own endemic competition issues, which have little to do with the euro. Growth in the European periphery proved particularly easy to finance when global credit conditions were easy. Growth in the periphery outpaced growth in the centre as the unified Germany continued to reabsorb the former German Democratic Republic. In retrospect, there were many other teething problems in the Eurozone, but the external balance of payments issues are of particular importance between European nations. Imbalances reflect the differences between imports and exports between nations in the free trade zone. Many of the countries in Europe’s periphery increasingly imported more goods and non-financial services from the centre than they exported back to the centre. This left the peripheral countries owing money to pay for the extra imports from the centre, generating new sovereign bonds, borrowing to pay for the difference. Nations such as Portugal, Greece and Ireland had not competed economically with France, Germany or the Netherlands for centuries. They now had the same currency. While this brought huge advantages, it also added to the competitive challenges faced by periphery industries. For a simple illustration of these competitive issues, let’s take an example from the south-eastern European tourism sector. Prior to Greece substituting the drachma with the euro, it competed with Turkey and Croatia in a similar tourism market segment. When Greece entered the Eurozone, this gave tour operators in Croatia, and especially in Turkey,27 a competitive advantage over their Greek counterparts. Devaluation, though not a panacea, can be bene­ficial for international tourism. Greece could no longer devalue and yet inflation continued apace in its new hard currency (after the

phillips  |  9 drachma was replaced by the euro), with Greek tourist operators increasing prices year on year. This inflation had previously been counter­balanced – for international visitors with hard currencies – by devaluations in the drachma. Now there was no drachma and the euro was going up in value against the US dollar. It was a double whammy for Greek tourism for non-Eurozone visitors. Price increases were compounded by rising costs in real estate (such as hotels), lowering the competitiveness of the Greek tourism sector. The end result of hard currency inflation meant that Greek tour operators, in price-sensitive markets, lost market share to their neighbours in Turkey and Croatia. They simply could no longer compete. Apart from balance of payments and competition issues, EU ­nations also have varying national corporate tax rates. This situ­ ation is made worse by idiosyncrasies in national laws that enable taxes to drift offshore, with multinationals – using tax avoidance schemes such as transfer pricing and taking advantage of special tax incentives – transferring their EU profits between EU states and then on to tax havens. Perhaps most significantly, from a financial standpoint, EU nations differ as to how they regulate their national financial sectors. These contradictions would blow up in their faces when the domino effects from the US Great Recession brought down some of the biggest banks in Europe. Rescue funds: multilateralism euro-style In an attempt to deal with the 2008 US collapse in private finance, the federal government created various rescue funds to shore up the financial sector. These included the Troubled Asset Relief Program (TARP)28 and the Maiden Lane funds. In Europe, a variety of mechanisms were also put in place to socialise imminent losses in the private sector, backstopping them with national and EU taxpayer funds. The ECB’s neoliberal charter meant that it was unable to dispense funds directly to Eurozone member countries’ central banks, so the European Commission created its own special-purpose vehicles in Europe’s onshore–offshore capital, Luxembourg, to mimic the rescue capabilities of a central bank but in a convoluted manner. The ECB also lowered interest rates to private banks in the hope that they

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would buy up otherwise unpopular sovereign debt, providing loans in long-term refinancing operations (LTROs). After the first ad hoc rescue in Greece, the EU formed the European Financial Stability Facility (the EFSF, in 2010), then the European Financial Stabilisation Mechanism (EFSM, 2011), followed by the European Stability Mechanism (ESM, 2012). Trillions of euros followed trillions29 of US dollars flowing from the public sector in a desperate attempt to prop up the collapsed private financial sector. Europe’s handling of an essentially private financial crisis resulted in a widespread sovereign debt crisis in the EU. Bad debt jumped ship from the private to the public sector. It became the taxpayer’s problem. Terms of the rescue Banks all over Europe recognised their massive exposure to losses from the debt they had bought and sold in the credit boom. The credit bubble burst when the sub-prime crisis hit the US financial sector and when global lending, particularly in dollars, froze abruptly in 2008. Some local European banks had political leverage in their host nations and negotiated for rescue. Banks with exposure to crossborder lending, however, presented more of a challenge;30 this was particularly true for loans made by banks in the centre to banks in the periphery. The European periphery’s banks were vastly over­leveraged and they rapidly collapsed. Neither the banks in the periphery nor the governments that supposedly regulated them would ever be able to pay back all the defaulted debt they owed – even had they wished to do so. This posed a quandary for the banks that had lent them money. How could they reduce their exposure to the collapsing periphery? Put another way: who could pay back their bad loans? According to the principle of creditor co-responsibility, lenders should share exposure to losses with borrowers, especially for recently made loans, which – at least in retrospect – had little chance of ever being repaid. When public debt is being restructured (because it cannot be paid), the term burden sharing is used to describe essentially the same idea – loss distribution or sharing the pain. Lending banks, mainly in the European financial centres, desperately wished to minimise co-responsibility or avoid it altogether.

phillips  |  11 Banking in peripheral countries started to implode quickly in 2008 when the global credit bubble burst. Many banks in the periphery (and some in the centre) are now bankrupt. Their collapse was painful for their shareholders. The bondholders – who had lent money to these collapsed banks31 – did not wish to suffer the same fate. The problem, from the point of view of the remaining solvent banks, was the money they had lent to banks that had collapsed. Although loans to these collapsed banks were private contracts, the strategy of the overextended lending banks was to go cap in hand to their local governments to convince them that they needed help, even when normal banking procedure stipulates that these loans should be (at least partially) written off.32 The EU created rescue funds – under the auspices of the European Commission – to supplement funds from local governments and from the IMF. If the European banks were expert at one thing, it was offshoring to Luxembourg-based funds. The Commission set up its own rescue funds in Luxembourg too, backstopped by EU taxpayer guarantees. The new funds were another rescue opportunity. This time, all of Europe’s taxpayers were on the hook together. The US journalist Bill Moyers interviewed Neil M. Barofsky to discuss the US bailout of AIG on ‘Moyers & Company’.33 Between 2008 and 2011, Mr Barofsky was the US Treasury Department’s Special Inspector General overseeing the TARP. He was a senior fellow in the New York University School of Law and has written a book on bailouts (Barofsky 2012). In the ‘Moyers & Company’ interview, Barofsky put US and European bailouts in context: The real goal in most bailouts is to make good for the counterparties and the creditors, the people on the other side of the trans­ action … when Europe is talking about bailing out the European government, what they are really talking about – when they are bailing out Greece or Spain – is bailing out the banks that lent all the money to those countries. So bank bailouts, or institutional bailouts, or country bailouts, usually all come back to the same thing: making sure that the banks on the other side of these transactions are made whole.

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The ploy worked. With few exceptions (Iceland is one), Europe’s banks were bailed out by the generation of billions of euros of public debt. Public generosity to the banking sector was astonishing, if not downright excessive. First, national governments (both in the centre and in the periphery) dug deep into their taxpayers’ pockets to bail out some of their local banks. In the periphery, however, the situation was beyond the pale. There was not enough money to rescue their hyper-leveraged financial sectors. This posed a problem for the banks in the centre because the leverage used by the banks in the periphery was made possible through money borrowed from them. Peripheral governments generated public debt in an attempt to rescue their distressed private financial sectors, but when this proved insufficient they were forced to take the drastic step of asking for help from the Troika, inviting intervention in their economies. Troika loans and liquidity came with curtailment of the intervened government’s economic duties to its own citizens. Recommended economic policies were laid out in documents that the Troika required national governments to sign – withholding rescue funds until their national congresses ratified these prescriptions. These lists of austerity measures were called memoranda of understanding (MoUs). Former British prime minister, and one of the early adopters of neoliberalism, Baroness Margaret Thatcher, was never fond of the Common Market but she did revel in a good crisis. The Iron Lady used her political slogan TINA (There Is No Alternative34) to push through Thatcherite neoliberal policies such as privatisation and anti-union laws. The Troika is now using the same TINA arguments to bulldoze through its rescue policies, prioritising debt repayments and implementing neoliberal policy measures in the intervened ­nation. This is ostensibly done to force the depressed economies into budgetary surplus, presumably so that they can use this surplus to pay back sovereign debt. Measures written into the MoUs have failed to solve the economic problems in the periphery. Structural adjustments – now relabelled austerity measures – have just made things worse. However, they did provide a breathing space to shift the cost of the crisis from the private sector to the public sector,

phillips  |  13 and there were some juicy discount privatisations of state assets to be bought by private investors. This book Europe on the Brink examines the influence of neoliberal economic policy and its failures in the Troika’s multilateral rescues, from the creation of excess public debt to the prioritised repayment plans (designed to pay back that debt). Clauses in the MoUs include regres­ sive increases in individual taxation, reduced social services and even national escrow35 accounts used to explicitly remove budgetary controls from national governments for certain income streams. In 2014, more than half a decade after the crisis began, the EU is still slipping in and out of recession, and peripheral economies have been brutalised by years of severe recessions. This book asks the hard questions about what the European taxpayers got for their generosity: who benefited, who lost, and what can be done better in the future? Consisting of five core chapters, the book brings together local experts from three affected countries to analyse their own national economic problems, collapses and subsequent interventions: Ireland (Tony Phillips), Portugal (Mariana Mortágua) and Greece (Christina Laskaridis). Different chapters focus on the financial, economic, political and social consequences of the crisis resulting from the redirection of public funds to bail out banks and to pay the increased interest rates on sovereign debt. Two further chapters provide a global context of international government finance from non-Europeans focusing on global issues and on the Third World. In Chapter 5, former Argentine Minister for Economics Roberto Lavagna shares relevant reflections from his experience negotiating the Argentinian default with the IMF and private international investors. This is supplemented in Chapter 2 by a theoretical and practical analysis of the recent history of financial contagion across other regions – such as Latin America and South-East Asia – by Anzhela Knyazeva, Diana Knyazeva and Joseph Stiglitz.

14  |  introduction

Notes 1  An intervention by the Troika entails a memorandum of understanding (MoU) and certain financial support – usually in the form of long-term loans or liquidity measures that are contingent on acceptance of the MoU, i.e. this implies intervention in the nation’s control over its own economy. 2  The European Commission’s Eurostat statistics can be found at epp. eurostat.ec.europa.eu/portal/page/ portal/eurostat/home/. 3  The ultra-orthodox neoclassical economists tend to believe that financial market ‘efficiency’ makes bubbles impossible. Nobel Laureate Eugene Fama of the conservative Chicago School of Economics is one such proponent of the orthodoxy. He is known for his work on asset pricing and the Efficient Markets Hypothesis (EMH). In an interview in The New Yorker, Fama was asked about the burst credit bubble. His answer is revealingly doctrinal: ‘I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.’ Available at www.newyorker.com/online/blogs/ john cassidy/2010/01/interview-witheugene-fama.html. 4  Unorthodox (but still capitalist) economics are typically referred to as ‘heterodox’ schools. For more on combining orthodox and heterodox economics, see Chapter 5. 5  See the ‘Consultative Document’ issued in June 2013 (BIS 2013). The BIS is currently writing new international banking standards for leverage and other matters called ‘Basel III’. 6  Shadow banking consists of off-balance-sheet banking activities, i.e. those that do not appear on public accounting records in order to eschew scrutiny of any kind and oversight by government financial regulators. Lever-

age is calculated using on-balance-sheet assets, and thus it does not reflect the true finances of financial institutions. For more on shadow banking, see www.ft.com/intl/cms/s/0/39c6a41400b9- 11e1-930b-00144feabdc0. html?siteedition=intl. 7  Collateralised debt obligations (CDOs) are an infamous example of repackaged debt, and were one of several channels used to transfer risk between banks and hedge funds. 8  In Europe, various attempts at QE have been made but these have, in fact, led to the creation of little new or useful small business and consumer credit in the ‘real economy’ by private banks in Europe. 9 See The Wall Street Journal’s ‘Comparing debt ratios’ at online.wsj. com/article/SB100014240527487037891 04576272891515344726.html and Eurostat updates. 10  The official name of the legislation introduced by US Senator Carter Glass and Congressman Henry Steagall, and then signed into law by President Franklin Roosevelt, is the US Banking Act of 1933. 11  The ISDA now has over 800 member firms in eighty countries. 12  See ‘Proposal for a Directive of the European Parliament and of the Council on financial collateral arrangements (presented by the Commission)’. Available at eur-lex.europa.eu/smartapi/ cgi/sga_doc?smartapi!celexplus!prod! CELEXnumdoc&numdoc=52001PC0168 &lg=en. 13  A video of Mr Pickel’s testimony is available at www.c-spanvideo.org/ program/RoleofD. 14  Of particular importance were new securitisation mechanisms of bund­ ling debt (credit derivatives in general and credit default swaps) and the advent of the shadow banking system.

phillips  |  15 15  Firewalls against such a financial wildfire had been eliminated at the request of the global financial sector by the US and European governments, and by the European Commission. 16  This is now typically referred to as the ‘Great Recession’. 17  They also cited an employee of the bank. 18  Goldman Sachs & Co. decided to settle the litigation with the SEC, paying $550 million and leaving its ex-employee Fabrice Tourre as sole litigant. 19  The Abacus 2007-Ac1 was a security sold at a value of approximately $2 billion which contained BBB-rated sub-prime mortgage CDOs. 20  Another company based in New York called ACA Management and its parent company ACA Capital Holdings were actually in the middle of the deal and were part of the SEC case. ABN Amro assumed the credit risk for the super-senior portion of Abacus 2007-AC1’s capital structure in the event that ACA Capital Holdings was unable to pay. See www.sec.gov/litigation/ complaints/2010/comp-pr2010-59.pdf. 21  See Litigation Release No. 21489 at www.sec.gov/litigation/litre leases/ 2010/lr21489.htm. 22  Shorting an investment is making a bet that the value will drop. 23  Royal Bank of Scotland later (in 2010) demerged its ABN Amro arm back into ABN Amro. See www.abnamro. com/en/investor-relations/financialdisclosures/archive/subsidiaries-archive. html. 24  The fund was founded in 1994 by John A. Paulson, one of the world’s richest men. See www.forbes.com/profile/ john-paulson/. 25  For an Irish example, see Smith 2013. 26 Finanzmarktstabilisierungsanstalt, the Federal Agency for Financial Market Stabilisation or Bundesanstalt

für Finanzmarktstabilisierung (www. fmsa.de). 27  Croatia, as a member of the EU and a candidate for euro membership, has certain restrictions on devaluations of its currency relative to the euro. Turkey has not. 28  TARP (at $475 billion) proved to be just a small proportion of an enormous US state rescue, as revealed by an audit of the Federal Reserve completed by the US Government Accountability Office in 2011, pursuant to the Dodd– Frank Wall Street Reform and Consumer Protection Act of 2011. For more information, see the various Maiden Lane transactions, which rescued AIG and Bear Stearns, among others. See also the Federal Reserve Transparency Act (2009). 29  Estimates of total rescue funds up to the end of 2013 in the US vary from $7.77 trillion (see www.bloomberg. com/news/2011-11-28/secret-fed-loansundisclosed-to-congress-gave-banks13-billion-in-income.html) to $14 trillion. 30  In the case of international banks, some of this debt was with affiliates and subsidiaries. 31  Many of these banks were situated in countries in the European ‘core’. 32  See Chapter 2: ‘Indeed, by becoming “too interlinked to fail”, the banking system can shift risk from itself to the government.’ 33  The ‘Moyers & Company’ (Web Extra) interview is available at www. youtube.com/watch?v=pcMWc7RPNxI. 34  Generally, Baroness Thatcher used TINA to refer to a lack of alternatives to free trade, free markets and globalisation. 35  An escrow account is a trust account held in the borrower’s name that is used to pay obligations. In this case, the borrower is the intervened nation and the monies held in the account can be taxes, income from privatisations, etc.

16  |  introduction

References Barofsky, N. M. (2012) Bailout: An inside account of how Washington aban­ doned Main Street while rescuing Wall Street. New York NY: Free Press. BIS (2013) Consultative Document: Revised Basel III leverage ratio frame­ work and disclosure requirements. Basel: Bank of International Settlements (BIS). de Morais, P. (2013a) ‘Castigados e ofendidos’. Correio da Manhã, 30 April. Available at www.cmjornal. xl.pt/detalhe/noticias/opiniao/ paulo-morais/castigados-e-ofendidos 002645370. — (2013b) Da Corrupção à Crise: Que fazer? Lisbon: Gradiva Publicações. Eisinger, J. and J. Bernstein (2010) ‘The Magnetar trade: how one hedge fund helped keep the bubble ­going’. ProPublica, 9 April. Available at www.propublica.org/article/ all-the-­magnetar-trade-how-onehedge-fund-helped-keep-thehousing-bubble. ISDA (2001) A Retrospective of ISDA’s Activities in 2000. New York NY: International Swaps and Derivatives

Association (ISDA). Available at www.isda.org/wwa/retrospective_ 2000_master.pdf. Krugman, P. (2013) ‘The 1 percent’s solution’, op-ed column. The New York Times, 25 April. Available at www. nytimes.com/2013/04/26/opinion/ krugman-the-one-percents-solution. html. Lapavitsas, C. (2012) Crisis in the Euro­ zone. London: Verso. O’Hearn, D. (2009) ‘Reassessing the Irish growth “model”’. Paper prepared for an international seminar on Cohesive Growth in Europe after the Crisis, Friedrich Ebert Stiftung, Berlin, October. Available at www. fes.de/wiso/pdf/international/2009/ 231009/02hearn_paper_irish_growth_ model.pdf. Smith, M. (2013) ‘Still waiting for the truth from the regulator’. Village Magazine, 9 April. Available at www.villagemagazine.ie/index. php/2013/04/still-waiting-for-thetruth-from-the-regulator/. Wilson, J. (2009) ‘Hypo reality’. Financial Times, 19 March.

1  |  THE GREAT RECESSION, SPILLOVER IN EUROPE, BANKING COLLAPSE IN IRELAND

Tony Phillips

Introduction This chapter takes a look at the role of the private international financial sector in the European sovereign debt crisis. Traditional economic theory – the neoclassical (or neoliberal) schools – tends to underplay the role of the private sector in the creation of sovereign debt. In retrospect, neoclassical economic theory has had a difficult time keeping up with the changing realities of modern international finance: financial innovation, securitisation and the globalisation of government bond markets. Whether such blindsiding has been intentional or whether it is simply the result of an excessive belief in the mastery of the markets, a few key blind spots in the theory are evident and some of these are covered in this chapter. Unfortunately, due to the prevalence of neoclassical economic theory, these blind spots sometimes lead central bankers, finance ministers and other policy makers to prescribe policies, austerity for example, that serve to tackle only the symptoms rather than the root cause of the crisis. This investigation proceeds by interpreting public sources, particularly the US Senate Banking Committee (SBC) and G-20 announcements, in an attempt to unscramble the concern about ‘spillover effects’ between the US and European economies. The analysis ­traverses a hidden virtual bridge of securitised debt crossing the Atlantic between Washington policy makers and New York finan­ ciers to their European equivalents. The policy perspective is both national and regional (covering the European Union or EU), while also providing a perspective on the globalised private financial sector. This chapter analyses transatlantic influences that affect pro­posals for the resolution of the European sovereign debt crisis. I look at the interactions of the international private financial sector with

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democratic institutions both in the US and in Europe. The sovereign debt crisis in Europe is analysed from a variety of perspectives: finan­ cial innovation; government regulation; channels of international contagion via cross-border finance; and policy response. National policies are decided by politicians, but in close consultation with multilateral debt agencies and the private financial sector. In Europe, there are three multilaterals: the European Central Bank (ECB), the European Commission and the International Monetary Fund (IMF), collectively referred to as the Troika. Apart from examining the in­ effective firewalls in place to prevent further contagion, I also look at proposals for loss sharing as a result of debt restructuring. In the financial world, this is called ‘burden sharing’. In practice, the burden is shared between the private and the public sector. If private debt is made public (or ‘socialised’), debt becomes a moral and a political issue. Former US President Harry Truman used the phrase: ‘The buck stops here.’ In the end, this is where the artificial world of finance meets the more concrete world of democratic decision making. Burden sharing is at the heart of the problem: the buck stops there. Spillover The United States has an ‘immense economic stake’ in Europe, noted Lael Brainard, Undersecretary for International Affairs in the US Treasury. It was 16 February 2012 and Ms Brainard, a Harvard economist, was giving evidence to the SBC hearing entitled ‘Examin­ ing the European Debt Crisis and its Implications’.1 The crisis in Europe had concerned the SBC for quite some time. Those responsible for the US financial system had concerns about their exposure to Europe or what they called the ‘spillover’ to the US economy. The SBC is a forum where regulators from government agencies, especially the Federal Reserve (FED) and the US Treasury, face questions from senators representing US public concerns on finance. The SBC is only one of three such US government legislative forums, the other two being the House Financial Services Committee and the Senate Agriculture Committee, the latter having partial responsibility for the regulation of derivatives (more on this later).

phillips  |  19 The interests of the regulatory agencies do not necessarily coincide with the interests of the private financial sector that they regulate: banks, investment banks, securities and insurance providers, hedge funds, etc. In fact, the private financial industry lobbies the US senators hard to weaken or alter legislation designed to regulate the industry, and the industry is often successful at dodging the bullet. With the interests of the senators not necessarily coinciding with those of the agencies, this dynamic makes for interesting debates. This chapter examines the links and dependencies between the European and US financial sectors, exploring how these relationships affect policy choices for dealing with the crisis within Europe. Private sector interests have a significant influence on European rescue plans, thereby affecting problem resolution. What we now call the European sovereign debt crisis or the Eurozone crisis is in fact a crisis that has had many names. It is by no means strictly European. In fact, it is simply the European face of a globally mobile investment crisis, one with extreme mobility between the United States and Europe. I shall explore various financial instruments and pertinent regulatory decisions that demonstrate this financial interdependence. Along with private and public debt (sovereign bonds), I also examine the role of unregulated derivatives, particularly credit default swaps (CDSs). SBC debates The televised SBC meetings, like those of the house committee hearings, provide a rare glimpse of the interplay between the financial markets, their regulatory agencies and elected government representatives. Using indirect language and codified in insider terminology, the hearings are the WikiLeaks diplomatic cables of the US financial sector. These debates are unfiltered primary sources, which sometimes provide pearls of information of surprising candour. Senate and house committee members are privy to global financial issues not in the public domain. They regularly speak to national and international stakeholders and governments around the world. US national financial policies (such as the new Dodd–Frank Reform Act) affect large-scale international investments and the markets in non-US securities, including European government bonds.

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The two main agencies (the FED and Treasury) giving testimony in these forums are also directly responsible for the global currency of record, the United States dollar. The dollar plays many roles outside the US and permeates many markets: of particular international relevance are trades in financial services, trades in commodities (oil in particular), US share trading (private share trades and trades on listed exchanges) and trades in foreign shares listed on US exchanges (called alternative deposit receipts or ADRs) and, most importantly for countries with weaker national currencies, accumulation of foreign dollar reserves in the US used by national central banks to adjust the relative value of their currencies to the US dollar. Cash markets for illicit goods and certain military goods markets are also widely denominated in dollars. Also of geopolitical relevance is the competition between the US dollar and the euro as the world’s two principal reserve currencies. Sometimes the euro is referred to in the financial press as the ‘un-dollar’. For these and many other reasons, the decisions made by US federal agencies have global implications. Senate and house regulatory committees have goals that are ­broadly aligned with the agencies, but conflicts occur and the committee hearings are a chance for the senate members to broach topics that they find interesting in an on-the-record setting. At the SBC hearings, agency representatives are literally on the spot to answer questions. They play a game of cat and mouse with committee members who ask difficult questions that, in certain cases, agency representatives would prefer not to answer in such a public forum. SBC sessions have two stages. First, high-level agency executives present to the committee, then, after the speeches, the senators are offered five minutes each of question time. Some senators just applaud what they have heard, using their time to thank agency representatives; others take their jobs more seriously and get right down to brass tacks. This chapter focuses on public evidence of important links between the European and the US financial sectors and their relevance to options to resolve the European sovereign debt crisis. Laws governing investor privacy in unregulated financial markets mean that investigations like this one are highly reliant on secondary public sources. The committee hearings are therefore very

phillips  |  21 valuable for the insight they provide into the financial agencies, ­rating agencies and banks and their interactions with the legislatures.

SBC questions on the European crisis  Treasury Undersecretary Brainard was asked about the exposure of the US financial system to the EU’s sovereign debt crisis. Ms Brainard categorised exposure in four segments: direct and indirect exposures to both the EU ‘periphery’ and the EU ‘core’.2 The word ‘periphery’ is an investment term for Portugal, Italy, Ireland, Greece and Spain, sometimes referred to in the financial press as the ‘PIIGS’. The term ‘core’ refers to the financial power of Germany, France and the UK, along with some smaller players such as Belgium, the Netherlands, Sweden, Finland and Austria, and non-European Commission financial players such as Switzerland. When speaking about US spillover, the most important Eurozone nations in the European core are Germany and France. When asked about exposure of the US financial system to the European periphery, Ms Brainard rated US exposure as ‘quite modest’. While from a US perspective this is good news, it also implies that the periphery can expect little direct help from the US, as we will see confirmed in the case study on the Irish ‘rescue’ below. So, if exposure to the European periphery in crisis is ‘quite modest’, why would US senators be interested in a crisis in the periphery? Ms Brainard gave us a small hint: she noted that the Treasury’s focus was on ‘indirect exposure to the European core’. She argued that possible contagion from the EU periphery to the EU core would imply financial exposure in the US too, or, as Ms Brainard put it, if this were to happen then ‘The spillover to our economy matters ...’ Timothy Geithner3 backed up his undersecretary’s assertions on the vulnerability of the US financial system to the core in written testimony to the House Committee on Financial Services. He characterised the risks of spillover in much the same way as Ms Brainard had done: Our financial system has relatively little exposure to the five European economies at the heart of the crisis, but we have significant financial and economic ties to Germany and France and the continent as a whole.4

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Again Geithner reaffirmed his support for the IMF in its role in the crisis, adding that it was good for Europe but also good for the US as its solutions helped to limit damage to the US economy. The IMF has also played an important role in Europe. The IMF has provided advice on the design of reforms, a framework for public monitoring of progress, and support for programs in Greece, Ireland, and Portugal in partnership with Europe, which has assumed the majority of the burden. These actions have helped limit the damage from the crisis to the United States and to economies around the world.

I will come back to direct and indirect exposure when discussing derivatives later. Who regulates global finance? Revolving-door policies between banks and large private financial groups and government agencies blur allegiances between the private and public sectors. This blurring of lines between the regulator and the regulated is referred to as regulatory capture. The European Shadow Financial Regulatory Committee has the following to say on regulatory capture: It is a common phenomenon in all areas of regulation that regulators become ‘captured’ by the industry they regulate, meaning that they take on the objectives of management in the firms they regulate. They may thereby lose sight of the ultimate objectives of regulation. Regulatory capture is particularly serious in industries such as banking where there is a conflict of interest between the firms’ objectives (to maximise profits) and the objectives of the regulation (to provide consumer protection and maintain systemic stability) (Benink and Schmidt 2004: 186).

Regulatory capture occurs to some extent in all nations, but in the US it is particularly important due to the relative size of the US financial services sector and the prevalence of the US financial industry in global finance. Because of links with financial centres

phillips  |  23 in Europe, US regulatory capture matters to European nations too. Global investment banks, some of the largest of which are based in the US, commonly hire senior agency staff or offer them boardroom seats when they complete their term in government. Many agency staff are sourced for their private sector experience and often return to private practice afterwards. A model for such revolving-door policies was Robert Rubin, who in his early career worked at international law firm Cleary Gottlieb Steen & Hamilton.5 This firm is best known internationally for sovereign bond litigation. Mr Rubin then moved on to Goldman Sachs, where he became chief executive officer (CEO) and vice-chairman of the board. From there he accepted an invitation from President Clinton to become US Secretary of the Treasury during the neoliberal hiatus in the 1990s, with Alan Greenspan heading up the FED. Alan Greenspan was sympathetic to free market capitalism and to ideas popularised by the writer Ayn Rand, whom Greenspan knew personally. Ms Rand was one of the philosophical linchpins used by neoclassical economists to argue for minimal government intervention in the private markets (deregulation). In congressional testimony on the 2007–08 global financial crisis, Greenspan conceded that he had made an error on regulation and had put too much faith in the self-correcting power of the free markets. Rubin’s period as Secretary of the Treasury was characterised by deregulation, and especially by resistance to controls on key financial derivatives products and the 1999 repeal of the Glass–Steagall Act. Robert Rubin, supported by Greenspan, also actively opposed giving the Commodity Futures Trading Commission (CFTC), an independent regulatory agency, oversight of over-the-counter (OTC) credit derivatives. Instead, he promoted deregulation policies leading to the Commodity Futures Modernization Act of 2000, which officially ensured the deregulation of OTC derivatives. Many cite such deregulatory changes as contributing to subsequent financial crises. The fact that the European Securities and Markets Authority (ESMA) has banned certain derivative contracts on sovereign debt shows that it also believes that unregulated derivatives have a negative influence in the current European crisis.

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Glass–Steagall was part of the 1933 Banking Act that introduced the US Federal Deposit Insurance Corporation (FDIC). This legis­ lation prevented mergers of entities providing certain key financial functions. In particular, it limited the investment possibilities of commercial bank securities, and banned affiliations between commercial banks and securities firms. Glass–Steagall put a legal separation between investment banking, insurance and retail banking in an attempt to prevent a repeat occurrence of certain risky financial behaviour considered of systemic risk to the US economy before the Great Depression, which began with the famous crash on Wall Street in 1929. With Glass–Steagall out of the way, Citicorp and Travelers Insurance fused as CitiGroup,6 which was, at the time, the largest financial services company on the planet. Former Treasury Secretary Rubin then returned to the private sector, taking a post with CitiGroup. Rubin was later invited back to government to serve under President Obama, during which time CitiGroup was rescued in the 2007–08 crisis. Rubin currently serves as co-chairman of the Council on Foreign Relations, an active forum for coordinating high-level relations between the US and Europe.7 While Robert Rubin may be the most prominent example of public–private revolving-door policies, he is by no means the only one. Former US Treasury Secretary Henry Paulson was a former executive president of Goldman Sachs. In Europe too this practice is common at high levels, with examples including Mario Draghi (incumbent president of the ECB) who was a former managing director of Goldman Sachs International. In fact, high-level public–private flexibility is the norm (not the exception to the rule) in those nations that do not have strict laws to restrict such behaviour. Studies have shown that it is particularly prevalent in Switzerland. In certain countries, specialised firms exploit the policy space between the regulator and the regulated: examples include those who conduct lobbying activities, promoting their services by highlighting their connections with current and former staff from the US Treasury (Braithwaite and Makan 2012).

phillips  |  25 US exposure to the European ‘core’ Undersecretary Brainard’s message was clear to the SBC. It is in the interest of US financial stability that Europe’s financial problems in the periphery remain in the periphery, because if they spread to the core then spillover to the US could occur. It is also in the interest of the EU core nations that further contagion from the periphery is prevented. At the time of writing, the private financial sector in much of the periphery remains on public life support and public sector finances are worse in many cases. Many private banks have received state help by being ‘rescued’, wound down or nationalised, but private financial problems are by no means restricted to the European periphery. Various significant banks such as Royal Bank of Scotland and Northern Rock in the UK, Dexia in Belgium, and Fortis Bank Nederland along with the German banks DEPFA/HRE and Sachsen LB also required state rescues. Contagion continues. If there was a ‘Plan A’ for resolution of the European crisis, it was a desperate bid to eliminate contagion based on the principle of ‘physician, heal thyself’. National financial rescues were proposed where governments were encouraged to rescue their own private financial sectors, especially in Ireland and Spain. The problem with this theory is that, in practice, sick financial systems, especially with imposed austerity and in a contracting economy, rarely have the resources to recover alone. Also, the international nature of banking can mean that nations are unable to solve their own private financial problems; examples include Iceland and Ireland, and may also include Spain. While vulture funds and private capital lurk in the background, the weakened sovereign typically slips deeper and deeper into crisis. Eventually the leaders of nations in the periphery cannot continue alone, so they call in help: first Greece, then Ireland, then Portugal, and then Cyprus. The Troika steps in with its standardised medicine and its basket of public European Stability Mechanism (ESM) and IMF funds and shores up finances with ECB liquidity. Of evident public concern is who will be left to foot the bill for the private financial crises. In particular, there are issues as to whether taxpayer rescues should be used to protect

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speculative loans, leaving the European core (and the US) with reduced exposure. Plan A was that national taxpayers provide funds to rescue their own broken national public and private finances in the periphery countries. This preferred firewall is essentially free to the core and was exemplarily conducted in Ireland, albeit arguably against the interests of Irish taxpayers. As the crisis progressed, public awareness and resistance to such blanket rescues for the private sector at the expense of the public grew, especially in Greece and Spain. Specifically, this doctrine implies that the bill for exuberant lending and bond losses should be absorbed by the country where the banks are located. These banks borrowed money to lend to their public and private clients, and to make investments both nationally and internationally. Less attention was paid to the sources of the money borrowed by these periphery banks in order for them to attain sufficient funds to lend to local clients. In general, EU core countries’ private financial sectors provided these loans (which is why the core is exposed to defaults in the periphery). Considerations such as where the borrowed money was invested also complicate this strategy, especially when collateral for loans lay outside the jurisdiction of the nation guaranteeing losses in its private financial sector. For example, in many cases the loans made in Ireland or Spain were invested outside those countries. These national private sector rescues are called ‘socialising losses’. Losses on private speculative investments are paid for by taxpayers in the societies where the bad loans were made. To make this happen, the provision of liquidity was necessary so that the banks and the governments would not collapse. The ECB, the European Commission’s funds and the IMF stepped in, happy to help out while the supposed recovery took place. In general, this is still the case. Costs are paid in future debt payments by national taxpayers in the PIIGS economies while the Troika controls the peri­ phery economy in ‘recovery’. The gauge for the success of this strategy is not whether the patient dies but whether contagion to the core is avoided. The technique is somewhat analogous to the medieval quarantine of a city

phillips  |  27 with an outbreak of the bubonic plague (or Black Death): casualties in the periphery don’t really matter. What does matter is that the next city is firewalled from contagion. On the positive side, this ‘tough love’ is also profitable to private secondary bond speculation. Unfortunately, even in this case the profits to secondary markets are usually repatriated to other financial centres outside the ailing periphery, so from the point of view of the periphery economy this constitutes yet more losses. Austerity and privatisation Austerity measures and privatisations are the standard recipe imposed by the Troika. Specifically, these ‘competitiveness’ measures include the reduction of the national minimum wage, cuts in ­national government services and national social programmes, personal tax increases and the flexibilisation of national labour laws. In the example of Ireland, all of this was happily put in place by two successive equivalent centrist governments. The only measures resisted in Ireland’s case were increases in corporate taxation. Again, the excuse for imposing costs on individuals rather than on corporations was ‘competitive’ reasons. The long-term implications are that the populations in the peripheral nations will reverse recent standard of living improvements and have many state sectors such as social welfare, water, transport and health privatised for ‘competitiveness’. Particularly important in the short term to bond owners, investors and speculators on secondary markets is the avoidance of sovereign bond defaults. They count on the peripheral governments’ willingness to restructure without default, spreading public debt interest payments over future decades. This may not work in the long term, but speculative investors are rarely in the game for the long term. International capital is also seeking expansion in the provision of services, including private funds ready to invest in privatised state assets (including recently nationalised banks). The European Commission – the largest, most neoliberal multilateral government agency in the world – has been promoting privatisations in the EU for decades, so many former state industries (some natural monopolies, such as water and forests on public land) have already been privatised

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or are earmarked now. Privatisation also offers buying opportunities for financial services providers, such as when nationalised banks are re-privatised. Usually this goes against the ‘too big to fail’ issue, but ‘too big to fail’ can be profitable too. Privatisation doesn’t always make sense. Many services are ‘natural monopolies’, despite neoclassical economics being anti-monopoly. In some cases public utilities have gone full circle. They start out public, then they are privatised, and then they are taken back into public ownership by the authorities (because privatisation didn’t work). Water utilities examples include the cities of Paris, France and Cochabamba, Bolivia, where the municipal water systems, having been privatised, were brought back under municipal control because the privatisation did not work for their captured consumers. In Greece, Ireland and Portugal8 there are still some family jewels remaining, mainly in the resource and services sector, to open up business opportunities for the private sector. If privatisation doesn’t work, these assets can be stripped and then the purchaser has the option of suing the state if it tries to make the assets public again, often leading to lucrative settlements. During the crisis, governments in need of funds often sell off publicly rescued banks and state utilities rapidly and cheaply. In many cases, private banks caused the crisis in the first place, but in politics many have short memories and allow themselves to be convinced of the merits of the competitiveness of the private sector. The mantra is that the efficient private sector will expand into government business via privatisations of inefficient public utilities. As illustrated in the recent movie Catastroika,9 made in Greece, consumers of the privatised utilities do not always benefit from becoming clients of these private industries. Escalation, contagion and burden sharing If there was a Plan A – ‘physician, heal thyself’ – it proved incapable of preventing contagion. National political leaders in the European core and their US interested parties searched for a Plan B that could extend the rescue of their private banks without more contagion. Plan B again required protecting core bank exposure to banks in

phillips  |  29 the periphery (those to whom they had made risky loans). It was optimal to find a way to do this while preventing the triggering of CDS defaults on those same loans (more on CDS later). Extra funds were required to save a collapsing financial sector and to ‘save the euro’ as national coffers were already empty in the peripheral governments. In any financial rescue, a choice is made between enforcing losses on the private sector and absorbing them into the public purse. The national purses in the PIIGS nations were already empty, so IMF and pan-European funds were targeted (such as the European Financial Stability Facility (EFSF) and ESM). In financial parlance, a loss is a burden (either to the lender or to the borrower) and the choice of who pays is called ‘burden sharing’. PIIGS governments could not afford their share of the burden as their debt costs had exploded, leaving them overextended and unable to pay back what they had already borrowed. Hence austerity measures were promoted so that the PIIGS states could tax more and spend less in the future to pay the new long-term debt that had been created so that they could pay their burden share up front, but even this was not enough. If the PIIGS couldn’t (or wouldn’t) pay more, a Plan B was necessary. It was time to push for European public funds, or to force losses on the private sector. Private financial interests in the core (and those exposed to spillover in the US) had an understandable preference for public funding. The ‘solution’ of Eurozone bond funding was raised yet again, and it was resisted yet again by core governments, particularly by German Chancellor Angela Merkel. Merkel knew that further German bank exposure existed but she also realised that her taxpayers were loath to save the banks. For core governments, it was politically easier to channel funds to European rescue funds (such as the ESM) that provide taxpayer-backed stability funds to periphery governments (in the form of debt), thereby providing indirect assurances to the exposure to losses faced by their own private banks. Theoretically, Eurobonds would imply that citizens of the core would pay higher interest rates for future bond issuances than for their current (predominantly AAA) national bond costs. Presumably, Eurobonds would have a cost averaged out over the credit risk of

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the Eurozone members. In simplistic terms, this would mean that nations with high credit ratings (such as Finland, for example) would end up with a higher cost of future borrowing, and inversely the peripheral nations (for example Portugal) would have lower future borrowing costs. Along with the fiscal cost of higher rates in the core, Eurobonds would also reduce national fiscal sovereignty. A less obvious mechanism for the direct purchase of national debt by European rescue funds has equivalent costs for the core and benefits for the periphery. While unpopular with core governments, it was judged less politically risky than Eurobonds and was implemented in an indirect way using funds including the EFSF and the ESM. The German magazine Der Spiegel (2012) reported that, by mid2012, the US and Italy were pressing for the EU to back risks to private banks – a policy also supported by the IMF, whose interests are also closely aligned with those of the US Treasury. Germany’s taxpayers, with the largest economy in Europe and some of its lowest bond rates, would pay the largest national share for such largesse. The Der Spiegel article, entitled ‘Outfoxed by Club Med: German dominance in doubt after [the G-20 meeting at Los Cabos, Mexico] summit defeat’, contained the following revelation in a section entitled ‘Unusual alliance’: During a break, the European members of the G-20 met with US President Barack Obama in a smaller room at the conference ­center in Los Cabos. To Merkel’s surprise, Monti and Obama handed out a document that advocated direct purchases of sover­ eign debt by the euro bailout fund, without special conditions. Hollande and Spanish Prime Minister Mariano Rajoy supported the unusual Italian-American alliance. Merkel was not pleased, and the meeting was adjourned. Others who were present, including European Council President Herman Van Rompuy and European Commission President José Manuel Barroso, felt that it was inappropriate to discuss a dom­ estic European problem with the US president (Der Spiegel 2012).

One might interpret the phrase ‘without special conditions’ as a plea not to force burden sharing on private bondholders – thereby

phillips  |  31 avoiding CDS triggers, as happened to a very limited extent in Greece. Analysing the Greek default, an article in The New York Times10 noted that: A number of economists worried that the ruling that the [Greek] writedown did not trigger a ‘credit event’ would hurt the CDS market, because if borrowers can structure defaults to circumvent swaps payouts, investors may come to see the swaps as unreliable. In the event, the swaps were triggered only on a relatively small pool of bonds with a small net payout. Nearly $70 billion of swaps were outstanding on Greek debt. But the net number was $3.2 billion, which is arrived at by subtracting swaps that pay out on a default from those that get paid.

In the Greek case, the following numbers indicate the profits that were made in CDS speculation and the respective losses to be shared by organisations offering CDS bond coverage, many of whom are based in the US. Because CDS bond coverage is via fixed-length contracts, which expire and end the coverage (they usually last one to five years), this provides an incentive for overexposed sellers of CDS coverage to renegotiate their exposure in times of heightened risk. However, it also provides opportunities for speculators to buy and hold CDS coverage from existing covered bonds to apply to future bond purchases. These are complicated transactions but can provide spectacular paybacks. One can cash in on CDS sales, or one can buy and hold the CDS then get the bond that is covered at a bargain rate and cash in on the CDS payment when the default (a credit event) occurs. Daniel Munevar (2012) describes the build-up and the early 2012 Greek endgame as follows: It was during that period – around June 2010 – that the CDS on the Greek debt started to climb significantly, going from 10 basis points to almost 80 in February 2012. The probability of a default had become much higher than the market agents had previously believed and this affected not only the price of obtaining protection but also the inclination of the financial entities to offer such

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protection in the form of a CDS. With the increased price of CDS on the Greek debt the net positions started to collapse. From a maximum of 9 billion dollars in November 2009 they went down progressively to 3.1 billion dollars in February 2012. And yet, the two phenomena are linked. Given that the payment default was just a matter of time the institutions who initially sold the CDS sought to transfer the risk to third parties, or to reach a direct agreement with the initial purchaser of CDS to end the contract with a cash payment, thus reducing the maximum sums payable in the event of a default … During the sale of 19 March [2012] the securities sold rose to 291 million euro and the retrieving value was fixed at 21.5 cents. The payment value of CDS at 78.5 cents generated payment obligations for a total of 2.5 million dollars, that is, almost 10 times the value of securities exchanged during the bid, for a total of 3.1 million dollars for net positions of existing CDS. This means that in the case of investors who acquired CDS before June 2010 and who kept their positions until the end, these instruments brought them a profit of … 785%! With such staggering profits it is not surprising that CDS have become the perfect tool for large-scale financial speculation.

Greece is a small economy. Many private financial companies abroad who sold CDS coverage on Greek debt were able to get out of the contracts by negotiation or by taking small losses. Also, the default was structured to minimise losses by triggered CDS contracts. Even given all of this, losses (and speculative profits) occurred. If this kind of exposure was there for Spanish, Italian and maybe French (and German) bonds, how big could this problem get? Could it be that private CDS exposure in the US (triggered by private sector burden sharing) was keeping Ms Brainard from sleeping well at night? Cracks appear in the design of Eurozone institutions The ECB, an institution designed by neoliberals, prevented the inclusion of any mechanism for socialisation of troubled national central bank rescues onto the EU taxpayer. While this is both prudent

phillips  |  33 and understandable given the independence of national budgets in the Eurozone, this extraordinary restriction may be the Achilles’ heel of the ECB’s relationship with the Eurozone national central banks. This is compounded by the impossibility of generating ‘Eurobonds’, i.e. bonds denominated in euros but backed by EU guarantees, as against national bonds in euros, which is what the Eurozone now uses for public (national) funding. In the end, this restriction leads to backdoor private fund solutions, which are more expensive in the long run and have also proven to be largely inoperable. The explicit ban of ECB rescues of troubled national central banks – equivalent to US or German federal state rescue mechanisms, for example – demonstrates design flaws in the current Eurosystem. In addition, the implicit trust in the private financial markets to take cheap debt from the ECB and buy state bonds has proved to be unfounded. With direct intervention impossible, the ECB decided to generate a huge fund to be lent to private European banks at low interest rates. The idea was that this extra funding would allow the private banks to afford to buy national Eurozone bonds at lower interest rates while still making a profit. The private banks, however, decided that the public bond investments would be too risky; they bought some bonds but preferred to hoard much of the cheap cash instead or to use it for other purposes. In some cases, instead of buying bonds from their own central banks or from others in the periphery, they deposited the low-cost credit infusions from the ECB back to the ECB itself. Even with spreads of more than 5% between the credit available from the ECB (at 1%) and bond rates in the periphery (some at 7%), the banks still consider bond investments as risky and prefer to take the loans from the ECB and hoard the money by loaning it back to the ECB at less than 1%. This is a clear indication of the depth of the EU crisis, and shows that both the public and the private financial sector are very unhealthy because banks prefer to take a loss by hoarding in the ECB rather than take a chance by loaning to each other or to their sovereign nations.

Regulation and bubbles: swimming naked  Government regulators trying to keep up with financial innovation in opaque markets can

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find it difficult to predict problems during the inflation of a financial bubble. Regulators are also under much less pressure to increase regulation until they are faced with the financial mayhem that can result when these bubbles eventually burst. Warren E. Buffett (chairman of the board of Berkshire Hathaway Inc.) observed: ‘You only find out who is swimming naked when the tide goes out.’ This was only too obvious in the US in 2008; it is now neap tide in Europe. Many banks have collapsed. One might ask questions about why this happened, and how it can be fixed. Bubbles usually begin with a legislative change, such as a deregulation, or as a result of ‘financial innovation’ (i.e. the launch of untested financial products with no regulations in place for unknown side effects). Not everyone is blindsided by the creation of bubbles – especially not insiders in the financial industry. As far back as early 2003, Mr Buffett wrote a famous letter to his shareholders delivered with the 2002 annual shareholders’ report, in which he noted: In our view, however, derivatives are financial weapons of mass des­truction, carrying dangers that, while now latent, are potentially lethal.

One can model the 2007–08 US financial crisis as a run on the shadow banking system. Oliver Huitson cites this in a book review of the New Economics Foundation publication on the UK banking system entitled Where Does Money Come From? A guide to the UK monetary and banking system. Various forms of securitisation have only blown the bubble bigger: by packaging up loans and selling them for cash, the scale of bank lending, and consequently their reserve requirements, is distorted. Securitisation and the wider ‘shadow banking system’ were pivotal in the financial crisis, having ballooned to over $10 trillion in size: the description of 2007/2008 as ‘a “run” on the shadow banking system’ carries a lot of truth (Huitson 2012).

During the period of growth of the financial bubble in the early noughties,11 speculative lending increased due to an ‘appetite’ for risk. Very low interest rates resulted from low perceived risk, but

phillips  |  35 were also the consequence of a change in the nature of the debt itself due to securitisation and the resale of debt, thereby spreading default risk to the buyers of that debt. The ‘growth’ phase of the bubble is rarely seen as a problem; indeed, growth usually implies that a large number of people are making money. Periods of growth are usually considered beneficial, a private stimulus benefiting from the availability of cheap credit as the result of a monetary stimulus – reducing FED interest rates in the US with ECB rates dropping later. In the run-up to the European crisis, this global private stimulus was channelled into risky bets on construction in Spain and Ireland and into increased public bond issuance in Italy, Portugal and Greece from various sources. The private banking sector in the core countries used these un­ usual credit conditions as a mechanism for generating debt cheaply, borrowing in dollars at low rates in the US in order to lend those dollars on in euros at higher rates in the European periphery and elsewhere. This grew the debt bubble. The mechanism of borrowing short at low interest rates and buying longer-term bonds in euros is one example of a ‘dollar carry trade’. This risky tactic yielded the greatest profits in pre-2008 credit conditions but was highly dependent on US short-term borrowing rates and availability. This market froze with the 2008 US financial crisis. European private banks were caught with their pants down. In June 2011, the Graduate School of Business at Stanford University in California organised the Stanford Finance Forum. It was devoted to the issue of bank capital and liquidity.12 Eric Rosengren, President and Chief Executive Officer, Federal Reserve Bank of Boston, gave a speech entitled ‘Defining Financial Stability, and Some Policy Implications of Applying the Definition’. Rosengren discussed money market funds (MMFs) and the European banks. The US MMFs were a largely unregulated source of dollar credit used by the European core banks building the debt boom in Europe. As we can see below, they remain part of the problem, as this hot money from the US was looking for profits in the European bond markets. Rosengren noted that the credit risk in MMFs had not been addressed (even more than two years after the 2008 US crisis). He described this situation as follows:

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There is vulnerability here. So [US] money market funds are looking to have higher yields and one of the ways of getting a higher yield right now is to invest in short-term debt instruments in ­Europe, so they do have exposure to European banks, for example … Similarly, taking it from the perspective of the Europeans, a critical source of short-term dollar financing for the European banks is the money market fund industry. So we have a pairing here that is a systemic vulnerability.

The FED acted quickly to assuage the difficulty in borrowing dollars, fearing that it might spill over into US money markets. At the same SBC hearing in February 2012 mentioned earlier,13 Steven B. Kamin, Director of the Division of International Finance, Board of Governors of the Federal Reserve System, described national central bank coordination as essentially comprising three steps: 1 ‘reduce pricing on dollars swap lines 50%; 2 extension of closing dates; and 3 providing swap lines for other currencies’ (quoted from the webcast of the hearing). So in 2012 the FED used its coordination with the ECB, the British, the Swiss and Asian central banks to feed international liquidity into the system via enormous swap lines between currencies trying to assuage Mr Rosengren’s short-term dollar funding issues, but this just made it easier for hot money to continue its search for the fast buck (or should I say the fast euro).

One bubble leads to another  When the dot.com bubble burst, the FED dropped interest rates. This in turn led to cheap credit in the US, designed to spur US growth. This cheap credit was also available to private banks in the European core. So one US bubble (dot.com, 1997–2001) led to the generation of more cheap credit (monetary easing) and other incentives to invest in real estate, the credit fed into mortgages, which then resulted in the formation of a mortgage/ real estate bubble (sub-prime, 2001–07). Among the financial innova-

phillips  |  37 tions exploited to create the sub-prime mortgage crisis were new derivatives and repackaged combinations of debt (such as repackaged mortgages, loans, bonds and credit card debt). This in turn fed into a parallel bubble in cheap debt in Europe. Private banks in the European core, and elsewhere, exploited this cheap credit as a carry trade on the dollar in Europe. However, in 2008 the US bubble burst, triggering the explosion of the European credit bubble as short-term dollar MMF credit dried up suddenly. As conditions worsened in the periphery of Europe, the European core and the US were looking at much greater default risks on their loans to the periphery. The US crisis has many of the same roots as the European crisis. Common to both are the availability of cheap credit and borrowing for speculation in real estate (mortgages) and other forms of debt; this was combined with ‘financial innovations’ such as the (sometimes false) security provided by CDS contracts. By packaging debt containing sub-prime mortgages with their innate default risks, the banks produced (asset- or mortgage-)backed securities (ABSs or MBSs). These were sold on to other banks, many across the Atlantic in Europe during the US sub-prime bubble formation. This also added to Europe’s financial frailty and dependence. Also, in the European context these problems were compounded by the creation of a new currency, the euro, and the resulting formation of new international markets for lending within the Eurozone. This lending included loans made from the core out to the periphery. The euro offered a false sense of security based on the erroneous impression that countries with the same currencies have the same financial risks – both for sovereign bond sales and in private loans – so interest rates did not reflect true risk, which led to an explosion in bond deals. Structural imbalances in imports and exports There was also the matter of ‘structural imbalances’ in European trade. European nations have always traded with each other, but they have always had certain capacities to protect their own markets: import duties and currency devaluation or revaluation. When Europe instituted a free trade zone (the Common Market), countries lost the first capability (import duties went to zero). When the seventeen

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nations who formed the Eurozone lost their national currencies, they lost the second (no more devaluations). The levels at which certain currencies entered the euro also caused wage inflation in countries with overvalued currencies, affecting their competitiveness. The euro implied that the smallest and the weakest needed to compete – on an even footing – with the strongest and most competitive nations in the Eurozone. Alternatively, they had to fund an increase in their own competitiveness. In general they did neither; they borrowed to increase their wealth and to fund the gap between their imports and their exports. This in turn created speculative mini-bubbles in the periphery such as those in real estate and in bond speculation. By increasing wealth in the periphery, inflation was sparked, including wage inflation, thus making the periphery even less competitive and leading to more pressure on the external sector (exports less imports). This competitiveness gap allowed the more competitive countries, such as Germany, to build trade surpluses, and was responsible for the ensuing need to bridge the financing gap (for the imbalances in imports and exports) through lending by the core to fund peripheral borrowing. The peripheral countries generated more bonds to bridge their funding gaps, paying for the excess of imports over exports (the deficit), and this process was further facilitated by cheap bountiful credit. While trade gaps increased with other non-EU nations, the trade gap in the Eurozone was even worse in the common currency as surplus countries found it convenient to extend intra-Eurozone trade beyond healthy deficit levels by lending to fund more imports. There is more on this in the next section. Gross domestic product The European sovereign debt crisis, we are told, is a result of unhealthily high ratios of debt to gross domestic product (GDP). In Greece and Italy, this ratio has been high for decades. In Ireland and Spain it was low but the crisis forced sovereign debt up and depressed GDP. The higher the debt-to-GDP ratio, we are told, the higher the risk of default. The higher the risk of default, the higher the interest rates on new debt. Higher interest rates pushed up the risk of more defaults by necessitating higher interest payments or

phillips  |  39 more borrowing. This self-fulfilling prophecy is a classic debt spiral. Without intervention from outside this can have only an ugly ending (a default). I have shown some of the dynamics in action with the rise in debt by financing deficits, but this leaves us with another question: what, exactly, is GDP? International economists discuss trade links. Trade happens both internationally, for example between the US and the EU economies or between the EU core and the EU periphery, and nationally, between different public and private sectors in the same country. International trade links are made up of the imports and exports divided into two categories: goods and services. A ‘good’ is a tangible import; by definition, a service is anything traded that isn’t a ‘good’. A crate of wine is a ‘good’ and a phone call is a service, but a loan from a foreign bank to your bank is also a service (a financial service). Trade in goods is more tangible. Within Europe such cross-border trade is promoted by the zero tariff in the EU free trade zone. This makes goods mobile across the EU, especially between the core and the periphery. In terms of mobility, cross-border services move even more rapidly than goods. Certain services are globally mobile at the push of a button, particularly financial services. Financial services also often have zero tariff barriers, even between the US and the EU where tariffs are often imposed on goods (to protect local production). This is one of the reasons why services between developed countries is a huge global growth sector. They are traded freely with neither tariff barriers nor mutually agreed regulations. Many of those services are financial. There are no standard definitions of services but, in general, one might split them into traditional services and financial services. Traditional services are normally work provided by people: people provide services such as accounting and health services, or they provide new categories of services such as software consulting or call centre ‘support’ services. With outsourcing, these services are globally mobile. Some services are more mobile than others: for example, a software service can be provided internationally over an internet connection (obviating the need for travel), while a medical service may require the patient to meet the doctor. A financial

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service, however, such as the sale of an OTC CDS, can be concluded over a digital phone line and an internet connection without travel, instantly and with minimal or no coordinated regulation between states, typically paying zero tax. In the traditional economist viewpoint, human services, utility services and financial services are treated the same way for GDP or ‘trade’ purposes, i.e. they go into the same column in the calculation of gross national product or GDP to compute surpluses or deficits in international trade. Certain economists describe financial services as an economic and legislative blind spot analogous to a driver’s blind spot in a rear-view mirror. This financial blind spot limits the vision of government regulators, especially as regards cross-border banking business. This blind spot can sometimes result in large-scale financial upheaval. As governments play catch-up in their understanding of innovations in financial services, they too are looking behind them at historic problems that led to the bubbles that burst, causing them difficulties in the past. In this case these governments are (in retrospect) looking at the combined destabilising power of both ­derivatives and non-derivative financial services. In the case of government financing sold by the global private financial sector (as a financial service), national and municipal authorities can get out of their depth rather quickly. As we mentioned above, from a GDP perspective, cross-border exchanges of financial service fees are interchangeable with other services, like software consulting, but they are clearly different. Worse still, from a neoclassical economic point of view (in the calculation of GDP, for example), banks are not even part of the picture. In particular, private debt generated by private banks is considered to be irrelevant even if it is internationally funded. The problem is that private debt is clearly relevant to public funds (and therefore GDP), as we have seen in the European crisis. Both the principal and the interest payments on public debt generated from socialised private debt are relevant to GDP. This has a direct effect on the stability of public finances. Some economists criticise the fact that neoclassical economics

phillips  |  41 is designed to be blind to finance – especially blind to private debt, and more particularly blind to derivatives on private debt. One such critic is a prominent Australian economist called Steve Keen. Keen put it this way in a recent article: Neoclassical economists treat banks as irrelevant to macroeconomics – which is why banks are not explicitly included in their models – and regard a loan as merely a transfer from a saver (or ‘patient agent’) to a borrower (or ‘impatient agent’) (Keen 2012).

Keen went on to say: ‘Neoclassical’ economists (who dominate both academic economics and policy advice to governments) have a blind-spot about the role of private debt in macroeconomics, yet despite the economy crashing once before because of it during the Great Depression, they continue to argue that it’s irrelevant now – during this latest crash (ibid.).

Traditional neoclassical economists view finance as ‘capital’ irres­pective of the source of the capital. In particular, neoclassical economics do not model the role of derivatives in how private debt is created. Simplistic economic models assume closed (national) systems and rarely model cross-border agents (such as foreign banks) and the systemic risks they represent. Even the Queen of England was alarmed. Queen Elizabeth II asked some really awkward questions of Professor Luis Garicano, her director of research at the London School of Economics’ management department. Garicano described this exchange as follows: ‘She was asking me if these things were so large how come everyone missed it?’ Garicano told the Queen: ‘At every stage, someone was relying on somebody else and everyone thought they were doing the right thing’ (Pierce 2008). So the neoclassical economists were blindsided and they thought they were doing ‘the right thing’. It may seem patently ridiculous to most non-economists that neoclassical economists don’t traditionally consider how financial services affect economies. The systemic risks of these international links should be part of their economic models. Traditional economists may be blind to the politics of international

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finance, but senators at the SBC are not. As we have seen, they do consider the importance of national and cross-border spillovers from one national financial sector to another. Financial services are by far the biggest and fastest growing service sector across the planet. For a while, just after the 2008 US phase of the crisis, financial services growth slowed down globally. This crisis almost collapsed the US financial services sector and led to multiple bailouts by President Obama. Later, though, when a sluggish commercial recovery began in 2010, the financial services industry recovered (supercharged by bailouts of cheap credit) and risk appetite increased again. Even after the fall of the recently collapsed financial players in the industry, the sector continued to successfully fight regulation, receiving special waivers on new Dodd–Frank and Volcker rules. The blindsiding of governments by the financial industry is, of course, only temporary. Once bitten, twice shy! However, the inventiveness of the financial sector – especially when it comes to complex derivatives – means that it tends to keep ahead of regulation, especi­ ally when it comes to quasi-legal (off the books) inventions such as special purpose vehicles (SPVs), which are typically offshore and therefore beyond national regulation anyway. SPVs combined with other financial innovations have been shown to provide near-fatal flaws in global regulation, as evidenced, for example, when calculating bank stability via ‘stress tests’ that still consider offshore SPVs as virtually invisible. Structural imbalances and their alternatives Ms Brainard implicated European structural imbalances, explaining that: ‘Since the advent of the Euro, very large external deficits were offset by very large surpluses in countries like Germany initially.’ Tariff-free import–export within the EU gives an advantage to large, ‘efficient’ exporting countries, such as Germany. The facility of the common currency means that it is even easier for core Eurozone countries to export more to their neighbours. In bilateral trade terms, Germany usually had a surplus with periphery nations, hence (by definition) those nations had a deficit with Germany. International economists call this a ‘structural imbalance’. Structural imbalances in

phillips  |  43 goods and services are the worst kind of trade imbalances as they are habit-forming by definition and cause long-term financial distortions. Germany and the core exported more to the periphery than they imported from them, so the difference had to be financed by loans. As Ms Brainard put it, ‘private savers were willing to finance that offset’ by buying government bonds from periphery nations. And, she added: ‘Restoring sustainability now requires difficult and prolonged adjustment.’ In free market parlance (the EU and the US are both very free markets), this may indeed be considered the ‘only’ option, but rebalancing exports with Germany is difficult as the imports usually cost less, are of better quality, and/or are marketed better and by bigger companies than local equivalent products. These factors give German corporations competitive advantages, helped by economies of scale and credit facilities offered to German industry by the German banking sector. Other solutions to ‘structural imbalances’ are ‘unorthodox’ and so they are not part of a neoliberal’s toolkit. Difficult and prolonged adjustment (or austerity) is not the only option. Other options ­exist to balance trade, which are sometimes called ‘managed trade’. Ms Brainard was, however, correct as regards the difficulty of the adjust­ment – neither restructuring free trade (to remove structural imbalances) nor orchestrating managed trade is easily done. These adjustments are further complicated when both countries use the euro and are in the same free trade zone. Using the euro removes the possibility of a devaluation, and both countries being in the same free trade zone removes their ability to adjust import tariffs (they remain at zero). This implies that other mechanisms of macroeconomic co­ ordination are necessary but they remain difficult due to the realities of nationalism and competition. Europe has had some successful experiments with managed trade. Research, development and the manufacturing divisions of certain companies have been distributed across national boundaries with some success. Unfortunately (for the periphery), this kind of distribution tends to be concentrated within the core nations. One large example is the manufacture of jet airliners, military jets and space rockets by the European Aeronautic Defence and

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Space Company N.V. (EADS). EADS has major plants in Britain, France, Germany and Spain and makes various military products and the Airbus civil jet airliners. The US does much the same thing, with public-supported private military industries being distributed to states, leading senators to support bloated Pentagon budgets. Such distribution has the desirable effect of balancing trade across regional groupings such as the EU. Managed trade is a non-free trade mechanism that can reduce structural imbalances and that could be used more in Europe to rebalance trade. Contagion via bond speculation We have seen that differences in competitiveness, better finance and economies of scale (aided by buyouts) led to structural imbalances in trade between the periphery and the core, which in turn led to higher debt levels in the periphery. This led to unsustainable debt levels and debt that is unpayable except at exceedingly low interest rates. When the ratio of sovereign debt to GDP rose to the limits of sustainability, the speculative debt markets attacked, generating fear via rating agencies and rises in CDS costs, among other things. This enabled the markets to demand higher bond interest rates for new government bonds, citing falls in sovereign ratings (higher risk for non-AAA debt) and higher swap costs. We have seen that periphery nations (and some core nations) have bloated sovereign debt to GDP ratios. When they were attacked, they were suddenly unable to pay the rates that the markets demanded. This speculative attack had a powerful role in destabilising the bond market in Europe and made the sovereign debt crisis a foregone conclusion: no nation can sustain a 120% or higher sovereign debt to GDP ratio for long in a period of slow (or negative) GDP growth, if interest on its bonds goes much above 3%. The interest payments quickly become too high for governments to pay. The bond markets demanded periphery debt interest at rates of 5% and 7% (2012) for new bonds. For example, bonds issued by Ireland in July 2012 reached the unsustainable rate of 6.5%. The problem, which had begun in Greece, moved on to Ireland

phillips  |  45 and Portugal, but contagion continued. In the case of Greece, the government had actually conspired to hide sovereign credit risk from the ECB so that Greece could enter the Eurozone in the first place. They did this with the help of the US investment bank Goldman Sachs. The details of the Goldman/Greece swap showed the incredible versatility and profitability of the CDS. J. A. Myerson gave some details on this deal in the online newspaper Truthout: It was growth that drove Greece to take out a secret deal with Goldman Sachs in 2001, whereby the country would borrow €2.8 billion and hide the loan under a credit default swap in order to stay within Eurozone debt limits. As part of the deal, Goldman used exchange-rate trickery to slap big-time fees on Greece, to the tune of $739 million, or 12 percent of Goldman’s record $6.35 billion revenue that year. (Lloyd Blankfein, who headed the Goldman unit responsible for the deal, is now Goldman’s chairman and CEO) (Myerson 2012).

With national rescues of private banking – Ireland first, then Spain – the private debt crisis spilled over into the public debt markets, but for a while it stayed in the periphery, giving the speculators time to plan. The sovereign crisis spread to other highly indebted countries such as Portugal. High debt-to-GDP ratios were dependent on growth to sustain them and on cheap credit; both became increasingly unavailable beginning in late 2007. At first it was less evident that the private debt crisis in both Ireland and Spain – nations that had pre-crisis low public debtto-GDP ratios and relatively healthy national accounts – would be vulnerable to a bond attack. But both nations had national ‘regulated’ private banking sectors that were out of control. Their governments were forced to spill this private financial crisis over into their public sector, which added them to the list of Eurozone nations affected by the sovereign debt crisis. Both the Irish and the Spanish governments were arm-twisted into rescuing their national banking sectors, which were bloated with defaulting (post-real estate bubble) and other speculative bad debt. In 2012, Spain was arguably capable of negotiating better terms than Ireland had done two years earlier.

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European Union finance steps in On 23 December 2011, the ECB lent €489 billion worth of three-year loans at an interest rate of 1% to 523 banks in an unprecedented loan programme designed to encourage lending to businesses and consumers and to prevent a credit shortage. The loans, referred to as ‘long-term refinancing operations’ (LTROs), were intended to stimulate some banks to borrow cheaply from the ECB, invest in high-yield bonds, and realise a profit from the difference between the two interest rates14 (a subsidy to the private financial sector and a stimulus in one). Neoliberal economic theory sees no problem in paying free taxpayers’ money to make profits on peripheral debt. It is seen as a good thing. Unfortunately, even with the huge gains to be made from buying national bonds, many private banks were hesitant to take on the risks associated with the faltering sovereign debt market and invested the money elsewhere. As previously mentioned, one extraordinary use of this vast cash flow was that the cheap cash was invested as a deposit back in the ECB at even lower interest rates than the cost of the loan (losing money but gaining access to safe, almost free cash). This forced ECB rates to near zero, leading to speculation that the ECB rate would go negative – as it did in Denmark in 2012 and in Sweden in 2009. Negative interest rates are the sign of a completely stalled financial system, frozen by fears of losses. In February 2012, the ECB again offered the LTROs and 800 financial institutions took €529.5 billion worth, bringing the December and February total to over a trillion euros.15 Although the LTROs created economic stimulus, they also had their critics. Some members of the Eurozone believed that the ECB should avoid such lending practices due to concerns that the ECB would stoke inflation. It didn’t. In July, the EU agreed that the EFSF could inject loans into stricken banks directly,16 but this facility was delayed and made somewhat inoperable. Contagion: the role of derivatives National debt crises often occur in the context of regional contagion: that is, one country’s problems spill over to another. In

phillips  |  47 financial terms, regional speculative attacks are common. A regional debt crisis (from the perspective of the speculative bond markets) is an opportunity to attack – by making a financial bet on bond failure. Regional speculative attacks target nations within the same region (Europe, in this case) and are focused on nations with certain commonalities (such as high debt-to-GDP ratios). The attack is somewhat indiscriminate, not necessarily taking into account differences between national economies. This happened, for example, in the Asian and Latin American regional speculative attacks of the 1990s. It also happened in the ever-expanding European periphery in crisis. Contagion can pass problems between banks in the same nation, between banks in a region and between nations in a region, and, in the current European context, there can be sovereign debt contagion across a growing sub-region (the European periphery).17 Contagion begins with financial difficulties experienced by bank customers in the periphery. If private loan defaults are big enough, the banks become destabilised. If this happens on a sufficiently large scale, it can leave the banks in the periphery in tatters. Many are less than worthless even after state rescues. In Ireland, for example, all the major banks were nationalised except one – Bank of Ireland (BOI). And even BOI received a generous public rescue, with 15% state ownership in early 2013. Once the sovereign is destabilised financially, regional authorities, such as the ECB and the EU Commission’s stability funds, along with global multilateral financial institutions including the IMF, put pressure on the sovereign peripheral governments to rescue their private financial sector. There is usually compliance but, as we have seen, this is not enough to prevent the risk of contagion to the core. Peripheral governments can nationalise private banks and guarantee deposits (even corporate deposits) but paying the loans back from these defunct peripheral banks to private banks in the core (their bondholders) is quite another matter. This requires more money than the peripheral countries can get their hands on. In Iceland this was impossible, so it didn’t happen. In Ireland it happened anyway. Saving ‘bondholders’ was an extraordinary measure judged necessary by the powers that be to prevent contagion from peripheral

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banks spreading to core banks. This rescue approach was accepted by the Irish government and advocated in other periphery nations. The rescued ‘bondholders’ are often private banks in the core that bought bad bonds from peripheral banks (the bonds were origin­ally issued to finance the debt bubble in the periphery). When these bonds faced the possibility of not being paid (a default), an extra­ ordinary rescue was mooted. The more ordinary measure would have been that Ireland, Spain and other nations in the periphery would simply allow their private banks to default on their bonds while providing limited protection to deposits, but this would have transferred the problem to the core. The scale of a bondholder rescue is enormous. In Ireland’s case it multiplied the ratio of the Irish government’s public debt obligations18 (to its GDP) by a factor of five and plunged the small nation into a deep financial crisis that keeps degenerating over time. Even though the Irish government, in late 2013, announced an exit from the Troika programme, it is still questionable whether it can pay this new debt (Whelan 2013). The Irish state’s blanket guarantee produced arguably illegitimate sovereign obligations. However, while ‘socialising’ local debt owed by banks in the periphery to the core may create illegitimate sovereign debt – for example, the sovereign debt might prove to be legally ‘odious’ (Toussaint 2011) – it does work to prevent contagion to the core – albeit for only a short time. This period can be critical if you are sitting on a CDS that is soon to expire. In the Irish government’s case, as we mentioned, the government did not have the money to rescue its collapsed private financial sector. However, the IMF, the Commission and the ECB stepped in, creating liquidity, and lent Ireland the money to do so, thereby ­saving themselves by indebting the Irish taxpayer. Restructuring private core exposure to Ireland's private banks, and thus minimising private bond defaults, was a workable firewall in the short term. But even Ireland’s assumption of questionable new ‘bondholder’ sovereign obligations was an inadequate firewall in the medium term, since it simply transferred the problem to the national public sector, while at the same time moving the risk to the regional public sector (the Troika loans and liquidity measures). Contagion continues to

phillips  |  49 threaten to spread onwards to Spain, Italy and Slovenia, and even in early 2014, the banks continue to gorge on free credit from European public funds with little sign of an end to this crisis. Private investment between Europe and the US Commercial and investment banks in the European core work closely with their counterparts in the US. Massive transatlantic flows of financial services are common. US banks and hedge funds trade in debt, especially new forms of repackaged debt and securitised debt. Banks lend to both the financial and the commercial sectors, covering these loans with CDSs. Banks loan to banks and to nonfinancial corporations. This happens between the US and Europe, and elsewhere. When these new bundled investments were shown to have much less value than their AAA ratings indicated, everything went terribly wrong. First, this nearly collapsed the US financial sector in 2008, and then later the problem shifted to Europe, with a speculative attack on public bonds. One prime culprit was the repackaging of bad mortgages into so-called ‘securitised debt’, which proved to be anything but secure, combined with the role of ‘swaps’. Before getting into the nature of certain ‘swap’ derivatives, it is interesting to note that derivatives are primarily an Anglo-Saxon affair. Many of their initial inventors were educated in the London School of Economics. For more details on the unpatented world of financial innovation, one could do worse than read Gillian Tett’s historic article in the Financial Times on the ‘Morgan Mafia’, replete with fun tales of creative cocktail parties by the pool on the Côte d’Azur or in Boca Raton in Florida (Tett 2006). Ms Tett extended her analysis in her book Fool’s Gold: How unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe, which won the Spear’s Book Award for the financial book of 2009. She investigated the early history of the inventors of credit derivatives; these were mainly British- and US-educated workers at JPMorgan. Since then, derivatives have grown in number and sophistication. Derivative sales took a big hit in 2008 with the collapse of American International Group (AIG), which was followed by a short dip in the number of new contracts, then they recovered and by mid-2012

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derivatives were marching right along, with notional values in the trillions of dollars, eschewing regulation as they went. Growth in derivatives continued through 2013. When JPMorgan was dipping its toes into derivatives in the 1980s, the department was simply called the ‘swaps’ team. In 2000, JPMorgan merged with Chase Manhattan bank and created what was believed to be the largest hedge fund on the planet; the party continued. JPMorgan Chase was listed in 2010 as the third largest hedge fund in the world (JP Morgan Asset Management) with over $46.6 billion in assets under investment. Most of the top twenty hedge fund firms in the world are still based in the US or the UK. Derivatives are key to understanding how the debt bubble in the European private financial sector grew in the first place. Some derivatives are used to hedge the relative movement of currency values: particularly important in the European context are dollar/euro hedges. The volumes of such derivatives trades are in the trillions, but they are not the primary enabling derivatives responsible for the European sovereign debt bubble. This role was played by CDSs. The US dollar carry trade We have mentioned that the US financial collapse put a dampener on the excessive European debt creation and sparked a panic. Much of the debt generated by private core banks had come from funds borrowed in the short term in dollars and lent out, on a longer-term basis, in euros. European banks in the core became addicted to this cheap credit when US monetary easing made borrowing dollars so inexpensive that they could use the difference in low dollar interest rates and higher euro yields to make a lot of money. Financial experts call this kind of financial arbitrage a US dollar carry trade. When the debt markets froze in the US, Europe was frozen out of US markets and the hugely risky game came to an abrupt halt – the problem thus crossed the Atlantic and so began crisis phase II, the European debt crisis: first private debt then, later, socialised public debt. The dependence of the European banks on dollar-denominated loans was revealed when dollar-denominated credit dried up after the US financial collapse in 2008. In an attempt to avert problems

phillips  |  51 in Europe, the US offered currency swap lines in order to stabilise sources of dollar financing to the European banks that were addicted to cheap credit in dollars. Timothy Geithner described this in written testimony before the House Committee on Financial Services on 20  March 2012:19 The Federal Reserve’s dollar swap lines with the ECB, the Bank of Canada, the Bank of England, the Bank of Japan, and the Swiss National Bank have played a critical role alongside the ECB’s direct efforts. European banks borrowed heavily in dollars before the crisis, and many lost the ability to borrow in dollars as the crisis intensified. The Fed’s swaps made it possible for Europe’s banks to borrow dollars from their central banks, which has helped avoid a more rapid deleveraging, reducing the impact on financial conditions in many countries where European banks had lent heavily.

Indeed, big banks in the European core did borrow cheaply in the US in the dollar short-term markets, but this did not cause the Eurozone crisis. It simply added to the bubble of speculative European bank borrowing in US MMFs. Loans made by the core private banks to the periphery entailed some risk, in particular systemic risks to the overheated financial sectors in countries such as Ireland, so insurance was necessary to cover this eventuality. The insurance on these speculative loans was provided by another kind of unregulated derivative, the CDS. In the advanced stage of the credit bubble in Europe leading up to 2007, core banks must have realised that there was an increasing risk that their loans to periphery banks would not be paid back. The CDS coverage helped to assuage their fears, hedging their speculative bets. The following section describes the role that derivatives have had in enabling this crisis and making it worse. It also shows how the crisis might destroy the derivatives sector and the rest of the financial system via contagion that could permeate globally, but that is particularly relevant in Europe and the US, and especially in the financial institutions concentrated in New York and in London that self-regulate and run the International Swaps and Derivatives Association (ISDA).

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The role of unregulated derivatives The first derivatives were farming hedges against bad weather: sales of futures on soft commodities such as bushels of wheat or corn always depended on the weather, so it was useful for farmers and their customers to be able to trade a ‘future’ on this produce. Futures fixed a future (harvest-time) price now for subsequent delivery. This fixed future price gave farmers the predictability they needed to invest in their crops. These derivatives made perfect sense until third parties began to affect the prices of commodity futures through speculation on commodity exchanges. The European sovereign debt crisis is not a weather event but speculation in the CDS market does have a role to play. One bank’s debt is another bank’s credit. If the debtor fails to pay the creditor, the loan goes into default. If the creditor has a CDS on the loan then the creditor has a ‘covered’ (insured) loan. In the event of a default, the seller of the CDS pays the creditor on the defaulted loan. A CDS offers unregulated insurance on loan default, a ‘swap’ being just an unregulated insurance policy. The effect of the swap is to insure the bank that creates the original loan, thereby spreading the risk (at least in theory). According to a 2013 June report on outstanding CDS contracts from the Bank for International Settlements (BIS),20 about 75% of all CDS contracts have a one- to a five-year term: ‘Of the $24,000 Bn. [notional amount] in OTC CDS contracts registered with the BIS, $18,500 Bn. have a 1–5 year maturity.’ This is important as it allows an insurer to get out of a bad hedge in five years on the expiry of the contract. One can think of this as the expiry date for the CDS spillover across the Atlantic. If we consider that the cheap CDS bond coverage stopped being sold shortly before the 2008 meltdown (say August 2007), this means that by August 2012 many of these cheap contracts expired. This is not to say that there are no new contracts. There are. But they are much more profitable for the insurer and therefore more expensive for the speculator buying this CDS coverage, making it more expensive to speculate. So CDS contracts are implicated in both the cause and the effects of the European crisis. We cannot actually see the effect of the CDS

phillips  |  53 market on the interest rates paid on debt by sovereign European nations because the credit default market is opaque and unregulated. However, the ESMA is so sure that speculation on CDSs is dangerous that it has legislated a ban on certain CDS contracts, and has made the ban permanent in the EU. This ESMA ban is on certain so-called ‘naked’ CDSs on sovereign bonds. Naked contracts are speculative in nature, as the default swap coverage is bought on an asset (a bond that may default) that the buyer of the swap does not own. The word ‘naked’ means that the owner of the CDS has no underlying insured bond: this is like having car insurance but not owning a car. A sensible person might ask why anyone would want to have insurance on the risk of a default on a financial asset that they don’t even own. Well, you wouldn’t, unless you were speculating that the risk might change, or unless you have a huge speculative bet on a bond market and your interest is in manipulating that market yourself. Not everyone in the financial sector believes that CDS coverage, even naked CDS coverage, is a bad thing. Certain commentators note that such CDSs increase liquidity. They argue that the existence of CDS coverage has enabled the creation of even more debt. This is certainly true, but CDS coverage has led to even greater systemic risk for the global economic system. For a more positive spin on the ‘social benefits’ of naked CDSs, and a revealing view of the mindset of hedge fund players in the naked CDS bond markets, see Sam Jones’ post (Jones 2010) and other similar writing on the Financial Times Alphaville blog.

Playing the game, owning the casino  Every market has its large and its small players. In the case of private markets, there can be certain advantages in being closely aligned to the rule makers (the large ­players). Private markets can be publicly regulated or not. The ­NASDAQ, for example, is a private market (a stock exchange) that en­ ables regulated trading of publicly listed stocks of private com­panies, these trades being regulated by the US Securities and Exchange Commission (SEC). The SEC does not prevent large players moving markets but it does have certain rules against insider trading and

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provides reporting requirements for executives buying and selling shares in their own companies. In the case of CDS contracts (and most derivatives), the market is, as yet, largely unregulated. In concrete terms this implies that it is largely invisible except when a swap is triggered: CDS contracts are triggered when a loan default happens. Without triggers, only gross figures – such as those reported by the BIS – are available for these contracts. The trading of a CDS is over the counter, not on an exchange. The sale of CDS coverage is made via private counterparty agreements. This means that a bank sells swap coverage to another bank (or hedge fund) and then this coverage can, optionally, be sold on. Neither the SEC, the FED nor the Treasury, nor any other government agency (in the US or in any nation), defines the rules of CDS contracts. These same governments are, however, responsible for mopping up the mess in the case of systemic financial collapses. Moral hazard at work again! Size also matters. In financial terms there are market makers and market takers, and in a market so new that it barely existed in the mid-1990s, there is also innovation. The new derivative-propelled financial system has many moving parts but no central guidance. It is out of control. The new techniques of selling on risk are extra­ ordinarily successful. They helped cause the rapid expansion of a global credit bubble, but in late 2007 violent ruptures appeared in unexpected places: first in the US and Britain and later, in this current phase of the crisis, in Europe. The European crisis can be seen as a somewhat controlled financial collapse: the deflation of a global credit bubble that started in late 2007.

Market maker collusion in the LIBOR markets  At some stage, certain forms of unregulated market collusion had to be called fraud. This term began to enter common usage with the LIBOR scandal, which shocked even the amoral financial industry. In mid-2012, the Barclays/LIBOR scandal taught us that very large banks are not above playing both sides. In the Barclays case – now ‘settled’ via a payment of $453 million to US and British authorities21 – the investigation proved that Barclays employees were influencing

phillips  |  55 global LIBOR rates. LIBOR stands for the London Interbank Offered Rate: that is, the average interest rate on loans that banks are charged when they borrow from other banks. Banks manipulated the rates for various reasons over the years, but particularly to favour derivatives (interest rate or currency swaps) made by the same bank and their colleagues in unregulated derivatives markets. This kind of corruption was uncovered in an investigation by the CFTC, which found that Barclays PLC, Barclays Bank PLC and Barclays Capital Inc. had violated US law in their manipulation of the LIBOR rates. On 27 June 2012, CFTC Secretary David A. Stanwick issued an order commencing public administrative proceedings against respondents.22 Although Barclays agreed to settle with the CFTC for a $200 million civil penalty (and also settled with the US Department of Justice for a $160 million penalty23), the ‘Facts’ section of the CFTC order is quite illuminating. Quoted below from the order is one of very many examples of communications between derivative dealers and those filing interest rates to LIBOR for Barclays. This one refers to a single €50 billion currency swap ‘fixing’. September 7, 2006: Senior Euro Swaps Trader: ‘because I am aware some other bank need a very high one ... if you could push it very low it would help. I have 50bn fixing.’

In the case of CDS markets, very large players can be market makers too. They have the ability to cover speculative European bond purchases with swap cover, giving them a ‘heads I win, tails you lose’ advantage. Corruption is in every market, especially unregulated ones. However, the scope for corruption in the financial derivatives markets is so large that it attracts attention from specialist government agencies and regulators. When problems are discovered they can often be on a mind-boggling scale. Following the 2008 collapse of AIG and Lehman Brothers, various banks collapsed within weeks. The public discovered how integrated ‘market participants’ were: banks, insurance companies, hedge funds, and so on. Everyone was selling on risk to one another. This same risky behaviour, commonly called ‘You

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scratch my back, and I’ll scratch yours’, was unearthed in the audit of the Irish banking sector completed in 2011, for example. The banks were buying each other’s bonds, acting, in effect, as counterparties to each other’s risky behaviour. This behaviour posed systemic risks but obscured this risk while banking leverage increased, thereby allowing the creation of more risky debt. This circular Ponzi scheme created a massive financial house of cards, often bigger than the GDP of the nation that hosted it. Banks would write more loans, securitise that debt, then sell it on again. This ever-expanding roulette wheel had unexpected wobbles, which meant that certain players lost their shirts, but the banks and the hedge funds that were market makers had the ability to re-stabilise these wobbly moments and survive or even make money. In the end, the merry-go-round stopped in 2008. It had become so large and unwieldy that it collapsed under its own weight when the US MMFs were pulled out from under it. At the centre was a cadre of US and European banks with AIG at the hub. When the music stopped, they were all effectively broke. The FED and the Treasury considered that they had no choice but to step in and rescue the majority of them. Banks operated with different rules in the credit bubble expansion. Whereas previously a bank sold a loan to a client and remained responsible for the risk on that loan till the principal was paid back, with interest, now banks created the loans then sold on the loans to each other (sliced and diced into complex derivatives called collateralised debt obligations or CDOs) with mixes of debt from credit cards, mortgages, government and corporate bonds, for example. They then sold these to other organisations that created even more complex derivatives to hedge their risk, and so on. In financial jargon, the CDSs acted as hedges on the CDOs, which were a form of complex securitised debt. This complexity for the traders meant that they could sell more and more new ‘products’ and make more sales commissions. For the banks, it meant that they could sell on default risk on loans that they made (or bought from others) to other organisations in a secret market (OTC) and thereby they could offload risky assets and increase leverage. On a systemic level, this means that there is more and more risky debt

phillips  |  57 being created and no one really knows the systemic consequences of a shock to the system. This high-octane finance is like building experimental skyscrapers in an earthquake zone with no regulation possible. Rules are not available because of the novelty of the materials being used and the new construction methods, and because the construction of this market is private and has its own private construction regulations. OTC finance is, in short, self-regulated, which in the systemic sense is the same as being unregulated. If there is an earthquake, the buildings might collapse and people might get hurt, but the manufacturers of the materials are so long gone that it will be someone else’s problem. It will be the problem of the individual investors in the buildings and of the people who live in those buildings. In the end, it becomes the government’s problem. The central banks and the finance ministries have to clean up the debris of their financial sector gone mad.

Credit events and naked CDS  The University of Iowa Law School’s Center for International Finance and Development has published an interesting analysis of the use of naked CDSs. This e-book,24 entitled Global Money, the Good Life and You: Understanding the local impact of international financial institutions, explains the European naked CDS ban as follows: CDSs are essentially bets on the likelihood of default for a given bond issuer. Investors use CDSs to hedge, speculate, or reduce the impact of losses on their bond holdings that run the risk of default. A CDS is ‘naked’ when the buyer of the CDS does not own the underlying bonds the buyer purchased the CDS against. The ban, which attempts to prevent speculative purchases, means that unless investors were hedging their interests in Eurozone debt that they owned, they would not be permitted to bet on – and poten­tially profit from – the likelihood of such bonds defaulting. The risk of potentially huge CDS bets was a greater concern because CDSs are unregulated and can generate massive losses that would further destabilize markets.

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German Prime Minister Angela Merkel’s proposed ban on naked short selling and taxes on the purchase and sale of certain securities along with her insistence on quelling speculative investments made her unpopular to some in Germany and abroad. However, as the crisis continued, more Europeans endorsed her position.

Those familiar with the US 2008 financial collapse might recognise these investments. They were a major factor in the collapse of AIG. When AIG collapsed in the 2008 (US) financial collapse, it was due to AIG’s exposure on CDS contracts that it had issued. European banks did particularly well on these CDS contracts, and AIG (then rescued by the US government) paid out handsomely. Bloomberg reports that two of the top three payments to counterparties were to core banks in Germany and France: The largest recipients were Société Générale, which got $4.83 billion, Goldman Sachs with $2.97 billion, Deutsche Bank AG with $2.92 billion, Calyon Securities with $1.89 billion and [the former investment bank bought by Bank of America in the crisis] Merrill Lynch & Co. with $1.32 billion (Son 2008).

The University of Iowa analysis also discusses how CDSs played out in the Greek bailout: Ironically, one culprit in the potential downfall of the negotiations was the same one that played a major role in the U.S. financial crisis – the credit default swap (CDS). Many hedge funds employed a controversial investment strategy using CDSs where they were assured profits whether Greece defaulted or not. Of the €200 billion of Greek bonds at issue, it is estimated that hedge funds owned €70 billion. In theory, by owning the CDS the investor was ­guaranteed the full value of the bond in the event the underlying bonds defaulted. Because Greek bonds were trading so cheaply, investors could purchase Greek debt with a face value of €100 million at a significant discount, say €30 million. By purchasing CDSs on the same bonds (which cost much less than the bonds) the investor stood to recoup €100 million on a €30 million investment (minus the cost of the CDS) if Greece defaulted. Thus, these

phillips  |  59 investors had no incentive for the restructuring negotiations to be successful.

Put another way, by manipulating CDSs correctly, investors can cover their bets: ‘Heads the investor wins, tails the Greek taxpayers or the seller of the CDS loses.’ In order for the bet to pay off, the Greeks had to default, creating a ‘credit event’. As the CDS market is as yet largely unregulated by national governments, whether a ‘credit event’ has occurred is determined by the ISDA. The procedure is explained in the following article from the Financial Times (Oakley and Hope 2012): Evangelos Venizelos, finance minister, told parliament on Wednesday the CAC [collective action clauses] legislation would be officially published by Thursday night, so that the tender offer can go out to bondholders on Friday. He said that bondholders would have 10 days to decide whether to participate. Bonds would be exchanged between March 9 and March 12. Once this has taken place, an investor holding Greek CDS, such as a hedge fund or bank, may well ask the ISDA committee to declare a credit event. The committee’s voting members will then make a decision. This will be followed by an auction, organised by the big banks, that will decide the recovery rate for the CDS, which is typically set in line with market prices.

In other words, a large speculator (with the possible capacity to move bond markets) could, in theory, buy cheap CDSs (at a discount possibly affected by a market-mover manipulation) and wait to buy cheap bonds. If the default happens, the CDS coverage on the bonds could pay more than the offer by the Greek government. So it pays better in such a situation to hold out on the bond restructuring than to settle with the Greek government. Again from the Iowa study … On March 9, 2012, the Greek government announced that 83% of bondholders had accepted the terms of the debt restructuring

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deal that Eurozone finance ministers had agreed to on February 21, 2012. The government indicated that it would invoke collective action clauses (CACs) to bring the participation rate up to 96%. Greek laws (as amended in February 2012) permitted the government to bind investors that purchased bonds under Greek law with the consent of two-thirds of such bondholders. By invoking the CACs, the Greek government created a ‘credit event’ that triggered payouts on the CDSs. Approximately $3.2 billion worth of CDSs were outstanding at the time the restructuring was announced and holders of the CDSs received $2.5 billion or 78.5% of the value of the underlying bonds.

A figure of $2.5 billion is a high payout for bond coverage in one credit event. Also, it is important to realise that this one credit event is just one restructuring for just one default for one small European country. Depending on where the company that sells the credit default insurance is based, the seller of the CDS coverage on the Greek bondholders could offer a bridge of contagion across the Atlantic between insured bondholders in the European core and CDS vendors in the US. This is one aspect of what Ms Brainard cryptically described as indirect (US) exposure to the (EU) core. In Greece, credit events have received a large degree of media exposure, especially in the financial press, but a small credit event happened in Ireland that was barely noticed. This event was a private default on private debt (a bond owned by a large private Irish bank, subsequently nationalised). This default is especially interesting for the alleged US political intervention that happened in the Irish Troika rescue. The €2 billion bank bond default in Ireland in 2011 A sizeable private default occurred in Ireland in 2011. This was not a sovereign default; rather, a private bank (called Allied Irish Banks or AIB), which had funded its lending in the boom by generating bonds and selling them on to other banks, some as unsecured ‘buyer beware’ bonds, had run out of rope. When AIB could no longer

phillips  |  61 borrow, it defaulted on its unsecured bonds. These private bond defaults don’t happen so much any more in Irish financial circles since the Irish government intervened by nationalising AIB (and other banks) and providing generous ‘blanket’ bank guarantees to its financial sector and its creditors. The Irish government continues to make payments on this new sovereign debt, much of which was created by blanket guarantees designed to rescue the private banking sector. This AIB €2 billion default is significant even though it received very little press coverage.25 Perhaps the most noteworthy aspect of this private bond default is how owners of the defaulted AIB bonds made calls on CDS coverage amounting to approximately €500 million (BBC 2011). Yes, the owners of defaulted AIB bonds (principally banks in the European core) went after the CDS insurance instead of the Irish government (at that time a majority shareholder in AIB). AIB stopped paying interest on some of its bonds and postponed their repayment dates. Nothing happened; the world did not come to an end; the bank continued to operate; the ATM machines functioned. After a waiting period of a few days, the periodic payment on the bond  was still not received. The Determinations Committee of the ISDA voted unanimously that ‘yes’, a ‘credit event’ – a technical default on private AIB bonds – had indeed happened26 and the swap  insurance should be paid. The ISDA is judge and jury on unregulated insurance derivatives such as CDS payouts. This is how international private financial contracts involving private bonds, with private CDS coverage, are supposed to work: private coverage protected private risk. Unfortunately for the Irish taxpayer, this was not the norm for Ireland’s overextended private banking sector. AIB, in early 2014, is more than 98% owned by the Irish government, which chose to ‘recognise’ even some unsecured bonds in the Irish blanket bank guarantee.27 By making that decision and standing by it later, the Irish state prevented some private bonds from defaulting on their private loans; the Irish government even felt that it was necessary to provide cover for bonds with private CDS coverage. Rather than calling in CDS coverage, in the case of further bank defaults covered

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by the guarantees, bondholder losses were to be borne by the Irish people. The rescue debt, a €90 billion elephant in the room, seems to imply that the Irish government’s guarantee to the bondholders may have been one huge mistake, at least for the Irish taxpayers. Renegotiation attempts by the Irish government in the subsequent Troika rescue seem to indicate that the government expected that it deserved a break for its generosity. Unfortunately, as Morgan Kelly, an Irish academic economist from University College Dublin, wrote at the time, this was not to be. Mr Kelly alluded to this expectation in his Irish Times opinion piece on Saturday 7 May 2011, entitled ‘Ireland’s future depends on breaking free from bailout’. He was referring to new sovereign bank rescue debt, much of which was the result of the blanket bank guarantee. At first, according to his opinion piece, the IMF was willing to share the burden, but unfortunately for Ireland, the US was not. The IMF, which believes that lenders should pay for their stupidity before it has to reach into its’ [sic] pocket, presented the Irish with a plan to haircut €30 billion of unguaranteed bonds by two-thirds on average. Lenihan [then Ireland’s Minister for Finance] was overjoyed, according to a source who was there, telling the IMF team: ‘You are Ireland’s salvation’ (Kelly 2011).

But, Mr Kelly informed us, this deal offer was torpedoed from an unexpected direction: At a conference call with the G7 finance ministers, the haircut was vetoed by US treasury secretary Timothy Geithner who, as his payment of $13 billion from government-owned AIG to Goldman Sachs showed, believes that bankers take priority over taxpayers. The only one to speak up for the Irish was UK chancellor George Osborne, but Geithner, as always, got his way (ibid.).

Geithner had vetoed burden sharing; the Europeans had to clean up their own mess, and the Troika felt that this new debt was a sovereign obligation of the Irish state. This might be interpreted as yet more evidence that the US government was cautious over US CDS exposure to the European core. This vetoed haircut in sovereign

phillips  |  63 debt obligations makes the Irish state an even better global financial citizen (by rescuing its banks without triggering more swaps). Morgan Kelly went on to imply that this was: ‘An instructive, if painful, lesson in the extent of US soft power, and in who our friends really are.’ US swaps risk to Ireland’s financial sector are minimal, as Ms Brainard informed the SBC, but what would happen to the fragile US economic recovery if all of the European peripheral nations and all of their interconnected loans defaulted, and CDS owners called in the swaps due to non-payment on bonds bought by the banks in core countries? Could it be that the implosion of the derivatives bubble of securitised debt would come home to roost in New York? Maybe Mr Kelly was a little naïve to think that the US might put Ireland’s needs over its own, especially since Ireland continued to play ball anyway. The former Irish Minister for Finance, Brian Lenihan, died in 2011. In June an obituary in the English Daily Telegraph newspaper28 affirmed the theory of the large, possibly systemic, risks to the US economy. In particular, it seems Timothy Geithner was preoccupied by €120 billion in swaps exposure. The obituary had the following to say about Geithner’s preoccupation, and added details on why the UK government tried to stand up for the Irish deal: Pressure [on Finance Minister Brian Lenihan] mounted from the United States government to underwrite the debts – Timothy Geithner, United States Secretary of the Treasury, feared that an Irish bank debt default, while not threatening of itself, could have spread contagion to the entire European system, to which American-backed ‘credit default swaps’ were exposed to the tune of 120 billion euros. This was later confirmed by State Department cables leaked through WikiLeaks. Alistair Darling, then Britain’s Chancellor, was severely critical of the guarantee, which put the British financial system at a disadvantage in the markets.

More recent evidence is provided on US CDS exposure in an Organ­isation for Economic Co-operation and Development (OECD) study entitled ‘Solving the Financial and Sovereign Debt Crisis in

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Europe’ by Adrian Blundell-Wignall (2012). Mr Blundell-Wignall is the Special Adviser to the OECD Secretary General on Financial Markets and Deputy Director of the Directorate for Financial and Enterprise Affairs (DAF). His study indicates that US CDS exposure could be much higher than estimated in the Daily Telegraph. Without even mentioning large financial economies such as the UK and Germany, Mr BlundellWignall notes in section eight of the report (‘Cross-border exposures to Italy, Spain and France are the problem’) the peculiarities of the statistics in Table 3 on page 13 of his study. This table is entitled ‘Cross-border exposure of banks’. It indicates that approximately 70% of total bank exposure to Portugal, Ireland, Italy, Greece, Spain and France is underwritten by US banks: One surprising feature of the table [Table 3] is the interconnectedness of US banks to Europe in the case of CDS derivatives (for all sectors). Cross-border guarantees extended including CDS to securities of the six countries [the PIIGS and France] on the left are large (US$ 1.2tn), with US$ 344bn from EU banks and a much higher US$ 865bn from US banks (US$ 347bn to France, US$ 238bn to Italy and US$ 149bn to Spain). This diversification of risk makes sense for Europe, but it underlines how the EU crisis could quickly return to the United States in the event of insolvencies within Europe (ibid.).

In the above mentioned SBC hearing on the European situation, a senator cut straight to the chase, asking FED representative Steven B. Kamin about indirect exposures, mentioning derivatives. Kamin was coy in his reply, saying that alertness of the Financial Stability Oversight Council (FSOC) was high and they were closely monitoring the ‘European situation’. FSOC is a US federal government organisation, established by the Dodd–Frank Wall Street Reform in 2010. FSOC has broad authority to identify and monitor excessive risks to the US financial system arising from the distress, or failure, of large, inter­ connected bank-holding companies or non-bank financial companies, or from risks that could arise outside the US financial system. If FSOC is monitoring the situation, it is because risk exists.

phillips  |  65 Geithner too pleads for derivatives regulation For historical reasons, the US derivatives market is regulated by the Senate Committee on Agriculture. Secretary Geithner, Ms Brainard’s boss, spoke to this committee29 on what he then considered to be a critical component of financial reform: the framework of oversight of financial derivatives. In his speech, Secretary Geithner emphasised the reforms of the $600 trillion derivatives market, which grew up ‘on the financial frontier’ without the basic protections and oversight that exist in much of the rest of the financial system. Market participants, he said, were ‘basically being allowed to write their own rules’. This enabled firms to make huge bets using credit derivatives without regulations that required that they had the capital to back up those commitments. At the sure risk of understatement, Mr Geithner went on to say that such firms were unable to cover these bets when the recession hit. Operating largely in the dark, the credit derivatives did not cause the crisis, Mr Geithner said, but it made the crisis ‘much harder to manage’. Mr Geithner stressed the damage that these derivatives had done to the US financial system in the crash of 2008, citing a ‘catastrophic loss of basic faith and confidence’ and ‘enormous damage in our financial system’. The G-20 governments were also concerned with the regulation of derivatives. The June 2012 leaders’ declaration from the G-20 meeting in Los Cabos, Baja California, Mexico,30 included a whole section (numbered 39) on derivatives regulation: reaffirming our commitment that all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 [sic], OTC derivative contracts should be reported to trade repositories and non-centrally cleared contracts should be subject to higher capital requirements.

In other words, the G-20 was against an outright ban on such derivative contracts; instead, the governments wanted them regulated and sold on an exchange (not as an OTC private contract). This would, in theory, give visibility to the now opaque OTC CDS contracts; in practice, it didn’t. The G-20 also called for measures to ensure that

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CDS sellers had sufficient funds to pay the insurance on a default if the ‘credit event’ happened (something that would have been impossible in the case of AIG in 2008), thereby minimising the risks of massive uncovered hedges and reducing the scope for speculation, but even this was to be considered too much government interference. The moral of the story While it might be hopelessly old-fashioned to seek ethics (or ­morals) in the world of finance, once private debt becomes a sovereign liability then it is no longer a private issue. If that sovereign debt requires restructuring, for example because socialising the debt on the public was illegitimate, or because the state cannot, or will not, pay the debt, then the ethical issues of financial contracts are applicable and scrutiny by legal and democratic institutions is appropriate. The institutions that can scrutinise contracts include national courts and European regional courts (and financial ombudsmen, for example), and, of course, national parliaments and the European parliament can make their own decisions and demand their own inquiries. This has indeed already happened in various nations. There are also strong arguments that ethics, or at least strict regulation that reduces and defines corruption, will have to be reinstated in the private financial markets both in Europe and globally. This should be done to attempt to prevent a recurrence of such financial disasters in the future. In short, a rebalancing of global private financial power and sovereign state democracy shall happen (one way or another). The current realpolitik of sovereign financial negotiations means an uneven playing field between the intervened nation and the Troika. The multilaterals (in the Troika) are usually more interested in preventing Europe-wide systemic risks than in sovereign justice. Loan renegotiations are typically heavily influenced by decisions made in the private sector and their influence over national governments or clubs of nations such as the Paris Club.31 It is not so long ago that extreme arm-twisting – sometimes called ‘gunboat diplomacy’ – was also an option in debt negotiation disagreements. This term has been used to describe the pounding of the Venezuelan coast by German and other European naval vessels in the 1902–03 Venezuelan debt

phillips  |  67 crisis. The Venezuelan bombardment was the result of the request by private creditors, made to a new Venezuelan government, to reconsider their default on private German debt. In this case, the debt was owed for repayments for development projects such as the Krupp Great Venezuela Railway Company.32 In the end, the Venezuelan case was referred to the Permanent Court of Arbitration in The Hague, founded in 1899,33 and Venezuela lost. European voters in the twenty-first century will continue to face perplexing moral dilemmas when making democratic decisions as to who should pay for the current phase of the global crisis. While this will necessitate the co-participation of creditor and debtor burden sharing, the degree of loss borne by the taxpaying public should have an inverse relation to the moral hazard in the debt contracts. The more risky (or speculative) the loan, the less the public should have to pay. For more ideas on justice and debt, see Chapter 5. In the end, courts will deliberate on bonds bought by the private sector and issued by the public sector (or by the private sector rescued by the public sector). In particular they need to decide whether the seller knew full well that the bond could never be repaid. In so ­doing, the court can choose how the burden (loss) is shared between the debtor nation and the private bondholder. Unfortunately, such a decision is difficult to make, as we have seen in the case of the Greek bond restructuring. Many questions remain as to how this can be done in the future. How much can the debt be restructured? What to pay and what not to pay? Should the debtors and the creditors meet in the middle? Where is the middle? Who is responsible for international arbitrage on European debt contracts? In whose courts are the contracts renegotiated, and which law applies? Then there are systemic issues, such as whether it is more important to save a decadent international financial system bloated with toxic debt or whether the risk of collapse should be accepted, risking a simpler ‘jubilee’ approach: cancel all debt contracts and begin anew! If there is a moral issue that is accepted in the financial industry it is the issue of moral hazard, a sort of mea culpa of a financial debt industry that is ultimately driven – like all finance – by greed. Creating private debt contracts, with banks that obviously can never

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pay them back, and then putting the gun to elected governments in the periphery – threatening them with the collapse of the private financial system or expulsion from the euro if they don’t pay – could also be interpreted as moral hazard. In order to eliminate this kind of systemic moral hazard, some form of effective government co­ ordination (at a global- and EU-level) will need to effectively counter the power of the financial sector. Eventually, the European sovereign debt crisis will end with a negotiated solution where the balance of the losses is shared by the public purse of certain nations and the private banks that will most likely face consolidation, becoming fewer in number. There may also be a choice by certain nations and the Eurozone to take certain private financial services public (i.e. not just nationalising banks but keeping them national, running them as utilities rather than as private profit centres) and to create permanent new institutions to replace bailout funds that will require public oversight, such as a European Monetary Fund, as suggested in 2014 by the European Parliament. Lessons learned will imply a restructuring (or the collapse) of the Eurozone and a renegotiation of fiscal issues and relationships between the ECB and the national central banks in the Eurozone. This has already begun with small steps such as the fiscal treaty, but these are clearly insufficient to prevent future crises (nor can they even fix the current one). A balance between public stimulus and austerity measures will need to be reached. These economic changes will have to take place in the context of other non-economic realities such as the replacement of fossil fuel use to prevent catastrophic climate change and the ageing and shrinking European population. It won’t be easy, but a new Europe will probably be a better one, and, one hopes, a more democratic one. Conclusion Circumstantial evidence has been presented that the European debt crisis is just another phase of the collapse of a giant credit ­bubble that crossed from the US to Europe, but which remains anchored to the US by swap coverage and other financial and commercial links between the two continents (referred to as spillover).

phillips  |  69 This has been complicated in Europe by five factors: 1 a private financial industry addicted to the creation of Eurozone debt in the periphery; 2 an industry that, until recently, mistakenly believed that eurodenominated sovereign and private debt had similar risks in financially diverse Eurozone nations; 3 a new regional currency, the euro, built using a neoliberal financial model; 4 structural problems in the relationship between an ‘independent’ ECB and dependent national central banks in the Eurosystem, and the lack of Eurobonds or a stimulus mechanism such as another European development bank; and 5 global systemic issues such as the creation of CDS coverage in the late 1990s and the lack of regulation of US dollar-­ denominated MMFs. I have shown that one key part of the puzzle that enabled both the creation and the bursting of this bubble was the distribution of risk via the use of derivatives such as CDSs, and that this is also partially responsible for irresponsible lending practices in sovereign debt markets. I have shown that certain CDS contracts are considered by both US and European governments to be systemically risky, leading to a partial, but permanent, ban on naked CDSs in Europe. I have argued that concerns over triggering CDSs have been a major new complication in sovereign debt negotiations in Europe, particularly in Greece (and to some extent in Ireland) and that these concerns have influenced what would otherwise have been more independent policy options in Europe for resolving the sovereign debt crisis. I have shown that speculations in the swap markets lead to holdout behaviours and generally make restructuring sovereign debt even more of a political minefield than before. Finally, I have shown that contagion risk to the European core poses risks to the US financial sector and that this also relates to CDS contracts that have yet to expire. Much of the really cheap CDS coverage (five-year contracts created before the crisis) should have expired already, so there should be more room to manoeuvre now.

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While the inner workings of the self-regulation of the ISDA are by definition only partially available to non-participants, there is strong evidence of risks to the private banks of the European core, with probable spillover effects to the US and other countries. I have also shown that public deregulation and private financial innovations, both in and out of the derivatives sector (concentrated in the US and to a lesser extent in the UK), have resulted in speculative lending in both the private and public sector in the European periphery, and that this has been part of the root cause of the sovereign debt crisis in Europe. I have also shown that international actors could be severely affected by choices of burden sharing made by Eurozone governments and the Troika. This chapter argues that European citizens should be involved in deciding who is really responsible for creating this huge debt bubble and in the democratic decision about how Europe will handle burden sharing (including creditor responsibility) – such as when international public and private loans are created with ex ante knowledge of the risks of non-payment. Finally, it argues that the private sector that created this debt in the first place must be made to accept its part in the responsibility for eliminating debt from the Eurozone system and in the resolution of the sovereign debt crisis. Notes 1  See the website of the US Senate Committee on Banking, Housing, and Urban Affairs at www. banking.senate.gov/public/index. cfm?Fuseaction=Hearings.Hearing& Hearing_ID=46c5d29a-b9c9-4b89-9c5446b87d95d65b. 2  The term ‘core’ is synonymous with ‘centre’ as used in other chapters of this book: one can divide Europe in economic terms into centre/periphery or core/periphery. 3  On 16 November 2013, Warburg Pincus, a private equity firm, announced the appointment of Timothy F. Geithner as president and managing director,

as well as a member of the executive management group. See the news release at www.warburgpincus.com/ PDF/Warburg%20Pincus%20News%20 Release%2011162013.pdf. 4  ‘Written testimony of Secretary Tim Geithner before the House Committee on Financial Services’, 20 March 2012. Available at financialservices. house.gov/UploadedFiles/HHRG-112-BAWState-TGeithner-20120320.pdf. 5  Cleary Gottlieb Steen & Hamilton’s role in Greek debt negotiations is discussed by the excellent financial journalist, Felix Salmon, at blogs.reuters. com/felix-salmon/2012/01/18/greeces-

phillips  |  71 game-plan/. The firm has also been involved in the Argentinian and in many other debt negotiations. 6  ‘In 1998, that big change came with a merger that redefined finance – the Citicorp merger with Travelers Insurance. There was still one extremely major barrier or hurdle to overcome: technically Glass-Steagall did not allow for a combination between a commercial bank and an insurance company’ (cited in Grant 2010). 7  See the staff profile of Robert E. Rubin on the ‘Leadership and Staff’ pages of the Council on Foreign Relations’ website at www.cfr.org/experts/ world/robert-e-rubin/b292. 8  The list keeps getting longer. 9  The film Catastroika can be viewed online at topdocumentaryfilms.com/ catastroika/. 10  See ‘Times Topics: Credit default swaps’ on The New York Times website at topics.nytimes.com/top/ reference/timestopics/subjects/c/ credit_default_swaps/index.html?scp=1spot&sq=credit%20default%20swaps& st=cse (archived at archive.is/VxWnX). 11  The years from 2000 to 2009. 12  See www.bostonfed.org/news/ speeches/rosengren/2011/060311/index. htm. 13  See the website of the US Senate Committee on Banking, Housing, and Urban Affairs at http:// banking.senate. gov/public/index. cfm?Fuseaction= Hearings.Hearing&Hearing_ID=46c5 d29a-b9c9-4b89-9c54-46b87d95d65b. 14  This is also known as arbitrage. 15  For information on which banks took advantage of this second round of LTROs, see http://blogs.wsj.com/ eurocrisis/2012/02/29/which-bankstook-up-second-round-of-ltro/. 16  Yanis Varoufakis d ­ iscusses the inoperability of the f­ acility at yanisvaroufakis.eu/2012/06/07/ solidarity-euro-style-finnish-loans-

ecb-bond-purchases-efsf-tough-loveand-assorted-horror-stories-from-thepostmodern-euro-workhouse/. 17  For more on regional financial contagion and the models and theories built to explain it, see Chapter 2. 18  Expressed as a percentage of GDP. 19  ‘Written testimony of Secretary Tim Geithner before the House Committee on Financial Services’, 20 March 2012. Available at financialservices. house.gov/UploadedFiles/HHRG-112-BAWState-TGeithner-20120320.pdf. 20  See the BIS chart entitled ‘Credit default swaps, by remaining maturity. Notional amounts outstanding at end of June 2013 (in millions of USD)’ at www. bis.org/statistics/ dt24.pdf (updated biannually). 21  See the video ‘Barclays $453 million Libor settlement’ on the Reuters website (Sonia Legg reporting, 27 June 2012) at www.reuters.com/article/ video/idUSBRE85Q0J720120627?video Id=236218271. 22  The forty-five-page legal brief ‘In the matter of: Barclays PLC, Barclays Bank PLC and Barclays Capital Inc.’ is available at www.cftc.gov/ucm/ groups/public/@lrenforcementactions/ documents/legalpleading/enfbarclays order062712.pdf. 23  See the US Department of Justice Office of Public Affairs press release at www.justice.gov/opa/pr/2012/June/12crm-815.html. 24  Part Six of the e-book, ‘The European sovereign debt crisis’, is available at ebook.law.uiowa.edu/ebook/sites/ default/files/What%20Measures%20Did %20Europe%20Take%20to%20Contain %20the%20Crisis.pdf. 25  A few articles appeared on the BBC’s website and in the Zero Hedge blog (www.zerohedge.com), the Financial Times and The Irish Times. 26  See the ISDA Determinations

72  |  one Committee’s news release of 21 June 2011, ‘Allied Irish Banks, p.l.c. failure to pay credit event’, at www2.isda.org/ news/isda-determinations-committeeallied-irish-banks-plc-failure-to-paycredit-event. 27  The Irish blanket bank guarantee (official name: Credit Institutions (Financial Support) Scheme 2008) is at www.irishstatutebook.ie/2008/en/ si/0411.html. 28  The Telegraph published the obituary on 10 June 2011. See www.­telegraph. co.uk/news/obituaries­/8569027/BrianLenihan.html. 29  See the video ‘Geithner on derivatives (CNBC)’, which shows him addressing the committee, on The New York Times website at video.nytimes.com/video/2009/12/02/ business/1247465942454/geithner-onderivatives-cnbc.html?ref=derivatives. 30  See www.consilium.europa.eu/ uedocs/cms_Data/docs/pressdata/en/ ec/131069.pdf. 31  The Club de Paris is an organisation with headquarters in Paris that tries to resolve disputed claims held by the Paris Club member states either directly or through their appropriate institutions (especially export credit or official development aid agencies) on behalf of the member states. For a list of permanent members, see www.clubdeparis. org/sections/composition/membrespermanents-et/membres-permanents. 32  This was reported in The New York Times on 24 January 1903. See ‘German commander blames Venezuelans’ at query.nytimes.com/mem/archive-free/ pdf?res=F7081FF93B5412738DDDAD0A 94D9405B838CF1D3. 33  See the Permanent Court of Arbitration website at www.pca-cpa.org.

References BBC (2011) ‘Allied Irish Bank’s “default” triggers cash payouts’. BBC News,

13 June. Available at www.bbc.co.uk/ news/business-13752758. Benink, H. and R. Schmidt (2004) ‘Europe’s single market for financial services: views by the European Shadow Financial Regulatory Committee’. Journal of Financial Stability 1(2): 157–98. Blundell-Wignall, A. (2012) ‘Solving the Financial and Sovereign Debt Crisis in Europe’. Financial Market Trends 29(2): 201–24. Available at www.oecd-ilibrary. org/finance-and-investment/ solving-the-financial-and-sovereigndebt-crisis-in-europe_fmt-2011-5k9 cswmzsdwj. Braithwaite, T. and A. Makan (2012) ‘US Treasury Manhattan transfer’. Finan­ cial Times, 5 February. Available at www.ft.com/intl/cms/s/0/9c1d6b544045-11e1-9bce-00144feab49a.html. Der Spiegel (2012) ‘Outfoxed by Club Med: German dominance in doubt after summit defeat’. Der Spiegel, 2 July. Available at www.spiegel. de/international/europe/germandominance-in-doubt-after-summitdefeat-a-842056.html. Grant, J. K. (2010) ‘What the financial services industry puts together let no person put asunder: how the Gramm-Leach-Bliley Act contributed to the 2008–2009 American capital markets crisis’. Albany Law Review 73(2): 371–420. Available at www.questia.com/ library/journal/1G1-226046757/ what-the-financial-services-industryputs-together. Greenham, T. and J. Ryan-Collins (2012) Where Does Money Come From? A guide to the UK monetary and banking system. London: New Economics Foundation. Huitson, O. (2012) ‘The Uneconomics guide to money creation’. OurKing­ dom, 17 February. Available at www.

phillips  |  73 opendemocracy.net/ourkingdom/ oliver-huitson/uneconomics-guideto-money-creation. Jones, S. (2010) ‘The benefits of naked CDS’. Financial Times, Alphaville blog, 2 March. Available at ftalphaville. ft.com/blog/2010/03/02/161556/thebenefits-of-naked-cds/. Keen, S. (2012) ‘Economics without a blind-spot on debt’. Steve Keen’s Debtwatch blog, 15 March. Available at www.debtdeflation.com/ blogs/2012/03/15/economicswithout-a-blind-spot-on-debt/. Kelly, M. (2011) ‘Ireland’s future depends on breaking free from bailout’. The Irish Times, 7 May. Available at www. irishtimes.com/newspaper/opinion/2011/0507/1224296372123.html. Munevar, D. (2012) ‘Characteristics and operation of the sovereign debt: the example in Greece’. Committee for the Abolition of Third World Debt (CADTM), 12 July. Available at cadtm. org/Characteristics-and-operation-of. Myerson, J. A. (2012) ‘A new Europe: growing beyond growth for true demo­cracy’. Truthout, 8 July. Available at truth-out.org/news/ item/10212-a-new-europe-growingbeyond-growth-for-true-democracy. Oakley, D. and K. Hope (2012) ‘Greek debt swap pay-out prospect weighed’. Financial Times, 22 February. Available at www.ft.com/cms/

s/0/3abac05c-5d5d-11e1-889d-00144 feabdc0.html. Pierce, A. (2008) ‘The Queen asks why no one saw the credit crunch coming’. The Telegraph, 5 November. Available at www.telegraph.co.uk/ news/uknews/theroyalfamily/ 3386353/The-Queen-asks-why-noone-saw-the-credit-crunch-coming. html. Son, H. (2008) ‘AIG is said to pay $18.7 billion to Goldman, SocGen for swaps’. Bloomberg, 10 December. Available at www.bloomberg.com/ apps/news?pid=newsarchive&sid= awTKDqalyQVc. Tett, G. (2006) ‘The dream machine: invention of credit derivatives’. Finan­ cial Times, 24 March. Available at www.ft.com/intl/cms/s/0/7886e2a8b967-11da-9d02-0000779e2340.html. Toussaint, E. (2011) ‘Greece, Ireland and Portugal: why arrangements with the Troika are odious’. Committee for the Abolition of Third World Debt (CADTM), 25 August. Available at www.cadtm.org/Greece-Ireland-andPortugal-why. Whelan, K. (2013) ‘Ireland exits bailout with no backstop: a good news story?’ Forbes, 15 November. Available at www.forbes.com/sites/ karlwhelan/2013/11/15/ireland-exitsbailout-with-no-backstop-a-goodnews-story/.

2  |  CRISES AND CONTAGION: A SURVEY 1

Anzhela Knyazeva, Diana Knyazeva and Joseph Stiglitz

Introduction Financial and economic crises and contagion are the subjects of a vast body of macroeconomic and finance research. Many recent interventions by national governments and multilateral institutions, such as the International Monetary Fund (IMF) and the European Central Bank (ECB), sought to stem the spread of contagion and restore investor confidence and financial stability in crisis-hit countries and, more broadly, in global markets. The European crisis was clearly triggered by the US financial crisis. At the same time, within Europe, the Greek debt crisis fuelled fears of information spillovers and spread of investor unease to other European debt markets, such as Spain and Italy, as well as concerns about the effects on the portfolios of European banks and financial institutions invested in Greek debt. While the narrative of events is easy to describe, there is considerable controversy over the interpretation of both the causes and the consequences of the crisis in any particular country. The global financial crisis caused a global economic slowdown, which led to increasing deficits in most of the advanced industrial countries, as tax revenues plummeted and expenditures on welfare benefits and unemployment increased. In the case of Greece, these increases followed high levels of deficits before the crisis. The newly installed Papandreou government’s discovery that its predecessor had ‘managed the books’ – underestimating the deficit – combined with downgrades of Greek debt in late 2009 and early 2010, led to higher borrowing costs and heightened the risk of sovereign default. The Greek government attempted fiscal tightening to lower the deficit and subsequently negotiated a loan package with the European Union

knyazeva et al.  |  75 (EU), ECB and IMF. The May 2010 Greek rescue was the first major milestone in the international effort to restore confidence and financial stability in Europe and stem the European sovereign debt crisis. But it imposed severe austerity, which led to a marked downturn – far greater than those providing the assistance had anticipated. The declining economic prospects contributed to capital flight, a weakening of the banking system and a decrease in credit supply, reinforcing the contractionary effects of the cutbacks in public spending, in a downward vicious circle. To avert default, Greece sought a second agreement in February 2012, which guaranteed additional loans conditional on fiscal austerity measures but also included the restructuring of bonds held by private investors. Although it was the first economy in the Eurozone to request international financial assistance in the recent debt crisis, Greece was not the only one. In Ireland, a crisis in the banking sector – which the government attempted to stem through a publicly backed guarantee – and the economic slowdown were the central features in its debt crisis. In September 2008, motivated by concerns about a run on the banking sector, the Irish government provided a two-year guarantee for the debt and deposits of major Irish financial institutions. Amidst widening losses on property loans, the Irish government nationalised Anglo Irish Bank, formed the National Asset Management Agency (NAMA), and injected additional funds into major banks.2 The costs of the banking sector bailout led Ireland to negotiate an agreement with the EU/IMF in November 2010. In the wake of the global financial crisis, Portugal also struggled with rising budget deficits, slow growth and unemployment, which led to increases in the rate of government spending. With the debt markets closely watching indebted European economies after the Greece agreement, spreads on Portuguese bonds continued to widen. Credit ratings cuts further increased the government’s borrowing costs. In May 2011, Portugal’s loan request to the European Financial Stabilisation Mechanism, the European Financial Stability Facility and the IMF was officially granted. The final tally of the European debt crisis will far exceed direct costs of the rescue, due to the lasting contractionary effects

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s­ temming from the transmission of fiscal austerity effects through local economies (Stiglitz 2010a). While policy makers have, to a large extent, focused on the fiscal tightening and reductions in spending, a return to economic growth is of paramount importance for the long-term sustainability of sovereign debt markets. As Greece, Ireland and Portugal continue to deal with the debt crisis fallout, investor fears have also touched Spanish, Italian and Dutch sovereign debt. In early 2013, Cyprus was added to the list of countries needing a bailout. In large measure, its problems are a fallout from the Greek crisis: because of its banks’ large holdings of Greek bonds and large loans to Greece, the restructuring of those bonds, combined with the Greek depression, pushed the two largest Cypriot banks over the brink. The European debt crisis, like America’s banking crisis before it, has drawn global attention to the mechanisms of transmission of macroeconomic shocks within economies, trade-offs inherently associated with economic and monetary integration, as well as to the full extent of interdependence among banks and other financial institutions both within and outside the Eurozone. It has once again raised the question: under what conditions are countries vulnerable to a crisis? How can they reduce vulnerability? The history of crises – including the most recent episodes – has upturned a series of ‘conventional wisdoms’. The Latin American debt crisis of the 1980s was viewed as the outcome of government overspending. But then the East Asian crisis showed that one could have crises even with prudent governments. The East Asian crisis was attributed to crony capitalism, poor institutions and a lack of transparency. Developed economies were put forward as a model to be emulated, but then came the US financial crisis. It is similarly unclear if a single cause can be proffered for the European debt crisis. While Greece had run fiscal deficits, Ireland (like Spain) had had a fiscal surplus and a low debt-to-gross domestic product (GDP) ratio prior to the global financial crisis. Before assessing the effectiveness of interventions or designing a global financial architecture that limits the spread of contagion yet takes advantage of the benefits of integration, we need a rigorous

knyazeva et al.  |  77 under­standing of the mechanisms behind crises and contagion. Below, we provide a survey of the existing theories of financial crises and contagion. We conclude by discussing the implications of contagion for economies with open capital markets, illustrated by recent global financial crises in East Asia, the US and Europe. Economic crises are defined as a sudden downturn in the level of economic activity, accompanied by an increase in the unemployment rate and bankruptcies. Financial crises are typically associated with a sudden fall in the exchange rate or stock market prices. Banking crises are characterised by credit contraction, increase in defaults, and even bank runs and bankruptcies. Typically, the various crises are related (both temporally and causally): an economic crisis (whatever the cause) typically leads to a stock market downturn and a weakening of the exchange rate; and banking and financial crises typically lead to economic crises.3 (Sometimes, the causality goes the other way: the bursting of a stock market or real estate bubble leads to a broader financial crisis, and then to an overall economic downturn. Often, there are reinforcing effects: the economic downturn deepens the financial crisis. Moreover, the event seemingly precipitating the crisis need not be the underlying cause: the collapse of the exchange rate could be the result of some more fundamental problem.) Ireland provides an instructive example. For years, the Celtic Tiger’s growth had been backed by solid fundamentals, including investments in infrastructure and human capital, and productivity growth. Like the US and many other markets, Ireland also witnessed a property boom facilitated by low interest rates and easy access to bank loans. As long as investors pursued leveraged bets on the real estate sector, helping to sustain the growth in residential and commercial property prices, default rates on loans remained low. Consequently, banks enjoyed rising equity valuations and low yield spreads. However, as interest rates increased and investor sentiment weakened with the onset of the global financial crisis, the property market collapsed, bank loan losses mounted and major banks became undercapitalised. This survey is written from the vantage point of hindsight provided by the recent global financial crises. Several earlier theories

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of crises provide little insight into the recent crises, while other explanations have proven to be more relevant. In any case, the recent global financial turmoil provides a new lens through which one can see crises more generally. For instance, standard interpretations of  the East Asian crisis emphasised weak institutions and a lack of transparency, and suggested American institutions as an alternative model that presumably would reduce, if not eliminate, the incidence of crises. We now realise that whatever is meant by ‘transparency’ and ‘good institutions’ is more complicated than was widely thought at the time; in particular, it became evident that there were major deficiencies in governance and in transparency in American financial institutions, both the private institutions and the public ones that were supposed to regulate them.4 Standard models based on previous crises that attempted to predict vulnerability to crises would have suggested that the US and Western Europe were not vulnerable. This is, in a sense, in keeping with the long tradition of crises, where each one seems attributable to factors that were not singled out as ‘explaining’ the previous crisis.5 Indeed, according to the conventional wisdom, where flawed macroeconomic and monetary policies were often cited as playing a key role in the generation of crises, the US and Europe were given high marks (both by themselves and by outsiders).6 There is a large literature on crises and contagion. This survey focuses on the theory, and in particular on how to reconcile crises with standard neoclassical theory and macroeconomics. Crises pres­ ent a number of puzzles for standard economic theory. While some of the models discussed below resolve some of these puzzles, none to date does so in a fully satisfactory way, or at least in a way that is consistent with much of prevailing financial and macroeconomic theories: • A distinguishing feature of most financial crises is a sudden change in the exchange rate. While outside observers may have expressed continuing worries, say about an overvalued exchange rate, the exchange rate adjustment process does not appear to work smoothly (in contrast to standard forward-looking models

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•

•

•

•

with rational expectations, where individuals gradually revise their expectations in light of the steady inflow of information; typically, there is no new information of a magnitude that should have led to a readjustment of exchange rates of the magnitudes observed). This is an example of the more general puzzle of crises: large changes in outcomes that seem incommensurate with the scale of changes in the underlying state variables (see Stiglitz 2011b; United Nations 2010). Standard models suggest that diversification – the spreading of risk around the world – should have led to a more stable economic system. The 2008 crisis suggested the contrary: diversification helped spread the crisis. There is a growing consensus that diversification may reduce the exposure to small crises, but increase that to larger ones. As more countries liberalised their capital markets, global capital and interbank linkages became more prevalent. Countries around the world experienced spillovers from the US financial crisis. Irish banks had relied heavily on global interbank loans prior to the crisis. When short-term interbank lending froze in the third quarter of 2008, Irish banks faced significant funding constraints. Conventional theories imply that even in markets where there is some irrationality, all that is required to make markets work well (to make markets reasonably stable and efficient) is that there be enough (and enough may be a relative notion) rational market participants.7 The empirical evidence (buttressed by this crisis) is that rational participants exploiting the irrationality of others may make the markets highly volatile. After the crisis there is a focus on contagion – on how inter­ dependence can lead a crisis to move from one country to another. However, before the crisis there is an emphasis on the benefits of diversification – on how interdependence enhances stability. None of the prevailing models integrates coherently these opposite forces (with the exception of Stiglitz 2010b, 2010c). Policy frameworks have varied. The standard response to con­ tagious diseases is quarantine – the equivalent of capital ­controls. But many in the international community have resisted the

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i­mposition of capital controls, even in the event of a crisis. The change in the stance of the IMF in 2011, and even more so in 2012, represents a major U-turn, motivated in part by the crisis of 2008–09 and its aftermath (IMF 2011, 2012). • Policy decisions have often entailed interventions in the market that are announced to be (or believed to be) temporary, but it is argued that they will have long-term effects, shifting the equilibrium in the countries suffering from contagion. Why such temporary interventions would have long-term effects is often not clear (Stiglitz 1999a). A central thesis of this survey is that understanding crises requires an understanding of market imperfections – and especially of the constraints, for instance on borrowing, imposed by imperfect information – and how those market imperfections interact with irrationalities on the part of market participants and imperfections in the regulatory environment. In the discussion below, we follow the literature on crises through its various stages, motivated by the series of crises the world has experienced in the last three decades. There is a basic taxonomy into which we can put much of this literature: • models in which the shock giving rise to the crisis is exogenous, and those in which it is endogenous; • models in which markets are fully rational, and those in which they are not; • models in which there are multiple momentary equilibria, and  models in which there is a unique momentary equilibrium; • models in which there is a unique steady state (long-term) equilibrium, and models in which there are multiple long-term equilibria; and • models in which risk sharing and diversification reduce risk, and those in which they can amplify it. Many of the earlier mainstream models had limited predictive power in the case of the recent crises (see the discussion in Stiglitz 2011b, 2013; Wade 2013). Those models assumed that shocks to the

knyazeva et al.  |  81 system are exogenous, markets are fully rational, there is a unique momentary equilibrium and a unique steady state equilibrium, and diversification essentially eliminates risk. By contrast, prevailing interpretations of the current crisis see the shock as the breaking of an endogenous credit and housing bubble, in which market irrationalities played a central role. The logic of crises is simple: if there are multiple momentary equilibria, then the economy can suddenly switch from one to the other without any large change in any state variable (other than beliefs, which themselves are treated as state variables). If there are multiple steady state equilibria, then a shock to the state variables of the economy (whether endogenous or exogenous) can act as a tipping point, bringing the economy into a different ‘orbit of attraction’. The mathematics of crises is also simple: under the convexity assumptions made in most economic models, diversification spreads risks and reduces their impact. But, as Stiglitz (2010b, 2010c) points out, non-convexities are pervasive (bankruptcy, learning, etc.), and with non-convexities diversification can amplify systemic risk. This chapter is divided into three sections. The first surveys the literature on what causes crises; the second is on contagion and the effect of interdependence in amplifying crises; and the third covers the role of government. Not surprisingly, theories that stress the efficiency and stability of markets look to government as the source of the problem; stability is attained by government not interfering in the natural workings of the market. Theories that see the economy as inherently inefficient and unstable look to government to help correct market failures. Ascertaining which of these theories is correct is not easy, and beyond the task of this short survey. One of the reasons for the difficulties is that there are elements of many of the alternative ­approaches present in every crisis. No one could look at the recession of 2008 or the Irish banking crisis without noting market irrational­ ities. But does that mean we could not have had a crisis in the absence of such irrationalities? The major shock was an endogenous one – a housing bubble; the shock was not an exogenous event (‘a once in a hundred years flood’), but there were exogenous (at least to the

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economic system) events that perhaps could have triggered a major downturn, reflected in the spike in oil and food prices. What causes financial crises? The earliest approaches to the onset of currency and financial crises – the first generation of crisis models – focused on fundamental macroeconomic imbalances and adherence to a monetary policy incompatible with the maintenance of an exchange rate peg (for example, Krugman 1979).8 The 1994–95 Mexican crisis led policy makers to ask what ­accounted for the sudden onset of a market panic. Although funda­ mental macro­economic problems, including overvalued exchange rates, current account deficits and rising short-term foreign currency government debt, were present, the peso’s devaluation alone did not quickly stem the crisis.9 The crisis (like many before it) posed several questions. Why did it occur when it did? The fundamental imbalances had long been recognised. The large and immediate fall in the exchange rate, which many thought should have equilibrated the market – leading to what might be viewed as an equilibrium exchange rate – didn’t stem the crisis. Why not? The peso crisis led researchers to turn their attention to information flows and trader behaviour around market panics, which formed the second generation of theories of currency crises (for example, Agenor and Masson 1999; Sachs et al. 1996; and more informal discussions by Furman and Stiglitz 1998; Stiglitz 2010a).

Multiple equilibria  The ‘second generation’ literature explored one possible explanation for the sudden large change in the exchange rate (beyond what can be explained by changes in the shocks to the economy, including new information) and the failure of the exchange rate to equilibrate. While state variables such as capital stock change slowly, beliefs can change quickly. The peso crisis precipitated a massive loss of confidence in the currency and a full-on market panic. Although the importance of confidence is often mentioned, traditional macro models do not include independent variables that quantify confidence. Those that have tried to do so show that con-

knyazeva et al.  |  83 fidence10 can have significant explanatory power, but few models incorporate confidence in a formal way. One way of doing this is to assume that there are multiple equilibria.11 Models of multiple equilibria (such as sunspot equilibria) that formally incorporate ‘confidence’ suggest that a change in confidence can move the economy from one equilibrium to another. In the case of debt crises, Brazil (and perhaps Greece) provide examples: with low interest rates the country can easily service the debt, so it is rational that interest rates are low; but if interest rates become high, the country cannot service the debt, and it is rational that the interest rate is high to compensate for the risk of default (Greenwald and Stiglitz 2003). The idea of a self-fulfilling market panic originated in the context of a run on a bank. In Diamond and Dybvig (1983), banks have relatively illiquid assets; in other words, if a bank has to sell assets at short notice, it sacrifices a part of the asset value in the process. In every period, some customers withdraw money from the bank to meet their spending needs. In a perfect world, all others keep their money in the bank. However, customers are aware that withdrawals will not be honoured if the bank runs out of money (in their model, no deposit insurance scheme exists). As they observe other customers’ withdrawals, they could decide to take their own money out as well in anticipation of a bank run. Such self-fulfilling panics can leave everybody worse off.

Market frictions  A third generation of models of crises (beginning with Greenwald and Stiglitz 1988a, 1988b, 1990a, 1990b) does not explain the shocks to the economic system, but argues that even small shocks can lead to large consequences in the presence of market frictions (for more recent examples, see Caballero and Krishnamurthy 2001; Kiyotaki and Moore 1997; Mendoza 2010). While the importance attributed to specific financial frictions varies from model to model, a common theme in these theories of financial crises is the role of market imperfections in explaining the fast pace of diffusion and the large amplification of negative economic shocks, providing a recipe for a sudden crash, as well as the persistence of economic downturns. Financial constraints can mean that large downturns

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lead to widespread insolvencies, resulting in the destruction of informational and organisational capital, which further amplifies the downturn and makes recovery more difficult. Market frictions (information asymmetries, costly state verification, costs of contract enforcement, and bankruptcy – see Greenwald and Stiglitz (1993a) – limit the extent to which firms can use equity or hedging contracts.12 As a result, firms have to rely on debt, while remaining exposed to risk, and firms act in a risk-averse manner.13 With constraints on debt–equity ratios, a decrease in a firm’s equity reduces its ability to borrow. The macroeconomic consequences of these micro imperfections are severe, with investment (including inventory accumulation), for instance, expanding in booms by a multiple of the change in equity (the financial accelerator), and the converse happening in downturns (for example, Bernanke et al. 1996; Greenwald and Stiglitz 1993a). Not only are the effects of shocks amplified, but they can persist because it takes a long time for balance sheets to be restored.14 Other imperfections in financial markets can similarly lead to the amplification of shocks. Many borrowers face collateral constraints that limit borrowing capacity. Contract enforcement is complicated and lenders have only partial information. A collateral requirement can act as both a selection and an incentive device (Stiglitz and Weiss 1986) and can help manage default risk. For example, in Kiyotaki and Moore (1997), creditors cannot force repayment or seize the borrower’s human capital, so borrowers can strategically default on the debt. Collateral-based borrowing constraints tied to the value of the firm’s real assets become necessary.15 As a result, the maximum amount of debt the firm can take on, assuming collateral of a given value, is limited. Even a temporary shock to the value of collateral translates into reduced borrowing ability. Thus, a shock sets in motion a feedback effect that decreases investment and the rate of growth for several years. Credit-constrained firms are forced to reduce investment, resulting in further declines in asset prices and net worth, which in turn lead to tighter borrowing constraints and additional investment cuts. Similarly, Greenwald and Stiglitz (1993a) explain how with con-

knyazeva et al.  |  85 tracts for unindexed debt, a macroeconomic shock (such as monetary policy tightening) that leads to lower than expected prices results in decreased equity, with real effects that are amplified by the financial accelerator. Non-convexities in the relationship between equity and investment also imply that a distributional shock (for example, an increase in the price of oil) has macroeconomic consequences, with the contraction in the losing sector exceeding the expansion in the benefiting sector.16 The banking system itself can amplify especially large downturns. Banks can be viewed as highly leveraged firms (Greenwald and Stiglitz 2003), so that when their equity is diminished they reduce their lending. With credit rationed, investment is cut back. Institutional features and regulatory design can increase the extent to which there is amplification through the banking system. Excessive reliance on capital adequacy requirements can result in a built-in destabiliser; countercyclical prudential regulations or appropriately designed policies of regulatory forbearance may be able to offset the effects (see Helmann et al. 2000 and the various essays in Griffith-Jones et al. 2010). Regulation of maturity and currency mismatches in banks and the firms to which they lend can reduce the vulnerability of the banking system – and thereby the economy – to shocks. When an economic downturn is precipitated by the breaking of a credit and/or housing bubble, a natural response might be to tighten regulation. But the tightening of regulation (both the rules and their enforcement) may exacerbate the downturn and reinforce the pro-cyclical nature of those markets. Several of the effects that we have just described were evident during the Irish financial crisis. During that crisis, property developers facing declining real estate valuations were unable to refinance existing loans or obtain new loans. They had to sell their assets, leading to large losses and the start of a slow deterioration in real estate prices. Asset write-downs resulting from losses on property loans constrained the banks’ ability to raise new financing, in turn limiting their ability to lend. The downturn was exacerbated by the responses of the Irish government. Among the institutional flaws in NAMA (the agency formed to deal with the problem) was its

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c­ ommitment to a quick disposal of assets (in contrast to what was done in the United States, in its savings and loan crisis). While perhaps well intentioned (to quickly put the mistakes of the past, including lax regulations and regulatory enforcement, behind the government and regulatory authorities), this assured further weakening of property markets, asset values and the banking system – and thus further weakening of the Irish economy. In a related vein, reductions in business and consumer credit reinforced the downward pressures on both investment and consumption growth, compounding the weaknesses in the economy arising from austerity measures. Other institutional rules and policies (in both home and foreign countries), such as the weakening of automatic stabilisers (for example, safety nets17), can make countries more sensitive to shocks (see Stiglitz 2011a). Delegating authority of risk evaluation to rating agencies and imposing constraints on what pensions can invest in can contribute to volatility – a sharp downgrade by the rating agencies (as happened in Thailand in 1997) can precipitate a crisis (see Ferri et al. 1999) and also played an important role in the breaking of the housing bubble and the economic downturn in 2006 and 2007. Downgrades of sovereign and bank credit ratings in PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) significantly limited public and private sector capital market access, causing a credit contraction and reinforcing recessionary pressures. They also exacerbated the consequences of austerity: with budgets severely constrained, and more of the available money going to pay for past debts, there was less money available to stimulate the economy.

Systemic crises  In the third generation models just described, financial constraints (operating through collateral requirements, debt–­ equity constraints or real balance effects), especially in the context of imperfectly indexed debt contracts, can lead to the amplification and persistence of shocks. While research on systemic shocks began well before the Great Recession, the recession has enhanced impetus for this work (see, for example, Haldane 2009; Haldane and May 2011). Greenwald and Stiglitz (2003) and Allen and Gale (2000) describe

knyazeva et al.  |  87 bankruptcy cascades – how the bankruptcy of one firm can lead to that of others. The extent to which this occurs depends on financial interdependence. As a result of externalities due to incomplete markets and imperfect information, privately profitable contracts will not generally be socially optimal (Greenwald and Stiglitz 1986). In fact, managerial contracts implicitly based on relative performance can lead to excessively correlated risk taking (Nalebuff and Stiglitz 1983). Moreover, there are strong incentives, especially for large banks, to become excessively interdependent and correlated, so that in bad outcomes they will be bailed out (see, for example, Acharya and Yorulmazer 2008; Stiglitz 2010a).

Market and individual irrationalities  Even when customers are able to assess a bank’s financial condition, they sometimes end up ignoring their private knowledge and copying the actions of others, which is known as herding (see, for example, Banerjee 1992; Bikhchandani at el. 1992). As a result, bank runs or sudden market crashes can occur even when only a few investors or depositors possess negative information. Such herding may be rational. Many have argued that irrationality plays a crucial role in both the onset and the creation of the conditions for financial crises, as well as in their spread when they occur (for example, Hirshleifer and Teoh 2009; Stiglitz 1999b, 2004). For instance, Kindleberger and Aliber (2005) noted that changes in the sentiment of borrowers and creditors over time could explain the well-known cyclical nature of bank lending, whereas Alan Greenspan has referenced ‘irrational exuberance’ of markets. Significant changes in sentiment also play an important role in Minsky cycles and credit crises. Increases in loan supply can be attributed to optimism in good times, while decreases in credit can be linked to pessimism in bad times. Irrational investor pessim­ ism causes rapid declines in lending, asset prices and exchange rates, typically seen during crises. Investor irration­ality can stem from the inability to correctly process available data, compounded by behavioural biases that cause investors to make suboptimal decisions based on the beliefs they have formed (see Barberis and Thaler 2003 for a detailed survey).18 The resulting overreaction to economic news

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can cause small negative shocks to trigger large-scale market panics that spread across national borders. When bubbles burst (or when panics lead to irrationally depressed prices), there are large real balance effects and the other effects delineated above arising from the financial accelerator, and these can give rise to a macroeconomic crisis. The devastating consequences of a burst housing-market bubble have been seen in the recent US, Spanish and Irish financial crises. In open economies with firms that have substantial foreign currency debt (with mismatches in the currency and maturity structure of assets and liabilities), large changes in exchange rates similarly can have dramatic effects on equity values or lead to large increases in collateral requirements, precipitating a crisis, for instance as firms make large cutbacks in investment. During the 1997–98 Asian financial crisis, firms with foreign currency liabilities and home currency assets were vulnerable to depreciation of the home currency (Cespedes et al. 2004; Stiglitz 2001).19 In standard dynamic stochastic general equilibrium models, the sources of crises are exogenous shocks, but the most important crises involve the bursting of bubbles, most of which can be attri­ buted to internal market dynamics. Housing prices, for instance, rise to the point where further increases are not sustainable given the constraints imposed by the institutional and regulatory system (even with mild forbearance). When home prices can no longer increase at the rate that has been anticipated, demand for housing (based on the expectation of capital gains) decreases suddenly, with the follow-on effects described above. This pattern, repeated historically, presents a challenge to models of rational expectations. There are two possibilities. One is that with short-sighted market participants the economy can evolve in a manner that is consistent with inter-temporal arbitrage equations for a very long time, before a (say, non-negativity) constraint becomes binding (e.g. Shell and Stiglitz 1967). The other is that there is uncertainty about the date of unravelling of the process, and a bubble can then be consistent with rational expectations for an extended period of time (Abreu and Brunnermeier 2003).

knyazeva et al.  |  89 We suspect, though, that it is challenging to fully reconcile bubbles with perfect rationality. In the US, Irish and most other bubbles (Gurdgiev et al. (2011) discuss the Irish property bubble), large numbers of investors recognised that there was a very high probability of a bubble (and took short bets), even if others believed that was not the case. The question is: why couldn’t those who knew better correct the market irrationality? Note that the analysis of such situ­ ations requires the construction of models in which individuals have different beliefs; even as they extract information from the market, they do not converge to the same beliefs. Recent models focusing on the consequences of short sale restrictions for asset bubbles have provided insights, since those who are more optimistic are given more weight during booms than during recessions (e.g. Scheinkman and Xiong 2003). This gives rise to higher market volatility, with real consequences of the kind that we noted earlier in this chapter. In practice, delineating rational and irrational causes of crises can be hard, not only because investors face imperfect markets, but also because rationality and irrationality interact: there are rational actors willing to exploit the irrationality of others and the imperfections in the regulatory framework. While standard models assume that such rational exploitation of market irrationality stabilises the economy, in fact it often does not seem to be the case. The crisis of 2008 serves as an example. The lending during the housing bubble illustrates a high level of irrationality on the part of market participants. Incentive distortions led to excessive risk taking in mortgage provision. In the end, under the assumption of ‘too big to fail’ (hence, an implicit government subsidy), it was rational for major institutions (or, more accurately, for their managers, who gained from the build-up of the bubble but did not fully internalise the consequences of the subsequent decline) to make contracts with each other that amplified risks and made banks less transparent but allowed them to grow. The differences in beliefs referred to earlier can lead to high levels of economic volatility, especially as opportunities for market participants to take large (leveraged) bets increase as a result of financial innovation, such as the development of the derivatives market. When individuals differ in their beliefs, there is an ­incentive

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for them to engage in a bet about the future state of the world. Such bets increase the ex ante expected utility of both parties, who believe that their lifetime income is larger than it otherwise would be. This increase in wealth can be thought of as ‘pseudo-wealth’. Inevitably, the ultimate state of the world will be revealed: one will win the bet, the other will lose. One will have his expectation realised; the  other will not. The effect will be the destruction of some of the pseudo-wealth. In turn, the rapid destruction of such wealth can lead to an equally rapid change in behaviour, such as a reduction in consumption.

Destabilising market processes  The collapse of the exchange rate may restore the market equilibrium (by increasing exports and reducing imports), but it may sometimes have the opposite effect on the economy. If domestic firms have foreign currency-denominated debt, the change in exchange rates has large real balance effects (Greenwald and Stiglitz 1993a), which leads to large changes in behaviour – production, investment, inventory holdings, and so on – and can precipitate an economic downturn. It affects the ability to repay loans, and that in turn affects banks’ ability to lend. Limited access to credit and weak balance sheets impede the normal foreign exchange adjustment mechanism. A decline in the exchange rate can weaken aggregate demand and exacerbate the downturn.20 This is but one example of how economic processes that in simplistic models help the economy equilibrate may, in more realistic models, have just the opposite effect. In a recession, wage and price declines weaken aggregate demand, exacerbating the gap between supply and demand and deepening the economic downturn.21

Trend reinforcement and ‘orbits of attraction’  Battiston et al. (2007) describe a variety of other destabilising circumstances where there is a process of trend reinforcement: that is, a negative shock is followed by consequences that worsen the firm’s (or the economy’s) future prospects. Consider the evolution of a firm’s net worth as a stochastic process. A negative shock increases the likelihood that the firm will go bankrupt (reach the zero boundary at an earlier date), but that

knyazeva et al.  |  91 means that lenders will demand higher interest rates, increasing the pace at which a firm with negative drift moves downward. There can exist a range of state variables (here, net worth) such that in one set of initial conditions the firm (economy) converges to bankruptcy (crisis), while in another (often not too distant) it does not. Shocks can move the economy from one ‘orbit of attraction’ to another. How crises spread We have provided a brief and by no means exhaustive overview of finance and macroeconomics research into the causes of financial crises. The mechanisms behind shock amplification can help explain not only the onset of crises but also the spread of crises across countries. As countries remove restrictions on international capital flows, crises that arise when small shocks snowball due to market frictions increasingly involve multiple economies. In today’s global financial and banking marketplace, the issue of propagation of shocks and crises across countries is arguably of predominant importance. Therefore, we next turn to the role of contagion22 and other factors contributing to the spread of financial crises. In the discussion below, we focus on financial linkages, but the global financial crisis demonstrated clearly that trade linkages can also be important in the propagation of disturbances.23 It should be obvious that substantial trade or capital linkages can contribute to the spread of crises. A shock to one country will have repercussions in others. But that does not mean that the linkages exacerbate crises. They may dampen the crisis in one country, while at the same time bringing about a downturn in another. Had the US not exported so many of its securitised mortgages in the period leading up to the recent crisis, arguably the US crisis would have been worse. In standard models, however, the global aggregative effect is reduced through interdependence. Diversification reduces the impact of shocks. The worry, however, is that financial interdependence leads to the opposite effect, in a process that is called contagion by analogy to the spread of disease, where interaction amplifies the overall incidence of the disease.

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Of course, even if diversification leads to better overall global economic performance, countries may worry about their own ex­ posure to risks. The last section explained how, as a result of financial constraints, economic systems may amplify shocks, and the costs of offsetting and managing risks may be significant, and not worth the benefits of increased integration. Stiglitz (2006) has, for instance, discussed the high costs associated with reserves that countries maintain to enable them to better manage the shocks that they face. Financial linkages can take several forms: • a reduction in foreign direct investment, as a result of financial constraints either in the investing country or in the markets for which the goods to be produced are destined; • a decrease in financial inflows, not adequately offset by the a­ ctions of domestic monetary authorities, that leads to financial constraints and/or higher cost of capital; or • a reversal of financial flows – from inflows to outflows – which typically is associated with large changes in exchange rates. While these changes in exchange rates would, in the standard trade models, enhance aggregate demand through an increase in net exports, balance sheet effects (especially important when debt is denominated in foreign currencies) often dominate. Moreover, the changes in financial flows can be motivated by changes in information or beliefs (investors suddenly realise that the risk of investing in foreign countries is greater than they had previously believed), by changes in financial constraints, or by real shocks amplified through financial constraints. The financial constraints can arise from regulation or from institutional/informational imperfections. Finally, investor actions can bring about a correlated onset of crises if investors update their views about the likelihood of a crisis based on witnessing a crisis in another market, or if investors (including banks) have exposure to several different markets through their portfolios. One example of what is sometimes called ‘pure contagion’ involves investors fleeing a country after observing a crisis in another economy  that has no trade or capital ties to the original economy. The idea that investors can infer an economy’s prospects from crises

knyazeva et al.  |  93 in other economies is central to the information contagion view (see, for example, Chen 1999; King and Wadhwani 1990). Intuitively, falling asset prices in one market can convey information about the value of securities in other markets if the two markets share some common risks.24 Imperfectly informed investors learn about the odds of a crisis in their own economy by observing crisis episodes overseas. The caveat about investor rationality applies here as well. The explanations above focus on rational investors. Often, at least some degree of irrationality is involved in investor panics. If investors overreact to news or make other mistakes when drawing inference from other crises, contagion can spread faster as a result of investor irrationality. Even if investors do not perceive a dramatic shift in risk, an expectation that other investors will update their beliefs about risk may be sufficient to spur a sell-off. The channels through which pure contagion exerts its effects are all of those described in the previous section, including the impact of prices (especially through fire sales) on borrowing constraints and real balances. Several studies focus on the role of direct financial linkages in shock diffusion. Financial linkages can take the form of risk-sharing arrangements or balance sheet exposure to distressed countries or financial institutions. In a series of papers, Battiston et al. (2007), Gallegati et al. (2008) and Stiglitz (2010b, 2010c) ask when is it the case that such risk-sharing arrangements exacerbate rather than reduce systemic risk. Gallegati et al. (2008) model diffusion of shocks among interlinked financial institutions. Links can be viewed, for example, as loans extended to other banks. Interbank loans allow individual banks to diversify away idiosyncratic shocks to their loan portfolios, reducing the likelihood of failures. However, when economic tides turn, bank failures are more likely to be systemic in nature if banks are interconnected. Moreover, bank managers typically have incentive conflicts and do not fully internalise the spillovers of bank failures; as a result, they tend to establish too many interbank links.25 (Indeed, by becoming ‘too interlinked to fail’, the banking system can shift risk from itself to the government.) Several other papers explain how the interconnectedness of bank

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balance sheets can facilitate the spread of shocks affecting an individual bank to other financial institutions. Allen and Gale (2000) provide a model of balance sheet contagion in the banking sector. Contagion occurs due to overlapping claims between different banks. Liquidity shocks to one bank lead to losses at other banks in the economy because of the decline in value of their claims on the ­troubled bank. This channel can augment the effects of relatively small shocks and lead to contagion and financial fragility in the banking system. Greenwald and Stiglitz (2003) provide a similar analysis of ‘bankruptcy cascades’. Wagner (2010) likewise concludes that banks motivated by the diversification of idiosyncratic risk can contribute to systemic risk. Haldane (2009) shows that these linkages may reduce the risk of failure when there are small or uncorrelated shocks, but they increase the risk of failure when there are large and correlated shocks. The analysis of the consequences of financial linkages across countries is, in many ways, parallel to that of linkages among banks (or banks and firms) within a country (Stiglitz 2010b, 2010c). In the international finance setting, capital flows between countries can serve as a similar risk-sharing mechanism. Capital market integration allows individual countries to smooth country-specific shocks to their output. Assuming a high level of country-specific risk and a high cost of such risk to consumers, risk sharing through international capital flows is beneficial. On the flipside, a major adverse event that affects a single economy has the potential to cause systemic failure in all economies interlinked through capital markets. In the absence of financial market frictions, or, more broadly, the absence of non-convexities, diversification (achieved through risksharing arrangements) benefits risk-averse investors and consumers. A similar argument extends to risk sharing across countries. However, with bankruptcy costs and, more generally, pervasive non-convexities (where markets are inefficient), diversification may result in a higher incidence of bankruptcy and lower aggregate output (net of such costs). Capital market integration could increase rather than lower the likelihood of a financial crisis in a given economy. Even if risk sharing does not initially increase the likelihood of a crisis but only

knyazeva et al.  |  95 increases the probability of a near-crisis state, the resulting increase in borrowing costs results in what we referred to earlier as trend reinforcement, which raises the odds of a crisis in the long run.26 One analogy is the way in which fuller integration of electricity grids saves on generating capacity, but increases the risk of a broader systemic failure. The underlying intuition behind these seemingly perverse results is that, in the presence of non-convexities, risk sharing may lower expected returns. Non-convexities are pervasive – they arise whenever there are information constraints, bankruptcy costs or learning processes (see, for instance, Radner and Stiglitz 1984). The process of trend reinforcement described earlier implicitly entails a non-convexity. In that model, with a negative drift to the stochastic process when equity falls below a critical level, increases in risk increase the chance that the firm escapes the death trap. Cross-border financial flows may exacerbate financial constraints, and therefore increase the magnitude of the global consequences of shocks and imply that much of the burden of a shock to a given country is experienced by countries with which it is financially integ­ rated. For instance, creditors may impose more stringent collateral requirements on foreign borrowers because of the greater information asymmetries. In Caballero and Krishnamurthy (2001), contractual distortions in the treatment of domestic and inter­national collateral can induce fire sales (presumably that are worse than those that would have arisen if cross-border lending was limited), resulting in liquidation of assets at a significant discount in the event of a shock. In a related vein, in Mendoza (2010), information costs, high leverage and borrowing constraints combine to cause fire sales. Traders facing high debt levels and borrowing constraints can be forced into fire sales of assets to less informed foreign buyers, even though the shock is only temporary. Such fire sales can precipitate rapid shutdowns of external capital markets (i.e. countries facing these fire sales lose access to foreign funds) and large consumption contractions.27 Stiglitz (2002) described how these effects served to deepen the East Asia crisis of 1997–98. Greenwald and Stiglitz (2013) describe how asymmetries of

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i­ nformation can play a role in inducing capital flight and crises. Those within a country are more informed about the circumstances of that country (for example, the ability of the government or companies to repay what they owe), and outside investors know this. Outside investors therefore worry about the better-informed investors fleeing the markets before they have a chance to do so. In response, they rationally react to smaller signals, i.e. to less adverse news, pulling their money out of the country, thereby precipitating a crisis. The spread of crises to economies that have the same creditors or investors (such as global banks or hedge funds) as the economy in crisis constitutes another channel for the transmission of shocks. Creditors or investors that suffered losses in a crisis in one economy are likely to modify their lending or investment strategy with respect to seemingly unrelated economies. When banks face loan defaults, they are likely to scale back lending to all borrowers, even to those unaffected by the initial adverse event, due to capital requirements or balance sheet effects. The worse the effect of defaults on the bank’s financial health and its ability to raise equity, the more pronounced the cutbacks in lending to other borrowers. Because of information asymmetries, lending cuts may be disproportionately large for foreign borrowers. Chava and Purnanandam (2011) found empirical support for the role of lender portfolios in the transmission of shocks to previously unaffected firms in a study of borrowers dependent on bank debt around the 1998 Russian finan­ cial crisis. Rashid (2011) likewise found that foreign banks play an important role in the transmission of shocks across borders. Similarly, investors who lose money in one market might liquidate their positions in other economies (to cover losses or meet margin requirements). Shocks, therefore, can be transmitted as a result of portfolio rebalancing by investors with stakes in multiple markets (Kodres and Pritsker 2002). Investors are expected to respond to shocks that affect a given market by modifying their portfolio exposures to shared macroeconomic risk factors. Such cross-market linkages are likely to spread shocks faster during bad times and in the presence of high levels of foreign debt, as was the case for emerging economies in the Asian financial crisis.

knyazeva et al.  |  97 But even if there are no shared macroeconomic risks, globally diversified investor portfolios can also speed propagation of individual country shocks to other economies through investor wealth effects (Goldstein and Pauzner 2004; Kyle and Xiong 2001). A crisis in one country leads to a reduction in the wealth of those invested in that country. The decline in wealth causes investors to rebalance portfolios, and possibly even to act in a more risk-averse manner, so they scale back holdings of risky assets in other countries, even when those other countries share no ties or risk factors with the original economy in crisis. Finally, crises can be transmitted via the real sector, for example through trade ties and competitive (terms-of-trade) effects, and especi­ ally so when there are interactions with the financial sector. Shocks affecting developed countries eventually affect those countries’ trade partners. The recent US economic downturn resulted in a slowdown in GDP growth and a reduction in import demand, adversely affecting many developing economies that traditionally exported to the US. Adverse exchange rate effects would, in the standard model, be viewed as purely redistributive – one country gains what the other country loses – but with financial constraints, as we have noted, the aggregative effect may still be negative (see also Paasche 2001). In this section we have discussed several alternative theories of financial contagion. Of the various theories, the pure contagion models are the least plausible. As Stiglitz (1999b) notes, while Brazil and Russia had few risk factors in common with South-East Asian economies, both countries saw significant capital flight in the immediate aftermath of the Asian crisis. Similarly, Brazil suffered in the aftermath of the Russian crisis. In those cases, the effects arose from financial institutions and hedge funds with portfolio exposures to multiple emerging markets both within and outside Asia, and especially from the financial constraints faced by those firms.28 More recently, disproportionate contractions in lending by banks in the PIIGS countries helped spread crises to Eastern Europe and emer­ ging markets. Our discussion of the circumstances that precipitate contagion and the spread of shocks to multiple economies has important

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policy implications for countries with significant international capital ­market linkages, including Ireland, which we discuss in the next section. Contagion and financial and capital market liberalisation The previous two sections have discussed the sources of disturbances (crises) and their propagation across countries. In this section, we discuss a few of the key issues in the policy response – both what governments can do when a crisis occurs, and what they should do to make crises less likely.

Short-run exchange rate interventions  A standard response to the threat of contagion includes an international bailout package, the essential ingredient of which is a commitment of large amounts of financial support. Some of this is used immediately for intervention to support the currency, and the rest is left to convince the market that more support will be provided, should the need occur. Such interventions are often ineffective (for example, in Russia in 1998, in East Asia in 1997 and in Argentina in 2001). First, why should a temporary intervention in the market have persistent effects? Moreover, if the crisis in one country conveys information about another country’s fundamentals, then even if the IMF intervention stabilises the first country’s currency, it need not change market perceptions of the underlying weaknesses in the second economy. Only if market participants were naïve enough to look at just the exchange rate (the outcome of market processes and intervention) would the intervention work.29 There are several sets of models in which such temporary inter­ ventions might make sense. The first is in the presence of deep market irrationalities – where market participants are truly naïve and look at only exchange rates, not what brings them about; where they have simple beliefs about contagion – that a crisis in one country is like a communicable disease, and if we cure the symptoms in one country, this can reduce the likelihood of its spread to others. A second set of circumstances in which temporary interventions might be desirable involves multiple equilibria and a scenario where

knyazeva et al.  |  99 interventions help move the economy from the ‘bad’ equilibrium to the ‘good’ one. A third explanation is that markets are often prone to overshooting and interventions are an attempt to prevent that. Given the real consequences of overshooting, such interventions (if they are effective) may make sense. Note that, in each of these explanations, market processes on their own are assumed to lead to suboptimal outcomes. But the advocates of these interventions at international financial institutions, which typically have placed strong confidence in the efficiency and stability of market processes, need to provide a clear delineation of the circumstances in which markets can be relied upon and those in which they cannot. Critics might argue that, in the case of crises, the market inefficiencies are so large that they simply cannot be ignored, but they are likely to be present at other times as well (Greenwald and Stiglitz 1987). More broadly, however, the models that we have delineated in this chapter provide a rationale for such exchange rate interventions. Markets with rational expectations but imperfect and asymmetric information are typically not efficient, especially when markets are subject to irrational pessimism. Then the effects of such irrational­ ities (even if relatively small) can be large and persistent; markets may exhibit excessive volatility, and government efforts at stabilisation can have real benefits. Financial market integration A central determinant of whether a crisis in one country leads to one in another is the extent of financial market integration – the ease with which money flows across borders, the extent to which one country’s financial institutions can operate in another, and the extent to which risks are shared among countries.30 It used to be thought that financial and capital market liberalisation would help stabilise economies.31 A country in trouble could borrow from abroad. Such borrowing could stabilise consumption and income. The discussion in the previous section has explained why the presumption – prior to the crisis – that the greater the

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extent of financial market integration the better was wrong. More integration may lead not to more growth, but to more instability. There is strong evidence that this is the case – not surprising, given that capital flows are pro-cyclical rather than countercyclical. Countries that have opened their capital and financial markets have found themselves more subject to external shocks, some of which can be quite large, although even moderate shocks can precipitate a crisis through the amplification process described in the previous section. This is especially true in the absence of a sound bank supervisory and regulatory framework. The experiences in Scandinavia, the US, Japan and Europe have shown that even advanced countries have a hard time constructing such frameworks. When there is rapid liberalisation in a developing country, the likelihood that there will be deficiencies in these frameworks is high – and thus so too is the likelihood of a crisis. We now have a much better understanding of why (and the circum­ stances under which) financial and capital market liberalisation can have such adverse effects. Earlier, we noted that more integrated electricity networks might save on generating capacity but increased the risk of a systemic collapse. In practice, well-designed electricity networks make use of circuit breakers. In international finance, capital controls serve as such circuit breakers. If well-designed capital controls could be incorporated to prevent contagion during crisis episodes without compromising the risk-sharing benefits of integration in good ­periods, full (or at least fuller) integration might be preferred. However, in practice, risk-sharing arrangements fall short of this ideal – as was so evident in the recent financial crises. Indeed, before the crisis, the conventional wisdom (expressed by the IMF) was that capital controls were anathema. (Fortunately, more recently, the conventional wisdom and the position of the IMF have changed.) Thus the ‘optimal’ degree of integration depends on the likelihood of a large shock (and ensuing systemic failure) relative to the level of country-specific risk, and the costs associated with variability (both the costs of systemic risk and the smaller levels of volatility that diversification is supposed to reduce). Moreover, the types and

knyazeva et al.  |  101 severity of informational and other frictions present in different countries must be considered for a complete assessment of the trade-offs and benefits of capital market integration. There are many explanations of the large external shocks confronting countries that have liberalised: irrational investor perceptions that can suddenly change; sudden changes in investor willingness to bear risk, sometimes related to changes in monetary policy in the countries from which the money originates; sudden changes in interest rates in industrialised countries; or (as in the most recent episodes) financial and economic crises elsewhere. What is clear is that countries that link themselves closely with the world’s unstable and volatile global financial markets are exposing themselves to large risks, larger than most can easily handle. Furman and Stiglitz (1998) and Stiglitz (2004) argue that the rapid growth in un-hedged short-term debt exposures following the liberalisation of their capital markets made East Asian markets vulnerable to sudden capital outflows and played a key role in the subsequent crisis. Moreover, financial integration limited the flexibility of the macroeconomic policy response because of the concern that interest rate reductions would exacerbate capital flight. The propagation of the shocks associated with the US and European financial crises has again illustrated the risks associated with capital and financial market liberalisation. In the aftermath of the Asian financial crisis and the Great Recession, the highly volatile, short-term, speculative nature of inter­national capital movements has led many emerging market governments to reconsider the benefits of full liberalisation of capital flows (Calvo and Mendoza 2000). Recently, the IMF has also argued that certain restrictions on cross-border capital flows may be desirable and has included such restrictions in some of its recent programmes (in Iceland, for example) (IMF 2011, 2012). Europe’s single market principle (including provisions under which a bank that is regulated by one jurisdiction is allowed to operate freely in other jurisdictions) embodies financial and capital market liberalisation (though limited to the members of the EU). Funds can flow freely within the region. With the crisis, we have

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seen some of the adverse consequences: failure of Iceland’s underregulated banks resulted in large losses to UK and Dutch depositors.32 Losses on Greek bonds affected not only Greece but (as we have previously noted) also contributed to the Cypriot crisis. Backing the banking system is the government (note: bank credit default swaps (CDSs) and sovereign CDSs are highly correlated). With the single market, it makes sense for depositors in countries at risk (Spain, Greece, Portugal, Cyprus, Italy) to take their money out and move it to stronger countries – deepening the downturn in the afflicted economies. There is now a growing consensus on two points: • Countries have to regulate all financial institutions operating within their jurisdiction (regardless of ownership) and they should be organised as subsidiaries (not branches) to ensure that there is adequate capital within the country (United Nations 2010). • There is a fundamental structural flaw in the Eurozone framework. A single market without a banking union with common supervision, common resolution and common deposit insurance is unstable.33 Since 1980, when the recent wave of capital and financial market liberalisation began, the world has experienced over a hundred crises. While these have had disastrous effects on the economies of the afflicted countries and on the lives and livelihoods of their citizens, they have provided us with a rich set of examples in which we can study crises and their propagation, and to devise policy frameworks that would enable us to reduce the occurrence and magnitude of future crises, as well as better responses to crises when they occur. We have identified a number of mechanisms leading to crises and their contagion. Most of the plausible mechanisms require us to go beyond the standard macroeconomic frameworks based on rational agents with rational expectations operating in well-functioning financial markets. We have identified key ways in which many of the models – and much of the policy discourse – are seemingly incoherent: in the standard models, diversification always reduces risk. Before crises, the virtues of financial integration are praised and there are few concerns about contagion; after the crisis, the focus shifts to

knyazeva et al.  |  103 how, in an integrated world, a crisis in one country can be quickly transmitted to another. Within these models, we have identified some key trade-offs, for example between the ability of the economy to ‘smooth’ small shocks and its exposure to large, systemic crises. We have noted that markets, by themselves, may not manage risks well: for instance, privately profit­able contracts (such as those concerning risk sharing) need not be socially optimal. In some cases, the policy prescriptions seem clear: the costs of the risks of systemic crises from cross-border banks that are too big to fail exceed any conceivable benefits from econ­ omies of scale and scope. Similarly, in the presence of bankruptcy costs and other frictions, the benefits from allowing banks to increase the debt-to-equity ratio have to be weighed against the increased costs of default of highly leveraged banks, and the repercussions of bank failures for the real sector. So too, a ‘single market’ such as that pursued by Europe is likely to be highly unstable without a banking union with common prudential supervision, common deposit insurance and common resolution. Without such a banking union, the system is dynamically unstable, and countries are exposed to a greater risk of crisis (and larger losses conditional on the crisis occurring in one economy, as the crisis spreads to other economies within the single market). These are examples of situations where trade-offs are clear and, accordingly, policy prescriptions are straightforward, but in other cases the trade-offs are more complicated and the answers less clear. What is needed now is a comprehensive model that integrates various crisis transmission channels and provides a coherent set of policy recommendations to reduce the magnitude and frequency of shocks, to stem contagion and to respond to the crises that nonetheless occur. Notes 1  This chapter is adapted from an essay originally published as ‘Crises and contagion: a survey’ in What If Ireland Defaults?, edited by Brian Lucey, Charles Larkin and Constantin Gurdgiev (Dublin: Orpen Press, 2012, pp. 17–49). The

authors thank the editors of that volume for their helpful suggestions. 2  The Irish government formed the NAMA, which took land and construction loans off bank balance sheets in an effort to shore up major banks. There

104  |  two were major institutional flaws in the design of NAMA that undermined its ability to fulfil its mission. These are not the subject of this chapter. 3  We say ‘typically’ because there are exceptions: in the Great Recession, though precipitated by the US banking crisis, the US appeared to be a safe haven, and its exchange rate appreciated. The subsequent low interest rates and depressed wages helped (at least tem­porarily) to buoy stock market prices, even though economic activity languished. 4  Even before the US financial crisis, though, this standard interpretation of the East Asian crisis had been criticised. The most serious financial/banking crises immediately prior to the East Asian crisis were those in the Scandinavian countries, usually held out to be a model of transparency; and prior to that was the US savings and loan crisis. Models trying to explain vulnerability to a crisis did not suggest that transparency was a major determinant (see Furman and Stiglitz 1998). 5  After each crisis of the 1980s and 1990s, policy makers identified a factor that seemed to be pivotal as the source of a crisis: an overvalued exchange rate, excessive public indebtedness, insufficient private savings, lack of transparency. But the analysis was ad hoc and had little predictive power. Mexico’s problems in 1994 were markedly different from those of Latin America in the early 1980s. East Asian countries had high savings rates and low public indebtedness. The last set of countries to suffer from a financial crisis before the East Asian crisis were those of Scandinavia, generally viewed as the most transparent in the world. Furman and Stiglitz (1998) attempt to identify econometrically the factors that contribute to an economy’s vulnerability to a financial crisis. Needless to say, their

results confirm the lack of predictive power of the standard explanations of vulnerability to a crisis. 6  At the time, the focus was on ‘Great Moderation’ and stability in the global economy. 7  That this is not so in general – that markets with even large numbers of well-informed participants may look markedly different from those in which all are well informed – is one of the central messages of Salop and Stiglitz (1982). Grossman and Stiglitz (1980) showed that uninformed market participants could extract some, but not all, of the information from the prices generated by informed traders. 8  The essential insight was that with an overvalued exchange rate the country would generate a trade deficit, which foreign exchange reserves could finance for only a limited amount of time. Of course, if markets anticipated this, with rational expectations, the crisis would occur well before foreign exchange reserves were finally exhausted. 9  There is some evidence that normal trade adjustments, spurred in part by devaluation, were central to the resolution of the crisis; the bailout, by temporarily leading to an exchange rate that was higher than it otherwise would have been, may in fact have impeded adjustment (see Lederman et al. 2001, 2003). 10  As reflected, for instance, in standard surveys. 11  In these models, there is no way that market participants can anticipate when the economy might shift from one equilibrium to another. 12  See also the earlier work of Myers and Majluf (1984) and Greenwald and Weiss (1984). 13  This is either because managers are forced to bear some risk, as part of optimal incentive contracts, or because of bankruptcy costs (see Greenwald and Stiglitz 1990a, 1990b).

knyazeva et al.  |  105 14  Such downturns are, accordingly, often referred to as ‘balance sheet recessions’. This has clearly played a role in the slow recovery from the current economic downturn. 15  Moreover, the value of firm equity can change rapidly, and there may be many claimants. 16  Similarly, Miller and Stiglitz (2010) use a model with collateral requirements to demonstrate how shocks can turn into crises in the presence of high leverage and overvalued assets. 17  The move in many countries from defined benefits to defined contribution pension funds is one example of a shift that has weakened safety nets. 18  More recent research has emphasised that individuals discount information that is inconsistent with their prior beliefs, and give too much weight to information that is consistent. If a bubble is forming, they tend to weigh more heavily the information that is consistent with their beliefs. There can be equilibrium frictions, where they ‘rationally’ believe that there is a bubble (see Hoff and Stiglitz 2010). 19  We should also note that large changes in interest rates and exchange rates can have significant effects on a firm’s net worth, but the effects can differ markedly according to the assets owned by the firm. Since it may be difficult to ascertain the precise effect on each firm’s balance sheet, sudden changes in exchange rates or interest rates induce high levels of uncertainty, which are an impediment to investment and to a firm’s willingness to enter contractual (e.g. lending) relationships with others. 20  Traditional economic theory – and economic policy – has taken ambiguous positions about these destabil­ ising adjustments. It has been standard fare to worry about ‘overshooting’. Excessive exchange rate adjustments,

it is thought, impede the adjustment of the market economy to the new (or ‘correct’) equilibrium, and this provides justification for interventions to reduce the magnitude of the exchange rate adjustment. In some cases, there is evid­ ence that such interventions actually impede the adjustment process. Indeed, one set of studies suggests that it was the normal foreign exchange adjustment mechanism that restored Mexico’s growth, and that attempts to dampen the foreign exchange correction (driven by concerns about the impact on foreign creditors) slowed down adjustment. In particular, if there had been larger foreign exchange adjustments accompanied by debt restructuring, the economy arguably would have recovered more quickly (Lederman et al. 2001, 2003). 21  Standard macro theories are of two minds about the role of wage and price rigidities. While the Hicksian I­ S-LM tradition focuses on wage and price rigidities, the Fisherian tradition revived by Greenwald and Stiglitz (1993a, 1993b, and the articles cited there) emphasises that, with imperfectly indexed debt contracts, wage flexibility may exacerbate economic downturns. In a model where both wages and prices are flexible, but imperfectly so, the economy can have sustained unemployment (see Solow and Stiglitz 1968). 22  Although many sources mention contagion, no consensus has emerged on a precise definition (see, for example, Gallegati et al. 2008). In the broadest sense, contagion involves spillovers of economic events from one country to other countries (or, in the context of lending, from one borrower to other b ­ orrowers). A narrower view, more s­ pecific to crisis episodes, defines contagion as an increase in correlations between two countries in bad times or, in the words of Dornbusch et al. (2000: 178), ‘a significant increase in cross-market

106  |  two linkages after a shock to an individual country, as measured by the degree to which asset prices or financial flows move together across markets relative to this comovement in tranquil time’. 23  There were large declines in trade volumes, including of manufactured goods, so countries for which manufactured exports were particularly important were exposed to large negative spillovers, even in the absence of financial linkages with the crisis econ­ omies. As we noted earlier, in turn, a large economic downturn can obviously affect the country’s banking system. 24  Bank decisions in anticipation of contagion can increase the level of systemic risk. For example, Acharya and Yorulmazer (2008) consider the lending decisions of banks affected by common as well as idiosyncratic shocks. If one bank fails, investors update their assessment of other banks. Investors are unable to tell if the bank failed for bank-specific or systemic reasons, so they become more reluctant to invest in the remaining banks. Anticipating such investor actions, banks try to minimise unfavourable information spillovers of bank failures by investing in more highly correlated loans. Thus, the expectation of contagion causes banks to herd, which aggravates systemic risk and the magnitude of contagion occurring ex post. Nalebuff and Stiglitz (1983) examine the role of incentive conflicts in explaining herding. 25  It is not just the number of links that is important, but the structure. With some structures, systemic risk can increase. 26  Stiglitz (2010c) uses a lifecycle model to show that capital market liberal­isation may actually reduce the scope for inter-temporal risk sharing, and thus lower the expected utility. 27  The general theory is set out in Korinek (2008).

28  Institutional considerations also seem to play a role: if a particular set of funds has invested in Brazil and Russia (and these holdings are significant in the relevant portfolios), then a loss in the value of Russian assets may force a sale of Brazilian assets, both as the fund seeks to rebalance its portfolio and as investors withdraw their money from these funds as a result of their disappointment in the funds’ managers. These institutional considerations may have played an important role in the transmission of the shock associated with the 1998 rouble crisis to Brazil. 29  Alternatively, if contagion occurred through ‘real’ channels – Mexican purchases of Argentinian goods were enhanced as a result of exchange rate support, because real balance effects are more important than relative price effects – then the Mexican intervention could reduce spillover effects. These effects did not play an important role in the discussions preceding most of the bailouts. 30  The discussion below can be thought of as part of a broader analysis of the ‘optimal’ financial architecture – the kinds of inter-linkages that would best maximise social welfare, taking into account impacts on growth, the ability of the system to absorb small shocks, and the possibilities of systemic risk. Stiglitz (2000, 2002, 2006, 2010b, 2010c) analyses the optimal design of inter­national financial architecture given both the benefits and the costs of financial integration. 31  In this context, we refer to the opening of a country’s financial system to banking institutions (and other financial institutions) from abroad as financial liberalisation, and to the elimination of a broader set of restrictions on the flow of funds into and out of a country as capital market liberalisation. 32  Iceland is not a member of the

knyazeva et al.  |  107 EU, but it is a member of EFTA (the European Free Trade Area), and so Iceland’s banks were allowed to operate freely elsewhere in the region. 33  This is a necessary, but not a sufficient, condition for stability. Free migration can lead to labour movement out of highly indebted countries, in the absence of a stronger fiscal union. See Stiglitz (2014) for a fuller discussion.

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as informational cascades’. Journal of Political Economy 100(5): 992–1026. Caballero, R. and A. Krishnamurthy (2001) ‘International and domestic collateral constraints in a model of emerging market crises’. Journal of Monetary Economics 48(3): 513–48. Calvo, G. and E. Mendoza (2000) ‘­Rational contagion and the global­ ization of securities markets’. Journal of Economic Theory 51(1): 79–113. Cespedes, L., R. Chang and A. Velasco (2004) ‘Balance sheets and exchange rate policy’. American Economic Review 94(4): 1183–93. Chava, S. and A. Purnanandam (2011) ‘The effect of banking crisis on bankdependent borrowers’. Journal of Financial Economics 99(1): 116–35. Chen, Y. (1999) ‘Banking panics: the role of the first-come, first-served rule and information externalities’. Journal of Political Economy 107(5): 946–68. Diamond, D. and P. Dybvig (1983) ‘Bank runs, deposit insurance, and liquidity’. Journal of Political Economy 91(3): 401–19. Dornbusch, R., Y. Park and S. Claessens (2000) ‘Contagion: understanding how it spreads’. World Bank Research Observer 15(2): 177–97. Ferri, G., L.-G. Liu and J. E. Stiglitz (1999) ‘The procyclical role of rating agencies: evidence from the East Asian crisis’. Economic Notes 28(3): 335–55. Furman, J. and J. E. Stiglitz (1998) ‘Economic crises: evidence and insights from East Asia’. Brookings Papers on Economic Activity 29(2): 1–136. Gallegati, M., B. Greenwald, M. Richiardi and J. E. Stiglitz (2008) ‘The asymmetric effect of diffusion processes: risk sharing and contagion’. Global Economy Journal 8(3): article 2. Goldstein, I. and A. Pauzner (2004) ‘Contagion of self-fulfilling financial crises due to diversification of

108  |  two investment portfolios’. Journal of Economic Theory 119(1): 151–83. Greenwald, B. and J. E. Stiglitz (1986) ‘Externalities in economies with imperfect information and incomplete markets’. Quarterly Journal of Economics 101(2): 229–64. — (1987) ‘Keynesian, new Keynesian and new classical economics’. Oxford Economic Papers 39(1): 119–33. — (1988a) ‘Imperfect information, finance constraints and business fluctuations’. In M. Kohn and S. C. Tsiang (eds) Finance Constraints, Expectations, and Macroeconomics. Oxford: Oxford University Press, pp. 103–40. — (1988b) ‘Money, imperfect information and economic fluctuations’. In M. Kohn and S. C. Tsiang (eds) Finance Constraints, Expectations and Macroeconomics. Oxford: Oxford University Press, pp. 141–65. — (1990a) ‘Asymmetric information and the new theory of the firm: financial constraints and risk behavior’. Ameri­ can Economic Review 80(2): 160–5. — (1990b) ‘Macroeconomic models with equity and credit rationing’. In R. B. Hubbard (ed.) Asymmetric Information, Corporate Finance, and Investment. Chicago IL: University of Chicago Press, pp. 15–42. — (1993a) ‘Financial market imperfections and business cycles’. Quarterly Journal of Economics 108(1): 77–114. — (1993b) ‘New and old Keynesians’. Journal of Economic Perspectives 7(1): 23–44. — (2003) Towards a New Paradigm in Monetary Economics. Cambridge: Cambridge University Press. — (2013) Creating a Learning Society: First annual Arrow Lecture. New York NY: Columbia University Press. — and A. Weiss (1984) ‘Informational imperfections in the capital market and macroeconomic fluctuations’.

American Economic Review 74(2): 194–9. Griffith-Jones, S., J. A. Ocampo and J. Stiglitz (2010) Time for a Visible Hand: Lessons from the 2008 world financial crisis. Initiative for Policy Dialogue Series. Oxford: Oxford University Press. Grossman, S. and J. E. Stiglitz (1980) ‘On the impossibility of informationally efficient markets’. American Economic Review 70(3): 393–408. Gurdgiev, C., B. M. Lucey, C. Mac an Bhaird and L. Roche-Kelly (2011) ‘The Irish economy: three strikes and you’re out’. Panoeconomicus 58(1): 19–41. Haldane, A. (2009) ‘Rethinking the financial network’. Speech given at the Financial Student Association, Amsterdam, 28 April. — and R. May (2011) ‘Systemic risk in banking ecosystems’. Nature 469: 351–55. Helmann, T., K. Murdoch and J. E. Stiglitz (2000) ‘Liberalization, moral hazard in banking and prudential regulation: are capital requirements enough?’ American Economic Review 90(1): 147–65. Hirshleifer, D. and S. Teoh (2009) ‘Thought and behavior contagion in capital markets’. In T. Hens and K. Schenk-Hoppe (eds) Handbook of Financial Markets: Dynamics and ­evolution. Amsterdam: Elsevier, pp. 1–56. Hoff, K. and J. E. Stiglitz (2010) ‘Equilibrium fictions: a cognitive approach to societal rigidity’. American Economic Review 100(2): 141–6. IMF (2011) The Multilateral Aspects of Policies Affecting Capital Flows. Washington DC: International Monetary Fund (IMF). Available at www.imf. org/external/np/pp/eng/2011/101311. pdf. — (2012) The Liberalization and Manage­

knyazeva et al.  |  109 ment of Capital Flows: An institutional view. Washington DC: International Monetary Fund (IMF). Available at www.imf.org/external/np/pp/ eng/2012/111412.pdf. Kindleberger, C. and R. Aliber (2005) ­Manias, Panics, and Crashes: A His­ tory of financial crises, 5th edition. Hoboken NJ: John Wiley and Sons (foreword by R. Solow). King, M. and S. Wadhwani (1990) ‘Transmission of volatility between stock markets’. Review of Financial Studies 3(1): 5–33. Kiyotaki, N. and J. Moore (1997) ‘Credit cycles’. Journal of Political Economy 105(2): 211–48. Kodres, L. and M. Pritsker (2002) ‘A rational expectations model of finan­ cial contagion’. Journal of Finance 57(2): 769–99. Korinek, A. (2008) ‘Regulating capital flows to emerging markets: an externality view’. Working paper, University of Maryland. Krugman, P. (1979) ‘A model of balanceof-payments crises’. Journal of Money, Credit, and Banking 11(3): 311–25. Kyle, A. and W. Xiong (2001) ‘Contagion as a wealth effect’. Journal of Finance 56(4): 1401–40. Lederman, D., A. Menendez, G. Perry and J. E. Stiglitz (2001) ‘Mexico: five years after the crisis’. In B. Pleskovic and N. Stern (eds) Annual Bank Con­ ference on Development Economics 2000. Washington DC: World Bank, pp. 263–82. — (2003) ‘Mexican investment after the tequila crisis: basic economics, “confidence” effect or market imperfection?’ Journal of International Money and Finance 22(1): 131–51. Mendoza, E. (2010) ‘Sudden stops, financial crises, and leverage’. American Economic Review 100(5): 1941–66. Miller, M. and J. E. Stiglitz (2010) ‘Leverage and asset bubbles: averting

Armageddon with Chapter 11?’ Economic Journal 120(544): 500–18. Myers, S. and N. Majluf (1984) ‘Corporate financing and investment decisions when firms have information that investors do not have’. Journal of Financial Economics 13(2): 187–221. Nalebuff, B. and J. E. Stiglitz (1983) ‘Prizes and incentives: towards a general theory of compensation and competition’. Bell Journal of Econom­ ics 14(1): 21–43. Paasche, B. (2001) ‘Credit constraints and international financial crises’. Journal of Monetary Economics 48(3): 623–50. Radner, R. and J. E. Stiglitz (1984) ‘A nonconcavity in the value of information’. In M. Boyer and R. Khilstrom (eds) Bayesian Models in Economic Theory. Amsterdam: Elsevier, pp. 33–52. Rashid, H. (2011) ‘Credit to private sector, interest spread and volatility in credit-flows: do bank ownership and deposits matter?’ Working paper, United Nations. Sachs, J., A. Tornell and A. Velasco (1996) ‘The Mexican peso crisis: sudden death or death foretold?’ Journal of International Economics 41(3–4): 265–83. Salop, S. and J. Stiglitz (1982) ‘The theory of sales: a simple model of equilibrium price dispersion with identical agents’. American Economic Review 72(5): 1121–30. Scheinkman, J. and W. Xiong (2003) ‘Overconfidence and speculative bubbles’. Journal of Political Economy 111(6): 1183–219. Shell, K. and J. E. Stiglitz (1967) ‘Allocation of investment in a dynamic economy’. Quarterly Journal of Eco­ nomics 81(325): 592–609. Solow, R. and J. E. Stiglitz (1968) ‘Output, employment and wages in the short run’. Quarterly Journal of Economics 82(4): 537–60.

110  |  two Stiglitz, J. E. (1999a) ‘Reforming the global economic architecture: lessons from recent crises’. Journal of Finance 54(4): 1508–21. — (1999b) ‘Knowledge for development: economic science, economic policy, and economic advice’. In B. Pleskovic and J. Stiglitz (eds) Annual World Bank Conference on Development Economics 1998. Washington DC: World Bank, pp. 9–58. — (2000) ‘Capital market liberalization, economic growth, and instability’. World Development 28(6): 1075–86. — (2001) ‘From miracle to crisis to recovery: lessons from four decades of East Asian experience’. In J. Stiglitz and S. Yusuf (eds) Rethinking the East Asian Miracle. Oxford: Oxford University Press, pp. 509–26. — (2002) Globalization and Its Discon­ tents. New York NY: W.W. Norton & Company. — (2004) ‘Capital market liberalization, globalization, and the IMF’. Oxford Review of Economic Policy 20(1): 57–71. — (2006) Making Globalization Work. New York NY: W.W. Norton & Company. — (2010a) Freefall: America, free markets, and the sinking of the world economy. New York NY: W.W. Norton & Company, pp. 333–4. — (2010b) ‘Contagion, liberalization, and the optimal structure of global­ ization’. Journal of Globalization and Development 1(2): article 2. — (2010c) ‘Risk and global economic archi­tecture: why full financial integ­ ration may be undesirable’. American Economic Review 100(2): 388–92. — (2011a) ‘Preface’. In D. Coats (ed.) Ex­

iting from the Crisis: Towards a model of more equitable and sustainable growth. Brussels: European Trade Union Institute, pp. 9–16. — (2011b) ‘Rethinking macroeconomics: what failed and how to repair it’. Journal of the European Economic Association 9(4): 591–645. — (2013) ‘Stable growth in an era of crises: learning from economic theory and history’. Economi-tek 2(1): 1–39. — (2014) ‘Crises: principles and policies, with an application to the Eurozone crisis’. Forthcoming in the proceedings of the International Economics Association’s 2012 Buenos Aires roundtable. — and A. Weiss (1986) ‘Credit rationing and collateral’. In J. Edwards, J. Franks, C. Mayer and S. Schaefer (eds) Recent Developments in Cor­porate Finance. Cambridge: Cambridge University Press, pp. 101–35. United Nations Commission of Experts of the President of the United ­Nations General Assembly on Reforms of the International Monetary and Financial System (2010) The Stiglitz Report: Reforming the inter­ national monetary and financial ­systems in the wake of the global crisis. New York NY: The New Press. Wade, R. (2013) ‘What economists should have learned from the Western financial crash and long slump: inequality, financial globalization, and macroeconomics’. Lecture delivered 17 January, Azim Premji University, Bangalore. Wagner, W. (2010) ‘Diversification at financial institutions and systemic crises’. Journal of Financial Inter­ mediation 19(3): 373–86.

3  |  COUNTERING THE MYTHS OF THE PORTUGUESE DEBT

Mariana Mortágua

Introduction This chapter argues that the policy failure in the resolution of the European sovereign debt crisis is a symptom of misdiagnosis of the root causes of the problem. Mainstream perspectives on the crisis are questioned using data from peripheral nations in the Eurozone, particularly Portugal. According to the common narrative, the collapse in Portugal and Greece – now also affecting both Spain and Italy – is the result of decades of systematic misgovernment combined with reckless finance in both the public and private sectors. Residents in these peripheral nations are accused of having been ‘living beyond their means’ and are now being called upon to foot the bill via austerity measures such as cutbacks in social services and wages. For too long, the mainstream media have painted the picture of discrete national disasters within each country rather than a European crisis as a whole. In fact, to date, the role of European institutions and of historical structural economic idiosyncrasies of the peripheral nations themselves remains largely unchallenged. Rather than suggest changes in the European Union (EU) and in the institutional framework of the European Monetary Union (EMU), a rebalancing of public and private balance sheets is advocated via austerity so as to ‘restore market confidence’. Additionally, great emphasis is placed on the implementation of structural reforms, particularly in labour markets, which are aimed at lowering labour costs and flexibilising employment. This, it is claimed, will create jobs and the conditions for a new period of strong economic growth.1 Unfortunately, this prevailing view of the crisis has some severe flaws. Some of these flawed viewpoints shall be addressed in this chapter in the context of the Portuguese experience. One glaring omission

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is the attempt to promote a cure to Europe’s public indebtedness while completely ignoring the role of the global financial crisis. This crisis, popularly known as the Great Recession, began to wreak havoc in global financial markets in the US in 2007–08 with the collapse of investment banking in general, and of Lehman Brothers, Merrill Lynch & Co. and AIG in particular. The pursuit of a cure for European financial problems seems to exist in a vacuum that purports to ignore the fact that this enormous financial crisis has even occurred. The collapse of the financial bubble referred to as the ‘sub-prime mortgage’ crisis undermined global financial confidence. Toxic financial assets had been spread across the balance sheets of global investors (many in Europe) and were soon discovered to be largely worthless. Lending in the interbank money market froze and liquidity dried up, rendering it impossible to sustain existing levels of bank leverage. Credit shortages had global financial effects, for­ cing asset sales at discount prices (causing a generalised fall in the financial and stock markets) and effectively shrinking global finance. Losses were held on bank balance sheets, both onshore and also in the ‘shadow’ banking sectors, and were then transferred to public accounts. The liquidity emergency became a solvency crisis. Holes in the balance sheets of banks had drastic effects on the amount of credit supplied to the economy. While the global financial crisis is clearly relevant to Europe’s current financial woes, this chapter does not intend to go into its broad causes. Suffice to say that it is, most certainly, a product of thirty years of deregulation and financialisation, which have brought greater income inequality along with the accumulation of both national and international economic imbalances. The mainstream viewpoint has systematically disregarded the importance of the rapidity with which this private financial crisis interacted with the national and European structural defects and evolved into a sovereign debt crisis, as European states rushed to bail out troubled financial institutions with public money. Repeated ambiguity and delays at the European level enabled speculation in the secondary bond markets with ner­ vous investors exchanging bonds for speculative funds. The nationalisation of private financial losses and, to a certain

mortágua  |  113 extent, the impact of policies such as automatic budget stabilisers (designed to automatically increase social expenses and reduce tax revenues as the economic and social situation worsens) caused rapid increases in public deficits. In particular, this has happened in those countries that were already in a financially delicate state, such as Portugal and Greece. The resulting degradation in public accounts has been used by ‘the markets’ to justify their pressure on public debt, raising interest rates and pushing some countries into external ‘rescue’ programmes. Existing data on public spending, wages and productivity disprove ‘common-sense’ arguments leading one to question the real meaning of ‘living beyond one’s means’. The underlying structural causes of the European imbalances are not the fiscal profligacy of lazy countries in the continent’s periphery, nor can they be addressed through draconian austerity programmes. On the contrary, cuts in public spending and tax increases, combined with liberal reforms in labour markets, have generated a spiral of recessive effects, from which it may take a decade to recover. As the peripheral nations rapidly approach a situation of fiscal exhaustion, the decreasing marginal gains of raising the tax burden and cutting expenditures become negative, thereby compromising the fiscal adjustment targets that are the very objective of these measures. What is now becoming painfully obvious is that the adjustment plans all over Europe and their formula of austerity and structural measures in labour markets are the wrong medicine for a poorly diagnosed disease. Delicate finances and speculative attacks The reasons why Portugal and similar nations were in such a delicate situation – or, in other words, the real root causes of the dismal performance of the Portuguese economy – remain in the shadows, the result of a dearth of serious analysis and a failure to reject  the simplistic arguments of the dominant view. This is a second major flaw in the handling of the periphery’s sovereign debt crisis. The majority of this chapter is dedicated to this analysis, with an emphasis on the Portuguese experience.

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Public indebtedness in peripheral countries was used as the justification for the successive downgrades by rating agencies, which in turn promoted financial speculation and raised doubts in financial markets about the solvency of both the state and of the private banks in those countries. Although there are other factors to be taken into consideration, speculative attacks could only have such an impact in degrading governments’ debt sustainability since those governments were not in control of the currency in which their debt was issued. The institution responsible for currency issuance and management, the European Central Bank (ECB), refused to act as a lender of last resort2 to states. Therefore, in the absence of an institution capable of preventing markets from gambling with government bonds, nation states were left with speculation as the only source of financing in times of economic distress. As the yields of Portuguese long-term bonds were driven up sharply, their values tumbled, affecting the solvency of national banks that were already facing serious finan­ cing difficulties.3 This, in turn, required injections of public capital, again compromising public finances and forcing further increases in bond yields. Irrespective of their origin, the high levels of sovereign debt were couched in the mainstream press as immoral – the cause (and the solution) of all evils. The population of indebted countries became the ‘sinners’ in need of redemption. Austerity was therefore proposed as a way to appease the gods and solve the economic crisis. In reality, as argued in this chapter, the true aims of austerity measures are to engineer an enormous cut in labour costs (by reducing both salaries and public services), transferring the weight of adjustment to workers and pensioners in an attempt to compensate for the massive capital destruction caused by the financial crash. Effectively, the crisis: evolved from a private crisis whose resolution would imply a re-foundation of capitalism, to a public sector crisis, the nonresolution of which would cause the collapse of the model of social protection and of the welfare-state system (Garcia-Arias et al. 2011: 4)

Even where one is obliged to admit that capitalism itself, as a

mortágua  |  115 broad economic system, is not in question as yet, one should not ignore those signals that suggest certain underlying mutations in the very foundations of neoliberalism towards a more conservative regime. The imposition of austerity implied the emergence of a discourse designed to convince populations to accept these retrogressive steps in their rights. This came not only from the political right but also from social democrat and socialist governments all over Europe. A novel moral discourse, calling for old concepts such as guilt, sacrifice, charity and redemption, preceded more authoritarian governance. Austeritarianism seems to be the new regime, meant to replace the old liberal–democratic states, implemented by elected governments to control populations’ reactions when confronted with two outstanding facts: • For the first time in history (in the ‘rich world’), neoliberalism is not representative of progress and a better life; on the contrary, the only solution that fits within its theoretical framework is a deep and generalised process of impoverishment. • Because it affects the very basis of European democracies – free public services and a universal welfare system – austerity is intrinsically undemocratic. A certain level of public awareness of these facts, together with the idea of the unequal distribution of sacrifices in society and the reckless behaviour of bankers and other financial market agents, is now leading to a generalised crisis of democratic legitimacy. This in turn has given birth to new kinds of social protest, such as the indignados in Spain and the Que Se Lixe a Troika in Portugal, and social movements that have spread all over Europe (and overseas). The following section discusses the situation in Portugal, arguing that the roots of the sovereign debt crisis are not found in the high wages of lazy workers or in an overly generous welfare state, but in a combination of structural factors including the institutional configuration of the Eurozone. It is argued that austerity may not be the most appropriate strategy to deal with the problem; in fact, it aggravates the problem, accelerating economic and social collapse.

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Portugal: could things have been different? The pattern of convergence of the Portuguese economy in the EU was anything but linear. Between 1986, the year in which Portugal entered the European Economic Community (EEC), and 1992, when the nominal adjustment process started in order to achieve the criteria to join the common currency, average incomes converged at a fast pace with those of the EU. From then on, national economic performance did not allow for any real convergence. Between 2001 and 2012, the Portuguese economy experienced stagnation or negative growth in its gross domestic product (GDP), which contributed to the increasing gap when compared with European growth rates. In two recent papers, the Portuguese economist Paes Mamede (2011a, 2011b) argues that, after 1999, the absence of real convergence in GDP was interrupted sporadically, mostly in election years. However, rather than suggest that the country suffers from a problem of profligate governments, such findings seem to confirm an alternative proposition: given the structural lack of dynamism in the economy, above average growth levels were possible only in periods of abnormal government spending. Hence, as suggested by Paes Mamede, rather than turn our attention to periods of public spending (or whether it was excessive), it might prove more useful to examine why the economy was not able to perform well at other times. Irrespective of most fiscal decisions, Portugal suffers from three structural weaknesses: • the low education level of the labour force; • a profile of economic specialisation based on low wages and low value added activities; and • the peripheral position of the economy in relation to the world economy and other markets. The interaction between these characteristics explains, in part, the weak performance of the economy. It is argued that this unfortunate combination of weaknesses was exacerbated (and also caused) by two other factors. The first was the process of integration in the EMU, and the second has to do with the historical foundation, the structure and the composition of the Portuguese economic ruling class.

mortágua  |  117 When Portugal joined the EEC in 1986, the percentage of workingage adults with secondary education was low at approximately 20%; this was just one aspect of the legacy of thirty years of fascism under the Salazar dictatorship. This figure improved impressively after the Carnation Revolution in 1974. However, changes of this kind require several decades or even entire generations to become visible and fully operational. Portugal still suffers from the lowest levels of school attainment in the EU. The widespread lack of qualifications, and even illiteracy, had serious implications in terms of both social progress and economic performance. It was, and is, deeply connected to the specialisation profile of the economy, both during and after the dictatorship years. By 1986, the fabric of the Portuguese economy was characterised by a predominance of primary sector activities, low value added and low technology intensive manufacturing industries; these were also a consequence of three decades of political and economic isolation. Since the end of the 1960s, when the regime started showing signs of some openness towards the outside world, the industrialisation process was driven mostly by waves of foreign direct investment attracted by a poorly qualified, and consequently low-paid, labour force within the common market. However, during the 1980s, in order to meet the nominal convergence criteria required to join the leading group of countries that would form the EMU, the priority for exchange rate stabilisation led to an appreciation of the Portuguese escudo in relation to a basket of other European currencies (I will come back to this later). Consequently, traditional sectors of the Portuguese industry suffered a major loss of competitiveness, regardless of wage levels. However, the persistent lack of qualifications among the labour force, combined with other structural factors, prevented these difficulties from generating a change in the pattern of specialisation (Paes Mamede 2011). To understand such processes, which resulted in the creation of incentives for investors to focus on other areas (away from the production of high value added tradable goods), it is crucial to focus on how economic power has organised itself in Portugal over the last 100 years.

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The Portuguese economy has been ruled from the nineteenth century onwards by more or less the same industrial and financial groups. These enterprises, mostly organised within powerful old fam­ ilies, have represented more than one-third of Portuguese income. They have determined the accumulation process and have shaped the entrepreneurial landscape of the country. The reason behind their economic and political power is their symbiotic relationship with the state, before, during and after the country’s period of dictatorial rule. In one way or another, they have survived and prospered under the state’s patronage with favourable rents and access to natural monopolies. In exchange, they have benefited from quite an impressive process of social and economic mobility, in an open revolving door between the government and the economic elite. By the end of the 1980s and during most of the 1990s, as a direct consequence of European integration, investment decisions within the Portuguese economy were influenced by, on the one hand, an overvalued currency and a sharp reduction in internal interest rates resulting from the nominal convergence criteria, and, on the other, the privatisation of large public companies as a result of public debt ceilings (part of the Stability and Growth Pact (SGP) criteria) and also to adhere to EU rules on competition and market liberalisation as promoted by the European Commission. Faced with this new political and economic landscape, the existing financial and industrial elite, already dependent on the state, found a means of doing business that was sheltered from risky activities by focusing on those sectors protected from international competition. By availing themselves of cheap international financing, national banks and industrial groups found profitable joint ventures in non-tradable areas including several natural monopolies, such as electricity, energy and telecommunications, but also in financial and real estate activities, construction, retail and distribution. Finally, as a by-product of the need to immediately reduce public debt, and allied to the symbiotic relationship between the state and national economic interests, consecutive governments created a large number of public–private partnerships. These are projects that assure long-

mortágua  |  119 term rents to banks and economic groups, exploiting public services such as hospitals and road construction. These partnerships, the largest number in any European country, represent the root cause of public indebtedness over the following twenty-year period. The incapacity, or unwillingness, of the Portuguese political and economic ruling class to move away from an economy based on nontradable services and low wage industries resulted in the stagnation of this specialisation profile, leaving the economy extremely vulnerable to forthcoming external shocks. Indeed, the weak Portuguese economy was one of the most affected by the entry of China into the World Trade Organization and the EU enlargement into Eastern Europe, along with the strong appreciation of the euro against the dollar between 2001 and 2008. As explained in Os Donos de Portugal (‘Owners of Portugal’), which tells the history of the Portuguese ruling class in the last 100 years: the Portuguese bourgeoisie was never able to bring democracy into the country’s modernisation. It is not a matter of unwillingness or inability, but rather a rejection of social distribution, since its levels of accumulation, granted and supported by the state, have allowed it to reap the benefits of the most extreme social inequality within the European area. The outcome is a strategy, rather than a contingency; it is a huge, and perhaps disturbing, success, but not a problem for the owners of Portugal … The owners of Portugal are Portugal’s main problem (Costa et al. 2010: 16).

The ways in which the Portuguese elite have structured the accumu­lation process help us to understand why the economic crisis has had such an impact, but it cannot and should not be separated from a second factor that is also worthy of analysis: the integration process in the Eurozone. This too has undoubtedly affected the Portuguese external position in terms of trade and capital flows and has also affected its internal public accounts. Asymmetric integration and external imbalances The foundation of the EMU was built on unfair rules that reinforced existing inequalities in growth models and economic power.

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0

-5 Portugal

-10

-15

1994

1996

1998

2000

2002

2004

2006

2008

2010

3.1  Current account balances as a percentage of GDP in Germany and Portugal, 1994–2010 (source: IMF).

In turn, these rules led to enormous imbalances within the union. The Maastricht criteria, together with the idea of an independent ECB obsessed with inflation targeting (while ignoring all other relevant variables in the economies), comprise some of the dogmatic economic theories that underlie the euro crisis. Portuguese exports suffered an immediate loss through the country joining the Eurozone. Economists commonly accept that the country entered the euro at a high rate of exchange when compared with Germany. This imposition was aimed at controlling inflation and sustaining a strong euro (capable of competing with the dollar). According to a recent study by Ferreira do Amaral, the country lost about 17% of its ‘competitiveness’ between 1991 and 2006, with the high exchange rate (between the escudo and the euro) accounting for 60% of that loss. This disadvantage has progressively increased in relation to the core countries, causing systematic current account deficits. One should keep in mind that deficits are a reflection of surpluses elsewhere, and German surpluses are the counterpart to deficits in Portugal (as shown in Figure 3.1). As shown in Figure 3.2, the financial accounts show opposite trends in Portugal and Germany.

mortágua  |  121 15 Portugal 10

5

0

Germany

-5

-10

1995

1997

1999

2001

2003

2005

2007

2009

2011

3.2  Financial accounts as a percentage of GDP in Germany and Portugal, 1995–2011 (source: IMF).

In short, faced with its incapacity, or unwillingness, to invest in a sustainable economic growth pattern, the private sector in Portugal reacted by generating debt. This process has its roots in Portugal’s structural problems, but was also favoured by the integration process in the EU and the EMU. Financialisation and liberalisation within the monetary area encouraged what has become known as the core nation ‘neomercantile’4 strategy, and offered the private sector an opportunity to get into debt cheaply. Private debt is, therefore, the result of a lack of internal growth caused by the economy’s productive structure combined with liberal integration into European markets. Without an integrated approach that was capable of developing the industrial and economic capacities of the various EU countries, these very different economies were left to a regime of free competition, with room for fiscal and social dumping. This zero-sum game at the macro level has produced ­losers and winners in Europe. Particularly on the losers’ side, part of this private debt, mostly belonging to the private financial system, is now being transferred into public accounts. By 2009, Portugal’s external debt was €369,155 million. General government and monetary authorities were responsible for 30% of

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the total debt, while the private sector held 70% of total liabilities. Within the private sector, financial institutions owed 72% of the private share of external debt. However, as the private crisis turned into a sovereign crisis, private debt has been transferred to public accounts. A good example of this operation is the Troika5 loan, which includes a €12 billion ‘package’ (out of €78 billion) that will serve to recapitalise private banks. As a result, according to the most recent data on gross external debt, which has now reached a total of €387,320 million, 52% (as against the previous 30%) belongs to the public sector. Asymmetric integration and public accounts As previously stated, the erosion in external accounts6 is primarily a result of a period of weak growth (with internal structural causes), but it is also the result of an uneven integration process in the EMU, which favoured core countries at the expense of the peripheral economies. The same argument applies to the country’s public finances.7 Increases in the levels of debt in the economy during the 1990s were related to falling interest rates (see Figure 3.3), among other factors. Between the years 1996 and 2000, these movements in the price of capital, combined with a decrease in oil prices, led to a boost in domestic investment and, as a consequence, a boost to average growth levels (of 4.6% in this period). With the economy growing at such a fast pace (levels unthinkable in the current decade), public accounts experienced significant improvements. In 2000, when the euro was introduced, the ECB started to tighten monetary policy by increasing interest rates. The increase in the central bank’s rate had a strong impact on the Euribor, the interest rate prevailing in the Eurozone, causing a decrease in the levels of available income and domestic demand in Portugal (which were supported by debt). The international economic slowdown associated with the collapse of the dot.com bubble in 2000 further aggravated internal fragility (this was reflected by an average growth rate of 0.8% between 2000 and 2005). This anaemic economic performance led to the erosion of public

mortágua  |  123 25

6

4 3

15

2 1

10

0

Lending interest rate

5

Growth

Interest rate

5

Annual GDP growth

20

-1 -2

0

1992

1993

1994

1995

1996

1997

1998

1999

-3

3.3  Interest rates versus GDP growth (percentages) during the process of nominal convergence, 1992–99 (source: World Bank).

finances, and to a public deficit of 4.3%. Portugal then became the first country to break the SGP8 and spent most of the next decade implementing pro-cyclic contractionary policies in order to prevent a recurrence. The consequence of these austerity measures, aimed at controlling public finances in a period of slow economic growth, was a 1% reduction in GDP in 2003 and a decade of real economic divergence from that moment on. The stagnation, or even reduction, in the national output increased domestic debt ratios, affecting investment and consumption decisions, and destroying any chances of economic recovery. This situation was obviously aggravated by a sequence of external shocks, starting with a further increase in interest rates between 2005 and 2008, the appreciation of the euro in 2007 and 2008, the 2008 peak in oil and commodity prices,9 and the beginning of the Great Recession with its epicentre in New York. When the Great Recession hit the economy: Portugal was still going through an adjustment process characterized by low economic growth, rising unemployment rates (from nearly full employment, 3.9% unemployment in 2000, up to 7.7% in 2006) and, largely as a consequence, a steady rise in the public

124  |  three

debt ratio (which surpassed the Eurozone average for the first time in 2006, reaching 69.3% of the GDP) (Paes Mamede 2011b: 7).

It is, therefore, always worth emphasising that the Portuguese debt-to-GDP ratio was below the European average until 2006, when it hit 69.3%. The same can be said of many of the so-called PIIGS10 nations, such as Spain (43%) and Ireland (27%). Dangerous myths By the beginning of 2010, the Portuguese government faced four major problems: rising unemployment; a decreasing GDP; growing public deficits; and the unsustainable cost of borrowing. In order to control ‘the markets’ and to reduce public deficit (and therefore, it was argued, promote growth), four different austerity packages were implemented within one year. These included cuts in public sector wages and social spending, a severe reduction in public investment and higher taxes on consumption and employment income. Despite this, unsurprisingly, austerity proved to be ineffective. Yields on Portuguese sovereign bonds continued to rise, in both primary and secondary markets, fuelled by rating agency downgrades and speculation, partly as a result of ECB behaviour.11 At the same time, the combination of high interest rates and slower economic growth caused the public debt to increase, setting in ­motion a ‘snowball effect’, a sovereign debt spiral. As a result, in  June, the ­Portuguese government and the two major right-wing parties12 signed a memorandum of understanding (MoU) with the Troika.13 As in Greece, this agreement implied a €78 billion loan, with harsh conditions. In 2011, the recently elected government initiated a violent consolidation plan, aimed at reducing the public deficit from 9.8% of GDP to 3% by 2013. Aside from the draconian cuts in public spending – social security, education, healthcare, capital investment and public sector wages – a new package of labour market reforms is being implemented, including the end of collective contracts and bargaining instruments, an increase in legal unpaid working hours, and changes in the duration of unemployment benefits.

mortágua  |  125 In Portugal, as in many other countries, two main arguments were used to make austerity acceptable: • Portugal lost its competitiveness because wages were growing faster than productivity14 and labour markets were too restrictive. • Debt is the result of people and the state living beyond their means due to high consumption and an excessively generous welfare state. As is the case in various other countries, the foundations for these theories are weak. Rather, these are moral judgements and not the result of any thorough analysis of the real economic situation. Across the European periphery, these myths are used indiscriminately, in all indebted countries, regardless of their specific characteristics and regardless of how the ‘public’ debt was created. Given such a simplistic causal analysis, the solution is straightforward: in order for a country to recover its competitiveness and pay off its debt, both the cost of labour and the size of the state must be reduced. These beliefs are deeply embedded in current economic policy – austerity is seen as a strategy to sanitise public finances and achieve an export-led model based on low labour costs. The following section examines the validity of these myths.

Portuguese wages grew faster than productivity, compromising competitiveness  Before going anywhere further in our analysis, let us start by performing a simple and clarifying exercise comparing the average gross annual earnings within Europe (Figure 3.4). Looking at the line representing the level of Portuguese average earnings, it is difficult to conclude that the major economic problem in Portugal is its high salaries. On the contrary, workers in Portugal are near the bottom of the European scale in terms of average gross earnings, well below other euro countries and above only certain Eastern European countries, such as Poland, Hungary, Romania and Lithuania. Also, when looking at the evolution of the unemployment rate (Figure 3.5), there is nothing that leads one to the conclusion that restrictive labour markets are the main cause of unemployment. On

126  |  three 45

Germany

40

Austria

35 30 25

Spain

20

Portugal

15 10

Slovakia

5 0

Bulgaria 1996

1998

2000

2002

2004

2006

2008

3.4  Average gross annual earnings (thousand euros), 1996–2008 (source: Eurostat). 20 18 16 14 12 10 8 6 4 2

q3

1 q2 998 1 q1 999 20 q4 00 2 q3 000 20 q2 01 2 q1 002 20 q4 03 2 q3 003 20 q2 04 2 q1 005 2 q4 006 20 q3 06 2 q2 007 2 q1 008 2 q4 009 2 q3 009 2 q2 010 20 q1 11 2 q4 012 20 q3 12 20 13

0

3.5  Official unemployment rate in Portugal (as a percentage of the active population), 1998–2013 (source: Statistics Portugal).

the contrary, unemployment seems to have increased with market flexibilisation in the past few years.15

Real unit labour costs  The standard measure used to compare competitiveness between countries is the real unit labour costs (RULC), which measures the nominal wage per unit of production (how much

mortágua  |  127 170 160 150

Greece

Portugal

140 130

Spain

Italy

120 Ireland 110 100

Germany

90 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 3.6  Evolution of real unit labour costs, 1995–2008 (source: Lapavitsas et al. 2010a).

it costs each unit of output in labour terms), or, in economic terms, the ratio between nominal labour remuneration and real output. Figure 3.6, taken from the Research on Money and Finance (RMF) report on the Eurozone crisis (Lapavitsas et al. 2010a), shows the evolution of RULC and compares several countries in Europe, using 1995 as the base year. The flatness of unit labour costs in Germany seems to confirm the idea that German nominal wages followed changes in productivity. On the other hand, nominal wages in the peripheral countries evolved faster than productivity, causing RULC to increase sharply in the last fifteen years. In layman’s terms, this means that the relative productivity of an average Portuguese worker falls compared with that of an average German in this period, right? Not necessarily. Contrary to popular opinion, the growth of RULC does not necessarily imply that wages are growing faster than output or that the share of wages in national income is growing. Furthermore, because it divides a nominal variable (wages) by a real variable (output), unit labour costs do not convey the effect of inflation on wages. As

128  |  three 6

5

Greece

Ireland

4 Spain

3 Portugal

Italy

2 Germany 1

0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 3.7  Inflation rate (percentage), 1997–2008 (source: Eurostat).

in many other countries, nominal wages in Portugal tend to catch up with changes in price levels. Therefore, differences in inflation partially explain (Figure 3.7) why unit labour costs evolved differently in the periphery compared with those in Germany. If we look at real compensation of labour, instead of unit labour costs, the overall picture changes. In fact, real compensation of labour was growing as fast in Portugal as it was in Germany. This fact, by itself, should suffice to question the wages myth. Nevertheless, it remains true that real compensation of labour grew faster in most peripheral countries than in Germany, which was compressing its internal wages. However, as stated by Lapavitsas et al. (ibid.) in their report, the real problem has not been excessive compensation for peripheral workers but negligible increases for German workers, particularly after the introduction of the euro. When looking at the evolution of labour productivity alone (Figure 3.8), two conclusions can be drawn. The first is that productivity grew faster than wages in the periphery after 1995. Again, this fact contradicts the wages myth. Secondly, the performance of Germany

mortágua  |  129 170 160

Ireland

150 140 Greece 130 Portugal 120

Germany

110 Spain 100 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 3.8  Evolution of the growth in productivity, 1995–2008 (source: Lapavitsas et al. 2010a).

in terms of productivity was anything but successful, even in relative terms. It should be clear by now that real wages in Portugal did not grow faster than productivity. In fact, the opposite took place, and the fact that this evolution was not enough to correct the problem of the Portuguese trade deficit is indicative of two aspects of the European economy: first, the absence of wage growth in the centre of Europe; and second, that wages and productivity are not the sole determinants of tendencies in international trade. This constant pressure on wages in Europe is, in part, the result of the SGP criteria, imposed by the Maastricht Treaty, within the context of a single monetary policy. Without control over monetary and foreign exchange rate policy, national welfare systems, the public sector and labour markets are left under the pressure of competitive international markers, and have to be managed in order to meet the debt and deficit requirements. Hence the SGP logic of permanent discipline over all public economic choices, imposing austerity as the ultimate policy, promoted as a ‘competitive’ model based on low wages.

130  |  three

Germany, because of its historical advantages (investment, techno­ logies, welfare state, and so on), has been far more successful in compressing its internal wages and taking advantage of the European liberalised goods markets. This strategy resulted in the accumulation of an enormous surplus in Germany’s current account, including its bilateral surplus with the PIIGS nations, mirrored by equally enormous deficits in Portugal and other peripheral nations.

Portuguese internal structural problems and the overvalued ­escudo Apart from the wage compression strategies in the core relative to the periphery, other factors have also contributed to the Portuguese disaster as a ‘competitive’ force within the monetary union. The internal structural problems addressed in the first section made an important contribution to this outcome, especially when combined with the effects of an overvalued currency. The previously mentioned study by Ferreira do Amaral stresses the fact that, of the 17.3% loss of competitiveness between 1991 and 2006, the strong appreciation of the escudo against a basket of European currencies counted for 60%, while the remaining 40% is related to structural factors such as energy prices. What this study reveals is that labour costs had no impact on Portuguese competitiveness. In short, the reality of European asymmetrical integration tells us that the main causes of divergence in Europe are far more complex than a simple comparison based on RULC can address. In fact, such an analysis seems to be completely misleading when it comes to orienting economic policy. Instead of fiscal deflation16 in the periphery, European policies should promote wage inflation in Germany and in other core countries that rely on a neomercantile strategy to accumulate trade-related gains. In a similar fashion, a system of automatic transfers from the core to peripheral countries – as happens in the federal economy of the USA – should be implemented in order to compensate for the structural weaknesses of the latter, which are forced to compete in a liberalised market with a disadvantageous institutional framework. Actually, the very process of economic liberalisation and the deregulation of financial markets should not only be stopped but reversed. The

mortágua  |  131 complete freedom of financial investment and speculative transfers is closely connected with Portugal’s current account imbalances.

People lived beyond their means and this is the cause of public debt  The idea that Portugal was running persistent (or structural) public deficits is not as clear-cut as it might seem. Portuguese public debt was below the 60% of GDP demanded by the Maastricht criteria until 2005. Figure 3.9 also shows that government gross debt, as a percentage of GDP, was lower in Portugal than in Germany until 2007. The sharp and unsustainable increase in public debt occurred after 2008, as a consequence of the automatic budget stabilisers, the sharp decrease in government revenues due to the economic recession (the side effect of austerity programmes), the bailing out of financial institutions and, later, the Troika loan. Similarly, available data on public spending and the number of 140 130 120 Portugal 110 100

Euro area

90 80

Germany

70 60 50

q1

20 q4 00 20 q3 00 20 q2 01 20 q1 02 20 q4 03 20 q3 03 20 q2 04 20 q1 05 20 q4 06 20 q3 06 20 q2 07 20 q1 08 20 q4 09 20 q3 09 20 q2 10 20 q1 11 20 q4 12 20 q3 12 20 13

40

3.9  Gross public debt in the euro area as a whole and in Germany and Portugal (percentage), 2000–13 (source: Pordata).

132  |  three Euro area 35

Germany Portugal

30 25 20 15 10 5 0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 3.10  Expenditure on social protection in the euro area as a whole and in ­Germany and Portugal (percentage of GDP), 2000–11 (source: Eurostat).

public servants seem to contradict the idea of an inefficient and spendthrift public sector in Portugal. The percentage of public ­workers in the total active population was below the Organisation for Economic Co-operation and Development (OECD) average in 2011, and far from the French or Danish levels. The same argument applies in terms of government expenditures. Total government expenditure as a percentage of GDP in Portugal was never above German levels, or even above the Eurozone average. By the same token, looking at the social benefit expenditure in terms of percentage of GDP, it is quite difficult to maintain that the welfare state in Portugal was ‘too generous’. If anything, Portugal was simply catching up in terms of social protection (Figure 3.10). This convergence process will most likely be interrupted as a consequence of the austerity measures, which, in addition to the budget cuts in 2011 and 2012, include an additional cut of €4 billion in social expenditure during 2013.

mortágua  |  133 160 140 120

Disposable income

100 80 60

GDP

40 20 0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 3.11  Total Portuguese individual debt as a percentage of disposable income and as a percentage of GDP, 1997–2010 (source: Bank of Portugal).

In fact, low wages, combined with insufficient protection and widespread forms of precarious work, explain why poverty rates in Portugal are well above average European levels. The in-work poverty rates confirm this: for more than 16% of the working population, their wages are not enough to prevent them from being below the poverty line. Again, the reality of these data disproves ‘common sense’ arguments, leading one to question the real meaning of ‘living beyond one’s means’. Due to SGP rules, Portugal has shown modest public deficits (and gross debt) over more than a decade (between 1995 and 2008), even at the expense of pro-cyclical contractionary policies. Hence, fiscal conservatism is not a new concept that governments have learned after the crisis; it was being implemented well beforehand. Public debt is therefore not the real cause of the sovereign crisis, nor was excessive public spending (whether social or not) the cause of rising public indebtedness after 2007. There is little doubt that individual debt grew to unsustainable levels during the past decade (from around 60% in 1997 to 130% of available income in 2008) (Figure 3.11). But that fact, by itself, does not constitute proof of profligate consumption among the majority of the population. Instead, it is more reasonable to conclude that

134  |  three 160 140

Total

120 100 80 60

Real estate

40 20

De c Ju 97 n De 98 c Ju 98 n De 99 c Ju 99 n De 00 c Ju 00 n De 01 c Ju 01 n De 02 c Ju 02 n De 03 c Ju 03 n De 04 c Ju 04 n De 05 c Ju 05 n De 06 c Ju 06 n De 07 c Ju 07 n De 08 c Ju 08 n De 09 c Ju 09 n De 10 c Ju 10 n 11

0

3.12  Real estate loans and total loans to individuals (billion euros), 1997–2011 (source: Bank of Portugal).

(private) debt occurred as a consequence of the ‘diminishing’ possibilities for workers, which are obviously linked to several other factors, such as the structural causes of feeble growth and the lack of redistribution policies. The country’s relative impoverishment was compensated by an increase in families’ indebtedness, sponsored by predatory bank behaviour. Therefore, the increase in individual private debt was not the result of increasing levels of luxury consumption: rather, it was mainly channelled, as in many other countries, into real estate, which is a partial reflection of the lack of public housing policies. This was the product of the liberal campaign during the 1990s and 2000s that promoted property ownership to sustain speculation levels in real estate markets, which was in turn fostered by the financialisation and deregulation process in Europe and, as a consequence, by the availability of cheap and easy credit. The adjustment programme: a fatal cure Decades of dismal growth, especially after 2000, combined with the increase in public debt in 2008 and high levels of private indebted­ ness, which all made the Portuguese economy vulnerable to the world recession and to speculative attacks against sovereign bonds. To control these attacks, and in an attempt to avoid excessive costs of

mortágua  |  135 financing in the primary markets, the government requested financial ‘help’ from the European Financial Stability Facility in April 2011. As mentioned before, in June 2011, the three major parties represented in parliament17 signed an MoU with the Troika agreeing to implement a large set of austerity measures and to reduce public deficit by 6.8 percentage points in exchange for a €78 billion loan. Austerity is being presented to the peripheral countries of the Eurozone as the inevitable solution to the crisis. Despite this, it would be a mistake to believe that only those countries in the periphery of Europe, or those that are in the Eurozone, are facing all sorts of draconian measures affecting the cost of labour and the provision of public services. The recent measures implemented in the UK should be enough to prove the contrary. This strategy is expected to be the answer to every problem in the Portuguese economy. The intended result is an increase in in­ ternal competitiveness through lower wages and greater liberalisation of public services and a reduction in the public deficit by cutting the number of public servants, cutting social and investment expenditures, and increasing taxes. All of this is combined with the promotion of employment by creating more ‘flexible’ labour markets. Orthodox economic theory leads us to believe that, by following this formula, Portugal can facilitate exports and promote an exportled growth model capable of leading the country out of the crisis, regaining the trust of the markets. Blind faith in austerity and privatisation or liberalisation means that there are no other measures in the programme aimed at promoting economic growth and employment. All sources of growth are expected to come from exports based on low wages and market liberalisation, which is supposed to also promote employment. Therefore, besides the imposed austerity measures (such as the decrease in the maximum duration of unemployment benefits), cuts in severance payments in cases of workers’ dismissal and the increase in unpaid working days, together with the rising levels of unemployment, are supposed to create enough downward pressure on wages to foster competitiveness. These measures, implemented within a context of economic

136  |  three

­ ownturn – not just in Portugal but also in the rest of the EU – led to d an immediate deterioration of the country’s economy. The economic recession experienced in 2009 is turning into a deep recession with the highest level of unemployment ever seen in Portugal. Ironically, albeit not surprisingly, the IMF published in its World Economic Outlook for 2012 that Portugal (post Troika) appears as fourth in the list of the world’s worst performing economies and is the world’s worst in terms of the sustainability of public finances. The reason is simple. Economic adjustment plans all over Europe and their formula of austerity and structural measures towards labour markets are the wrong medicine for a poorly diagnosed disease. This is first, because we have little reason to believe that this strategy will increase exports and lead to economic growth; and second, because austerity destroys the economy (and nurtures poverty and inequality) without solving the problem of public indebtedness. In fact, in 2013 the expected public deficit was around 5%, far from the 3% included in the MoU, and the public debt will reach 127.8%, well above the 114.9% initially predicted. Finally, the severe attack on workers’ rights and social welfare – in some cases designed by non-elected bodies – is seriously endangering existing democratic rights.

Tenuous export-led growth strategy  According to several authors, to have an impact on exports, wages should drop even further, by another 30% to 40% in nominal terms. Such a decrease in salaries, like the one that is already being implemented, will have serious consequences. Consumption and investment will drop sharply, affec­ ting business profits and cash flows, making it more difficult for firms to repay existing financial commitments. At the same time, unemployment will rise, increasing social expenditures and societal poverty levels, making it more difficult for families to repay their own debts and depressing consumption even further. Instead of solving the problem, the process of internal devaluation has generated a spiral of negative effects culminating in a severe recession in which public finances are out of control. The result is a process similar to a debt deflation, as described by Fisher (1933),

mortágua  |  137 in which the real value of debt keeps increasing in relation to the falling prices (and wages) in the economy. Most of all, such decreases in wages would be fruitless in terms of commercial competitiveness and economic development. As argued before, high salaries are not the main problem of Portugal’s lack of competitiveness. A strategy based on a cheap labour force, which cannot in any case succeed against China or some Eastern European countries, is not the way to promote exports. It will only aggravate the country’s already existing economic fragility. Let us consider, however, that lower wages were in fact to increase Portugal’s competitiveness; the question remains whether the export sector is capable of promoting the required boost in economic growth. Exports represent only a small part of the Portuguese GDP, especi­ ally when compared with domestic private and public consumption. Thus, even with diminishing imports as a consequence of lower internal purchasing power, exports remain a small part of the dom­ estic product. The main question is, therefore, by how much should exports increase in order to compensate for the negative impact of austerity in private demand, and is it realistic to hope for such an increase in the present context. In the second trimester of 2012, the positive contribution of exports to changes in GDP was 4.7%; however, this effect was more than offset by the negative impact of internal demand in GDP (−7.9%). On the other hand, the slowing down of the recession in the last quarters of 2013 (when compared with the same period in 2012) is not the effect of exports but the impact of a less pronounced drop in internal demand. According to the latest data available, the Eurozone as a whole is about to enter the second year of a fall in GDP (−0.3% in 2013), which means that the Eurozone is in recession. The main cause of this negative performance lies in the fact that all the countries are following the same strategy of compressing wages and improving their trade accounts. If one takes into account the fact that 70% of Portuguese exports are shipped to other countries in the EU, Spain being an important trading partner, it is to be expected that external demand will not be enough to support the much-needed

138  |  three 108 106 104 102 100 98 96 94 92 90 88

Euro area

98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13

19

96 97 19

19

19

95

Portugal

3.13  Unit labour costs in the euro area and in Portugal (2005 = 100), 1995–2013 (source: Ameco).

15 10

Exports

5 0

GDP

-5 -10 Imports -15 -20 2008

2009

2010

2011

2012

2013

3.14  Portugal’s exports versus imports and GDP (year-on-year change), 2008–13 (source: Bank of Portugal).

increase in international sales. Figure 3.14 shows that, despite the major compression in wages (Figure 3.13), the growth of Portuguese exports has been slowing down. Moreover, it should be emphasised that this programme does not intend to address any of the economy’s structural problems – quite the contrary. Cuts in public education and qualifications, as

mortágua  |  139 well as falling wages, will only aggravate the lack of qualifications and reinforce the already existing incentives for firms to compete based on low wages. The same, of course, applies to healthcare and social services. Added to this, the systematic postponement of public investment in infrastructure (to control public spending) will contribute to maintaining Portugal in Europe’s periphery. Postponed projects include the planned high-speed rail link to Spain and internal railways required to connect Portugal with strategic locations for international commerce. As long as the structural problems continue to be ignored, in the present European economic context, any improvements in the Portuguese commercial balance account are due to sharp reductions in imports – as a consequence of the country’s impoverishment – and only marginally correspond to any increase in exports directed to countries outside Europe, with the possible exception of emigrating workers seeking employment opportunities abroad. Reducing public deficit in times of recession: why it cannot be done The primary reason why austerity is not helping to reduce public debt is because it has failed, until now, to control the cost of public debt. Far from what has been promised, austerity measures have been unable to tranquillise financial markets. Simple statistics should be enough to show that there is no negative correlation between the several ‘austerity packages’ and the premium risk on sovereign bonds. First and foremost, speculation in financial markets assumes the characteristics of a self-fulfilling prophecy, which makes it almost impossible for the state to resist and control its effects in a liberalised economic environment (and without a central bank willing to intervene). Secondly, if anything, austerity worsens the country’s economic situation. The kinds of draconian cuts in public expenditure advocated by the Troika’s MoU, while increasing the tax burden, seriously compromise consumption and levels of investment. Without private spending, the economy cannot grow and so the debt-to-GDP ratio expands (since the GDP is stagnant

140  |  three 20 18 16

12

6 4

 



8

Austerity packages



10



External intervention

14

2

Ja n Fe 20 b 10 M 20 ar 1 Ap 20 0 1 M r 20 0 ay 10 Ju 20 n 1 Ju 2010 l Au 2010 g 0 Se 20 p 1 O 20 0 ct 10 N 20 ov 1 De 20 0 c 1 Ja 20 0 n 10 Fe 20 b 1 M 20 1 ar 11 Ap 20 1 M r 20 1 ay 11 Ju 20 n 1 Ju 2011 l Au 2011 g 1 Se 20 p 1 O 20 1 ct 11 N 20 ov 1 De 20 1 c 1 Ja 20 1 n 11 20 12

0

3.15  Percentage yields on Portuguese ten-year bonds, 2010–12 (source: tradingeconomics.com).

or falls) and this justifies new increases in sovereign bond yields, thus increasing their cost, and therefore also the future size of the sovereign debt burden. Figure 3.15 shows the evolution of the implied yield of Portuguese ten-year bonds since 2009, with the arrows representing the various austerity packages implemented in order to control the escalation of those yields. The white arrow represents the Troika agreement. It is obvious that austerity has failed as a strategy for controlling speculation in financial markets. Instead, ECB interventions, buying government bonds in the secondary markets, seem to have been much more efficient in doing so (Figure 3.16). Public debt is increasing, not only as a consequence of the bailout of financial institutions and of the economic recession, but also because of the impact of interest in service of the debt. Interest payments account for almost three-quarters of the expected rise in public debt in 2012; this is equivalent to the total size of the national budget for public healthcare services. Debt servicing in 2016 will correspond to the value of healthcare, education and social security budgets put together. Total interest payments will represent 5.1% of

Yield/bond purchases

n Ja

08

ar M

08

ay M

08

l0 Ju

8

p Se

08

ov

N

08

n Ja

09 ar M

09 ay M

09 l Ju

09

p Se

09

ov N

09

n Ja

10

ECB bond purchases begin

ar M

10

ay M

10

l Ju

10

p Se

3.16  Government bond yields (percentage) plotted against ECB bond purchases (billion euros) (source: Saunders 2011).

0

2

4

6

8

10

12

14

16

18

10

ov N

10

n Ja

11

UK, USA France and Germany

Spain Italy

Portugal

Ireland

Greece

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GDP (€9.8 billion), which means that, in order to meet the deficit target of −1.8%, the government will have to show a primary surplus of 3.3% of GDP, further restricting the state’s capacity to intervene in the economy or to improve social protection and public services. The Troika’s loan, of €78 billion, implies future payments of an additional €34 billion in interest and commission and the imposition of a severe payment schedule for the next decade. We are therefore looking at a debt spiral, in which increasing shares of public resources are absorbed by ever-growing debt servicing payments. Furthermore, deficit adjustment becomes almost impossible to achieve in a context of contracting fiscal policies. The economic slowdown caused by a reduction in economic activity decreases tax revenues, and this decrease tends to be compensated by increasing the tax burden and cutting wages and social expenditure. However, the pro-cyclical impact of such measures leads to new reductions in tax revenues and increases the necessity for new social expenditure. As the country approaches a situation of fiscal exhaustion, the decreasing marginal gains of raising the tax burden and cutting expenditures become negative, thereby compromising the fiscal adjustment targets. Last but not least, because it undermines economic growth, austerity automatically increases the debt-to-GDP ratio, even if the amount of debt remains unchanged. Austerity leaves the country trapped in the well-known fallacy of composition, referred to in the works of Keynes and Marx:18 while it might be beneficial if one debtor stops spending in order to pay off his or her debts at a given moment in time, there will be an economic collapse if every agent in the economy decides to do this at the same time. And this is exactly what is happening. With a lack of control over the monetary policy, decided by the ECB, a countercyclical fiscal policy is crucial in order to promote economic dynamism. Without bank lending, or direct access to the wholesale markets, the private sector relies mostly on public spending to inject money into the economy. However, the governments are doing the opposite: by taking money out of the system they are fuelling the crisis. Until now, the direct consequences of such a strategy, in Portugal, has translated into higher unemployment

mortágua  |  143 levels and a deepening of the depression, with growing public debt. Supply-side measures (the technical term for deregulating labour markets and competition rules), far from creating employment, have combined with cuts in welfare to augment poverty and inequalities in unprecedented ways. Within the straitjacket of fiscal conservatism there is no space for public policies to promote growth and employment. We are left with a slow and painful process of labour devaluation that will devastate part of the economy and foster a model of competition based on low wages. Meanwhile, social protection is being destroyed and public services transformed into charity institutions. By privatising all the remaining public companies placed in strategic sectors, such as ­energy, water provision, transport, public television and radio and postal services, the state is also compromising its capability to make a real intervention in the economy, making this impossible in the future. Believing that austerity and the current adjustment programmes can solve Portugal’s debt problems, restore its competitiveness in global markets and promote growth is a leap of faith. Recent experience indicates the contrary. Could it be that the economic heretics are correct? We must ask for a Plan B.

Some modest contributions to a much-needed Plan B  Any strategy that aims to overcome the present crisis implies restoring employment and economic growth, without compromising public services or salaries. Such a strategy by definition requires a break with austerity as imposed by the Troika and national governments. It should, further­more, include alternative measures implemented at both levels, since, as we have seen, the causes of the crisis are twofold: both European and national. A brief mention of Plan C  Before going into some ideas on Plan B, it would be negligent, given the current debate, to ignore that there is also the possibility of a Plan C for countries in the Eurozone. This could include the option of leaving the EMU. This strategy has both its advantages and its shortcomings. Above all, it also

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carries with it a huge level of uncertainty. I have myself, in a recent publication (Louçã and Mortágua 2012), declared against such an option for Portugal, for several reasons that, unfortunately, I do not have space to elaborate in this chapter. I would, nevertheless, like to add a caveat to my own opinion, reaffirming that it is only legitimate to defend permanence in the Eurozone while at the same time minimising losses in both national sovereignty and democracy. I am unfortunately forced to admit that the European institutions have come dangerously close to approaching such limits. It is also possible that the European institutions themselves might choose to force a country to exit the Eurozone as a retaliatory measure. One such scenario could result should a specific country (or group of countries) decide to suspend austerity programmes, moving forward instead with debt restructuring aimed at providing the state with much-needed resources to protect its population and stimulate its economy. Given recent election results in national elections in the European periphery, it seems likely that only left-wing forces, such as Syriza in Greece, would be able to form such alternative governments and press for a change in European policies and strategies. In such a situation, leaving the euro could be the undesired but potential outcome of facing up to the Troika, and one must be prepared for such a possibility. Alternatives at the European level  Recent developments have shown that neither the EU nor the EMU have presented mechanisms capable of dealing with financial turmoil, nor have they come up with mechanisms to counteract the asymmetries in national economic structures. Therefore, it is crucial to create the instruments and the right policies to deal with the differences in economic and social structures among member states, to stop financial speculation and to reinforce democratic rights at the European level. Instead of focusing on market liberalisation and creating the perfect environment for making profits in capital markets, the cornerstones of European integration should be convergence in salaries, preservation or enhancement of the welfare state, and promotion of democratic rights in member countries.

mortágua  |  145 Institutional reforms at the EU level must include the following: • Radical changes to ECB rules: these would allow the ECB to ­fin­ance national states directly, including in its mandate not only the target of price stability but also targeting levels of employment and growth. As with the proposal presented below, this would make countries less dependent on private financial markets to finance their own economic and welfare policies. A monetary policy focused on criteria other than inflation would, among other things, allow the ECB to engage in expansionary monetary policies in times of distress. Suffice to recall the months following the onset of the financial crisis, when the ECB was the only large global monetary authority persisting in maintaining its interest rates unchanged, and even raising its target rate in response to inflation fears. • Eurobonds: the creation of Eurobonds would protect countries from speculative attacks and enable risk sharing among member states. • Policy space for public investment: the creation of such space is needed to re-launch economic growth and employment in the absence of private activity. This could be done, for example, by excluding national co-financing of the EU Cohesion Policy from deficit accounting. • Minimum levels for taxes and wages: establishing some kind of minimum levels (without compromising the country’s sovereignty) would prevent national strategies from creating a ‘race to the bottom’ through low wages and permissive tax systems. • Automatic fiscal transfers: a system of transfers, combined with a stronger communitarian budget, would mitigate structural economic and social differences between member states. • A deep restructuring of the European institutions: this would be aimed at transferring the power of the European Commission – a non-elected body – to the European Parliament or to any other representative houses. Similarly, the independence of the ECB should be terminated: as with any other economic or political institution, the ECB must be accountable to democratically elected bodies.

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Without adopting measures that can truly bring about solidarity among member states, while at the same time respecting national sovereignty, the EU economy seems condemned to continue on its current self-destructive path of stagnation, recession, unemployment, and the gradual destruction of the social welfare system, which will result in total dependence on private financial markets in the future. Alternatives at the national level  On a national level, employment should replace debt as the centre of all economic concerns. Assuring workers a reasonable and stable income is the most efficient way of promoting economic dynamism and growth, while, at the same time, reducing public social expenditure. While certainly not a simple task, the following national policies could bear fruit: • Protect public employment in those sectors suffering from workforce shortages, such as education and healthcare. • Fight precarious work and promote long-term contracts in the private sector. • Guarantee that private enterprises can access financial resources to fuel their activity. One of the most efficient ways to channel credit into specific value-added sectors is through a state-owned bank, which is capable of internalising the social benefits that result from its activity. Banks are something that most nations now own, as various large banks have been nationalised or have received massive injections of public capital, so the infrastructure is already in place in the periphery. Furthermore, and notwithstanding the form they take, public policies will fail to attain successful strategies for growth as long as a nation’s resources continue to be absorbed by servicing debt; this is a route that leaves austerity as the only inevitable strategy. Therefore, public debt must be restructured and deficit targets drastically relaxed for various reasons. One reason is that, from a public accounting perspective, this debt is not payable, but it is also because part of this debt should not be paid, for two reasons. One reason for this is that part of the debt burden is a result of speculation, of abuse by rating agencies and of dominant market positions, as well as illegal contracts between the state and private enterprises.19 Another

mortágua  |  147 reason is that it is immoral for the state to pay its debt – any debt – at the expense of the population’s impoverishment. This restructuring process should be followed by a profound transformation of the national tax system, increasing taxation on capital gains, wealth, financial transactions and speculative activities, and a concomitant reduction in the tax burden on the incomes of workers, pensioners and consumers in general. By these means the tax system could be rebalanced in a more just way, inverting the current prevailing bias towards capital. In the coming years, a sustainable recovery in Europe urgently requires the democratic re-appropriation of social and economic instruments, of welfare states and public services. Recent experience has demonstrated that continuing with opposing strategies will only aggravate social conditions and undermine democratic rights, without counteracting the root causes that led to the crisis. In order to perform this radical change in the course of the EMU, myths and simplistic interpretations should be set aside so as to identify the real origins of the crisis and to enable policy makers to design appropriate solutions that put the people – and not the markets – centre stage. Notes 1  I should, at this point, make it clear that the ‘growth’ I argue for in this chapter is not meant to be interpreted in the mainstream way. I share with many other economists and activists a great concern about growth limits and the reckless exploitation of natural resources. A first step towards another model of economic development should certainly include a substantial change in the way we conceptualise and measure the relevant economic activity and growth. Environmental damage, as well as non-remunerated human activity, should be taken into account. Similarly, societies should value (and remunerate) other intellectual activities, away from a mass production and consumption models. Bearing in mind that such trans-

formations are not immediate – and I shall not enter into the debate between a sustainable, steady-state or negative growth model – the use of the word ‘growth’ presumes a path towards those changes. 2  Although the ECB has been performing its function as lender of last resort to private banks, the same has not been happening in relation to states through the purchase of public bonds directly from national public entities. 3  National banks were the major holders of Portuguese sovereign bonds. 4  For more on neomercantilism in Europe, see Bellofiore et al. (2011) and Lucarelli (2011). 5  ‘Troika’ is the term used for the three institutions responsible for

148  |  three external intervention plans: the ECB, the International Monetary Fund (IMF) and the European Commission. 6  The erosion in external accounts refers to a trade imbalance with a corresponding external debt accumulation. 7  Public finances are commonly addressed by the levels of public deficit and debt. 8  The SGP is a rule-based framework for the coordination of national fiscal policies in the EU. See ec.europa.eu/ economy_finance/economic_governance /sgp/index_en.htm . 9  This price spike is generally agreed to have been the result of derivative speculation on commodities. This ­attracted much international criticism but little regulatory change. 10  The PIIGS countries are Portugal, Italy, Ireland, Greece and Spain. 11  During the whole period of the crisis, the ECB was lending to private banks at low interest rates. This would not have been a problem in itself if banks had not been buying bonds at speculative prices, which would then be used as collateral to obtain new loans from the ECB. However, when confronted with high amounts of troubled public debt in the balance sheets of banks, the ECB began a programme of buying sovereign bonds in the secondary markets, leaving the states completely dependent on financial markets to obtain financing. 12  The Socialist Party was in government at the time. The two right-wing parties were the Popular Party and the Social Democratic Party. 13  The MoU includes a number of technical documents, subject to constant revaluation, with all the conditional measures associated with the loan (the ‘adjustment’ plan). It is worth mentioning, however, that the details of the loan itself, such as interest rates and payment schedules, are not made public by the responsible authorities.

14  This is usually measured using a variable called ‘real unit labour costs’. 15  The small decrease in the last quarters of 2013 is mainly due to emigration and the generation of low-paid jobs, with people working less than ten hours a week. 16  Fiscal deflation is a process of improving some countries’ capacity to compete in external markets by lowering internal prices (relative to outside prices). This can usually be done by devaluing the domestic currency – nominal devaluation. When such exchange rate mechanisms are not available – as in the Eurozone – ‘real prices’, such as wages, must be lowered. In reality, there is no evidence that lower wages are able to improve a country’s capacity to export or to improve its economic performance; in fact, evidence suggests the contrary. 17  The three parties were the Socialist Party and the two parties from the right wing that formed the government coalition: the Social Democratic Party and the Popular Party. 18  In other words, a particular description that can be true for any individual cannot be logically true for all. This is one of the main ideas behind Marx’s discussion on surplus value and the circulation of capital (Das Kapital, Volume I) and behind Keynes’ ‘paradox of thrift’ in The General Theory of Em­ ployment, Interest and Money (Chapter 23). 19  Public–private partnerships offer a good example of this. These are contracts in which the state assumes all the business and market risks, granting huge rents for the private sector.

References Bellofiore, R., F. Garibaldo and J. Halevi (2011) ‘The global crisis and the crisis of European neomercantilism’. Social­ ist Register 47. Costa, J., L. Fazenda, C. Honório,

mortágua  |  149 F. Louçã and F. Rosas (2010) Os Donos de Portugal: Cem anos de poder económico (1910–2010). Porto: Edições Afrontamento. Fisher, I. (1933) ‘The debt-deflation theory of great depressions’. Econo­ metrica 1: 337–57. Garcia-Arias, J., E. Fernandez-Huerga and A. Salvador (2011) European Peri­ phery Crisis, International Financial Markets and Democracy: Moving towards a globalized neofeudalism? Discussion Paper No. 34. London: Research on Money and Finance (RMF). Lapavitsas, C., A. Kaltenbrunner, G. Lambrinidis, D. Lindo, J. Michell, J. P. Painceira, E. Pires, J. Powell, A. Stenfors and N. Teles (2010a) Eurozone Crisis: Beggar thyself and thy neighbour. RMF occasional report. London: Research on Money and Finance (RMF). — J. Meadway, J. Michell, J. P. Painceira, E. Pires, J. Powell, A. Stenfors and N. Teles (2010b) The Eurozone

Between Austerity and Default. RMF occasional report. London: Research on Money and Finance (RMF). Louçã, F. and M. Mortágua (2012) A Dívidadura: Portugal na crise do Euro. Lisbon: Bertrand. Lucarelli, B. (2011) ‘German neomercantilism and the European sovereign debt crisis’. Journal of Post Keynesian Economics 34(2): 205–24. Paes Mamede, R. (2011a) ‘Uma integração europeia mal sucessedida’. In Ferreira, E. P. (ed.) 25 Anos na União Europeia: 125 reflexões. Lisbon: Almedina. — (2011b) ‘Causes, consequences, and ways out of the crisis: a perspective from EU’s periphery’. Green European Journal 1: 30–46. Saunders, E. (2011) ‘ECB bond purchases halve despite rising bond yields’. Financial Times, ‘Money Supply’ blog, 28 February. Available at blogs. ft.com/money-supply/2011/02/28/ ecb-bond-purchases-halve-despiterising-yields/.

4  |  GREECE: EUROPE’S WORST SUCCESS STORY

Christina Laskaridis

Introduction Greece has been under the tutelage of the International Monetary Fund (IMF) and the European Union (EU) for more than three years now. The Greek debt crisis has sparked heated debates, which sometimes neglected its broader political and economic context. Preoccupations with details of Greece’s political economy often overshadowed the effects of the global financial crisis on the Euro­ zone while underplaying the murky issue of Eurozone economic imbalances. In their place, less demanding and even racist myths regarding the causes of the crisis have been cultivated and endlessly reproduced in the media. Discussed here is what has happened in the Greek ‘rescues’ and the ongoing implications on the ground, attempting to detail the sequence of events, presenting alternative perspectives on the crisis, its root causes, their genealogy and inter­ connectedness, with the final aim of leading to proposals for less pernicious alternatives to current policies. The perspective presented here is that the global financial crisis and the resulting global recession, following on from the collapse of the US housing bubble and the associated sub-prime crisis, together with its effects in Europe such as financial losses, exposed grave fault lines in the financial architecture of the Eurozone. Greece was the weakest link, but soon several other countries followed. The starting point is that the bailouts to the troubled states stemmed from the need to protect an already weak and bailed-out banking sector. Expensive loans to debt-ridden governments, with their economies in recession, did little to alleviate the debt problems faced by these states. Neither the rolling out of 1980s-style structural adjustment programmes nor the setting up of stop-gap measures, such as leveraged bailout funds, addressed the structural faults in the Eurozone.

laskaridis  |  151 Arguments are made that decisions made between 2008 and 2010 may prove highly significant to Europe’s economic future. Having approved €971 billion for their banking sectors between 2008 and 2010, the German and French governments, who lead the Eurozone crisis management, decided that further threats to their banking systems would be dealt with ruthlessly.1 Their government priorities were to protect their banks’ exposure to Greek government debt along with substantially larger exposure in other Eurozone countries. Two political obstacles led to a peculiar situation when Greece’s troubles became apparent. EU rules neither made a bailout feasible nor was an outright default permitted. Endless trade-offs began, with negotiations about what to do and how to do it. Three years later, with five countries propped up and a spreading austerity pandemic, many European countries are even more debt-ridden and their dom­ estic private banking sectors show little improvement, while the EU’s gradual structural metamorphosis instils little confidence in its financial resilience.

Statistics: how the weakest link in the chain reached its breaking point  In order to lay the groundwork for the sections that follow, a brief overview will examine how the situation in Greece spiralled out of control. The crisis was sparked in autumn 2009 by a series of deficit revisions. Ministers, chief statisticians, the governor of the Greek central bank and IMF officials all differed in their assessments of the true size of the Greek deficit. Within months, 2009 deficit estimations were raised from a projected 6% to over 15% of gross domestic product (GDP). This resulted in rapid increases in borrowing costs and a wildly widening rise in interest rate spreads (measured in this case as the difference between the cost of new borrowing by the Greek government and the benchmark German bond rate). This led to Greek sovereign credit ratings being successively lowered and the cost of insuring against Greek government default being increased. With the sudden appearance of these worsening fundamentals – caused by the unexpected growth in the deficit – a negative feedback loop set in, whereby the increased prices of insurance against default (credit default swaps or CDSs) exacerbated ever

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higher borrowing costs. This was often understood as ‘betting on default’, and Greece was priced out of the markets within months. There were questions about the accuracy of the deficit statistics, the methodology used to calculate them and particularly the motivation behind the revisions. Andreas Georgiou, the former chief statis­ tician at the helm of the Greek national statistics office (ELSTAT), was subsequently placed under criminal investigation. Although the official narrative was that Greek statistic falsification was a perennial problem, and that finally the books had been put straight, the unfolding situation revealed a much more complex sequence of events. The methodology used in national accounting had become drastically politicised. The EU statistical authority (Eurostat) appeared surprised by the opacity of Greek statistics. It insisted that statistics relating to public utilities be reclassified, despite the fact that the existing classification had previously been acceptable. The 2009 deficit was rapidly bloated by including approximately €18 billion in debt owed by seventeen public and semi-public companies that had previously been categorised differently in the national accounts. Even a casual observation of the methodology undertaken to survey these com­panies and their financial obligations reveals that this was a hasty affair, incompatible with procedures laid out in national or international accounting practices. Also, many of the reclassified debts incurred by the railways, local authorities and military companies (among others) were owed to foreign banks. This begs the question as to whether pressure might have been applied to include these debts in government accounts. Eurostat and various EU officials manifested their fury at Greece’s inaccurate debt and deficit statistics but downplayed the retrospective reclassification of a further €5.4 billion in the 2009 deficit originating from a Goldman Sachs swap of 2001. This is particularly problematic, considering that it originated in an over-the-counter (unregulated) derivative deal, used to bypass Maastricht legislation, which had been designed precisely to hide the true size of the Greek deficit. As the credit rating of the security was tied to the government’s, which was eventually downgraded, the swap was offloaded from a Greek private bank (the National Bank of Greece) onto the government’s

laskaridis  |  153 books. This was not a Greek innovation – in fact, numerous countries, including Italy, were using derivatives to make their accounts look better on paper in order to ease their accession into the Eurozone (Norris 2013). The tacit acceptance of this practice by Eurostat and other EU institutions was known – the question remains as to why it was not dealt with at the time. This was further complicated by the fact that Georgiou took leave of absence from a senior position at the IMF to head ELSTAT – at the time when Greece was securing its first bailout – further questioning his independence. The abrupt worsening of deficit and debt indicators was the catalyst that swiftly drove Greece into the official bailout mechanism. The first section of this chapter looks at the series of debt agreements and bailouts that began in May 2010, and also provides a detailed chronological overview of the debt negotiations. The ­sequence and nature of choices regarding Greece’s debt management reflected a series of highly politicised decisions, one rapidly succeeding ­another, and none proving successful. The second section of the chapter discusses how these choices about debt resulted in deepening a recession that erased a quarter of the output from the Greek economy, simultaneously disenfranchising swathes of the population. Among other effects, this has led to a severe humanitarian crisis and the creation of a generation without a future, something that promises further political instability. This section examines the social consequences of the particular forms of debt management chosen by national and international authorities. These consequences include growing unemployment, a rapid deregulation of the labour market, and an abrupt rise in poverty and in social exclusion, as well as the spread of racial and gender-related violence, which is also detailed here. The third and final part of the chapter places the Greek debt crisis within the broader context of sovereign debt resolutions, raising tentative lessons from the past that may prove useful in Europe’s current era of sovereign debt problems. Despite the underlying clim­ ate of pessimism, paradoxically the people’s response to the crisis, by developing a variety of coping mechanisms, has also resulted in numerous demonstrations of social empowerment. Although these

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matters cannot be covered in depth, this final section discusses some alternative proposals for handling the debt. The Greek debt fiasco No need to restructure – Greece will be back in the markets before you know it.  (Anon.)

The first bailout  In autumn 2009, Giorgos Papandreou came into power with a social democratic programme, but within weeks announced a U-turn. A winter of confusion led to the spring of submission to the Troika – comprising the European Central Bank (ECB), the European Commission and the IMF. The government proceeded to sign an international agreement to secure a loan in return for accepting a list of onerous conditionalities laid out in the first memorandum of understanding.2 This process, unbeknownst to the majority of the Greek people, entailed quarterly inspections by Troika officials to examine compliance with the lenders’ con­ditions. By employing a carrot and stick approach, under the premise of fending off a debt default, the Troika spurred officials to push through hugely unpopular national reforms. The bailout packages for Greece were provided through a variety of institutional arrangements. The first one was agreed in May 2010 by the Eurogroup, the Eurozone’s group of finance ministers, and consisted of a joint package of bilateral loans from euro area member states. Originally agreed as a three-year programme (2010–13), it amounted to €80 billion in bilateral loans from member states plus a €30 billion loan from the IMF. This €110 billion bailout package originally came with a grace period of three years. The IMF funds were originally agreed under a stand-by arrangement.3 The European Commission did not act as a lender to Greece but was mandated to coordinate, administer and disburse the pooled bilateral loans through a newly created fund, the Greek Loan Facility (GLF). Bailout amounts were calculated in proportion to the paid-in contribution of each Eurozone country to the ECB, bringing Germany’s commitment to €22.3 billion, France’s to €16.7 billion, Italy’s to €14.7 billion, Spain’s to €9.7 billion, and Holland’s to €4.7 billion. These

laskaridis  |  155 loans were given at high and variable interest rates, ranging between 4.9% and 5.9%, despite the fact that borrowing rates for the lending countries themselves (most especially for Germany, France and the Netherlands) were several percentage points lower (EC 2010).4 Although initially praised by creditors for the implementation of reforms, Greece missed the targets laid out in the memorandum, a result that can be attributed to numerous factors. These include the resistance of the Greek people to the weakening of their rights and dramatic falls in their standard of living, and the simple fact that the planned reforms were quite impossible to implement. From a macro perspective, the austerity policies, coupled with consecutive overarching changes in legislation, brought on an era of great uncertainty and widespread recession. The irrationality of pursuing a pro-cyclical fiscal policy during a major recession has often been highlighted. By tightening fiscal policy, aggregate demand shrunk, thus worsening the recession. Given the inability to devalue the currency (the so-called euro straitjacket), the Troika opted for a policy of internal devaluation. The result was a spectacular failure even by the Troika’s own declared targets. The changes implemented became yet more onerous due to a steep fall in GDP during the year. When the government aimed for cuts in expenditure as a proportion of GDP, the fiscal balance would not improve by the same amount, despite making many cuts in spending, because the GDP (the denominator) shrunk in the following year (Weisbrot and Montecino 2012). Furthermore, in times of deteriorating conditions and increasing interest rates for Greece, borrowing to pay off previous loans leads to more debt, which rapidly proves unsustainable, and yet this situation was dealt with via further indebtedness. Recent financial developments affected euro area banks in ways that may further elucidate the reasons for the Greek programme’s failure. Simon Johnson, former chief economist at the IMF, relates the handling of the Greek crisis to the desire for large euro area countries to conceal the vulnerability of their own banking sectors. Addressing the weak balance sheets of large euro area banks creates fears that they may prove insolvent. This erroneous starting point is what led to catastrophic decisions for European macroeconomic policy:

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It is the French and German governments that should be held responsible for the severity of the depression in Greece – and for the excessive degree of hardship imposed on vulnerable people throughout the troubled periphery (Johnson 2013).

Policy choices and decisions about handling the crisis in large euro area countries were informed, and largely driven, by concerns over banking sectors that were in a perilous state after the global financial crisis triggered by the collapse of the US housing market. Who benefited from this fiasco? In Greece and in the other bailedout European countries, publicly guaranteed money was used to repay – in full and on time – previous holders of sovereign bonds, which, at that time, were mostly private investors. What was presented as a bailout of Greece was in essence a bailout of its private creditors. While a negligible part of the bailout money was channelled into the economy, the remainder was used to repay bonds falling due. When the time came for private bondholders to accept losses, given the degree of Greek insolvency, bailout terms meant that investors were better off after the bailout than before. Eventually, after several more changes to Greece’s debt profile, bailout money was used to pay interest on the bailout loans themselves, as discussed later in this chapter. Even though governments systematically stifled genuine public discussion, the fact remains that, as the government’s ease of borrowing decreased, several alternative options could have been pursued, were it not for the fact that the possibility of debt restructuring had been officially declared taboo from the outset. The IMF’s European Director Antonio Borges, ‘confident that Greek debt is sustainable’ in March 2011, was echoed in April 2011 by the Greek Finance Minister George Papaconstantinou, who stated that ‘there is absolutely no chance of a restructuring of Greek debt’. He is currently facing serious criminal charges for activities while in office. The official European Commission spokesperson, Jens Mester, agreed: ‘All support measures are in place, and there is no reason now to start thinking of this possibility of restructuring Greece’s debt.’ However, this was soon disputed. According to Greece’s IMF representative, and former finance minister, Panagiotis Roumeliotis: ‘We knew at the fund

laskaridis  |  157 [the IMF] from the very beginning that this program was impossible to be implemented because we didn’t have any – any – successful example’ (Donadio and Daley 2012; Reuters 2011). Strong popular reactions to the Troika’s policies led to a U-turn in March 2011, when a first debt restructuring was agreed at a meeting of the Eurozone heads of state. Greece committed to scaling up reforms and its privatisation programme, in exchange for slightly better financing terms on the bailout loans. The interest rate on bilateral loans was lowered by a percentage point to 4%, while the maturity of the loans was extended from four and a half to seven and a half years.5 These measures proved too little too late. With public outrage escalating, the first May 2010 bailout and its light restructuring in March 2011 had reached a dead end; a second bailout package, including a major debt restructuring, was already being discussed.

The second bailout: debt ‘cancellation’ worsens indebtedness  The first major Greek debt restructuring was agreed in July 2011 and concluded in November 2011. It was carried through by March 2012. According to the original proposal, private creditors’ bonds would undergo a 21% haircut off the bonds’ nominal value on condition that bond owners received various lucrative terms. Far from providing a lasting solution to Greece’s fiscal and debt woes, this agreement worsened the downward spiral. Presented to the public as necessary to save Greece and the euro, like most official decisions, in reality it proved to be yet another gift to the banks. It was condemned from the start, for various reasons. First, the original proposal bore the imprint of the Institute of International Finance (IIF), a global association acting as a lobbying group representing the world’s most powerful financial institutions. The final agreement was rooted in the IIF’s offer, with the group praising its catalytic role in reaching a solution. As the IIF had privileged access to senior policy makers and heads of state, it was no surprise that the EU summit decisions reflected the banks’ preferred choice rather than any realistic plan to make the debt sustainable. The fact that ‘Europe’s leaders took the unusual step of summoning the banks’ representative … into the summit to break the deadlock over how to

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cut Greece’s debt’ is just one example that lends credence to current complaints that the Greek programme lacks ownership (Neuger and Bodoni 2011). Second, the uncertainty leading up to the crucial summit of Eurozone heads of state in July 2011 had a severe impact on the prices of Greek bonds in the secondary markets, allowing those who had speculated during that period on Greek government bonds to more than double their money via the proposed haircut. Third, the need for a second bailout was an implicit recognition that the way in which the authorities had initially dealt with the problem had failed, and yet they continued in the same manner. Greece’s debt and economic situation were dramatically worse than before the first bailout, public outrage was at a peak, and the projection that Greece would return to the markets by 2013 was an obvious fallacy. The agreement to a 21% haircut did little to lessen the debt burden. By December 2011, the first bailout programme had been termina­ ted and replaced by the second bailout package, secured in November 2011 and finalised by the Eurozone finance ministers in February and March 2012. The first programme closed after six disbursements, in which €52.9 billion was loaned to Greece through the GLF and €20.1 billion through the IMF, bringing the total to €73 billion instead of the originally projected €110 billion. The second programme was agreed at €130 billion, plus the undisbursed €34.5 billion from the first programme.6 This time, the euro area’s loans would be financed through the newly created European Financial Stability Facility (EFSF) and not through bilateral loans. The EFSF is one of the four different arrangements that have been set up during the Eurozone crisis to administer and lend bailout funds (the other two short-term ones being the GLF and the European Financial Stabilisation Mechanism, plus a permanent one, the European Stability Mechanism). The EFSF raises money on the capital markets by issuing highly rated securities, guaranteed by the Eurozone states. Ironically, the mechanism set up for healing a serious crisis of market confidence itself relies on market confidence. Its vulnerability is reflected in the downgrading of its own securities: as the number of highly rated guarantors of the fund dwindles, so too does the stability of the EFSF, particularly considering the low likelihood of full repayment

laskaridis  |  159 of Greece’s bailout funds. Total commitments to Greece from the second programme were €164.5 billion until 2014, of which €144.7 billion would be lent via the EFSF, with the IMF lending another €19.8 billion. The stand-by agreement was terminated and the IMF funds would now come from the extended fund facility. In 2011, IMF contributions corresponded to three thousand two hundred and twelve per cent (3,212%) of Greece’s borrowing quota with the fund, a fact that caused discomfort for IMF management as well as for non-European contributors to the IMF’s capital (IMF 2011). As with the first bailout, money was secured by signing an international loan agreement, and was conditional on implementing extended austerity reforms contained in a second memorandum of understanding. This second memorandum was agreed in the midst of grave poli­ tical instability and mass protests that finally brought down the Papandreou government. The carrot and stick approach of money for reforms stumbled over a major hurdle in November 2011, when Papandreou suggested a referendum on whether Greeks would accept this second bailout package with the associated debt restructuring and more austerity. The Troika was aghast at this proposal, €8 billion was withheld from Greece, and its functionaries rushed to appoint a more reliable prime minister. They chose Lucas Papademos, former vice-president of the ECB and former governor of the Bank of Greece (during the crucial period in the run-up to Greece joining the euro). His government was described as technocratic, although its members were distinguished by their lack of political legitimacy rather than by their technical expertise. This move broke certain important taboos: an unelected banker who had never stood for election now led the new government and this government included, also without electoral mandate and for the first time since the fall of the Colonels’ Junta in 1974, politicians from an extreme right party (LAOS). The principal objective of this government was to carry forward the nefarious agreements of November 2011.

Creditor rights trump democracy  The second Troika bailout package was finalised by a government without democratic legitimacy. This

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arrangement stipulated that Greece would receive a new round of bailout money substantially larger than the first one and, crucially, that its debt would be restructured. The domestic banks that would otherwise collapse as a result of this restructuring would be propped up by more money borrowed by the state. The largest sovereign debt restructuring in history was supposed to redress the inadequacies of the July 2011 agreement by scaling up the hit on private creditors. Most of the €130 billion of the second Greek bailout (a colossal amount) was earmarked for private creditors from the outset. Private bondholders participating in the bond restructuring were provided with €30 billion, while another €50 billion was earmarked to recapitalise Greek banks. In other words, the Troika secured both credit enhancements and upfront cash for private creditors who had invested in Greek debt, and then passed the bill on to the Greek people. The restructuring in the spring of 2012 consisted of a bond exchange referred to as the private sector involvement (PSI) agreement. Old bonds were swapped for a bundle of four instruments at approx­ imately half the old bonds’ original face value. This meant about a 53% discount on the face value of Greek government bonds  held by the private sector. The €56.5 billion worth of Greek bonds held by the ECB and national central banks were excluded, thwarting the Troika’s own seriousness for a comprehensive debt reduction. On 21 February 2012, the Ministry of Finance launched an ­offer to exchange approximately €206 billion of outstanding bonds held by the private sector. The bonds brought forward amounted to €199.2 billion; bondholders received an identical bundle of EFSF notes, new Greek bonds, GDP-linked securities and EFSF notes to pay any interest accrued.7 Lucrative terms also included issuance of the new bonds under English law, monitoring of all Greek ministries by an international task force, and proposals for an escrow (segregated) ­account to prioritise debt repayments. Collective action clauses (CACs) were introduced retrospectively on all bonds covered by Greek law. This meant that, among the totality of bonds eligible in the exchange, all those holding Greek law-governed bonds were forced to participate due to the CACs, whereas only some of those holding foreign law-governed bonds took part voluntarily.

laskaridis  |  161 A result of the PSI agreement was that all three rating agencies downgraded Greece to default status. On 9 March 2012, the Inter­ national Swaps and Derivatives Association (ISDA) announced that the bond exchange constituted a credit event, as the Greek government had made use of CACs to force a higher participation rate, and thus the exchange was involuntary.8 Greece had now officially defaulted, and yet the government and the media, as well as international commentators, avoided the ‘D’ word as much as possible, presenting the occurrence as a purely technical affair. The widespread fear of contagion did not materialise, nor did any institutions that had written CDS contracts collapse (contrary to what had happened after the US sub-prime crisis). The CDS contracts triggered were anti­climactic, and the eventual settlements were small, around $2.5 billion. The bond exchange was heralded a success that would lead to debt reduction, taking Greece’s debt ratio from 167% of GDP in March 2012 to 120% of GDP by 2020. This was, yet again, complete fantasy. The failure of this agreement was immediately apparent, as the newly exchanged bonds were instantly trading significantly below par, meaning that bond markets expected another default as soon as the first one was concluded. Furthermore, the way in which the PSI bond exchange was completed meant that holdouts would be rewarded, being repaid in full by Eurozone bailout money. Participation in the PSI was finalised at 96.9%, meaning that €199.2 billion out of the eligible €205.5 billion in bonds was included. Holders of bonds originally issued under foreign law (English, Italian, Japanese and Swiss) escaped the CACs that would force their participation, although many decided to participate regardless. For example, 56% of those holding the €19.9 billion of Greek bonds already covered by English law participated, whereas 44% held out (Darvas 2012: Appendix 1). Speculative hedge funds took the opportunity to profit from Greece’s distress by pursuing what are known as vulture strategies. The first €435 million of holdout bonds expired in May 2012, between the two general elections, with Greece in socioeconomic disarray and political instability. The unelected interim government decided to pay out, and so those holdouts were rewarded; this presumably set a precedent for future payments for

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the several billion euros worth of remaining holdout bonds. Details were elusive on how this amount would be funded, or whether it was factored into the assessments of the Troika that a few months after the elections enforced €13.5 billion worth of further cuts in the Greek budget. Put another way, one might ask the following question: why would bailout money, having first indebted the Greek state (on condition of further impoverishing the people), then be used to enrich holdouts? An undisputed outcome of this debt restructuring was that less than eight months after its completion, the debt-to-GDP ratio had worsened catastrophically. The March bailout agreement predicted debt-to-GDP ratios peaking at 167% of GDP in 2013, but revisions made in the Greek parliament as early as October 2012 indicated 189% and a peak of 192% in 2014 (Spiegel and Hope 2012). The continuing collapse of GDP surely contributed to the debacle, but this situation was also due to the debt restructuring, which entailed cancelling €100 billion of debt on the condition of creating another €130 billion (at least) of new indebtedness. The Greek case is paradigmatic of certain features of sovereign debt restructuring that have occurred in the past. According to Sturzenegger and Zettelmeyer (2007: quoted in Panizza 2013): ‘Large “haircuts” may not restore sustainability; because haircuts and debt relief are not the same.’ Therefore, from the point of view of the debtor country, debt relief is much lower than the haircut. However, the overall results of restructuring proved even more controversial in another sector of the economy.

Banks recapitalised and pension funds wiped out  The bank recapit­ alisation scheme, worth €50 billion, was a crucial part of the PSI agreement. Greek banks and pension funds held a large volume of Greek government bonds, and their inclusion in the PSI had the immediate effect of ruining their balance sheets. Unsurprisingly, due to the PSI, the pension funds that secure pensions for working people lost €12 billion out of a total of approximately €24 billion, and, at the same stroke, Greek private banks were pledged €50 billion in recapitalisation. Indeed, approximately half of this amount was to bridge the gap from the PSI, the rest being additional (EC 2012). The

laskaridis  |  163 promise of recapitalisation of the banks did not, however, apply to all of Greece’s banks. One of the difficulties in finalising the terms and conditions of the second bailout package was deciding which Greek banks were going to be recapitalised and how this would be done. In January 2012, the government and the central bank of Greece commissioned BlackRock,9 a fund that managed assets close to $4 trillion, to assess Greece’s banking sector, for a fee of $17 million. The information that this provided such a fund might have proven even more important than the fee. Any fund scrutinising the portfolios of Greek financial institutions was privy to precious information for its other investment activities, yet the obvious risk of conflicting interests was disregarded by those who signed the accord (see, for example, Craig 2012). The actual terms and conditions of the Greek bailouts are opaque and hidden from public scrutiny. Following the second bailout, in 2012, important decisions regarding the financial sector and debt repayments were made. Two days before Greek general elections, ministerial decrees were published covering crucial policy areas such as the terms and timelines of the bank recapitalisation. They enabled the Hellenic Financial Stability Fund, together with the EFSF, to finalise contracts that increased the capital of four private banks by €18 billion, but that excluded the two banks in which the state was a majority stakeholder. The inappropriateness of an unelected government deciding such major legislation, just a few days before elections, was lost in the political turmoil. Inconclusive election results led to the creation of an interim government in May 2012, with the Troika yet again strong-arming Greece by withholding €1 ­billion of EFSF funds until late June 2012, when the second round of elections had produced a government to its liking. Throughout this period, the Greek banking system became more and more unstable. The Bank of Greece reports that private banks lost more than 36% of their deposits; total deposits in Greek banks  fell €85 billion, from a high of €238 billion in 2009 to €153 billion in August 2012. Non-performing loans increased, jumping from about 5% pre-crisis to 25% of gross loans by the end of 2012, with estimates indicating that they would reach more than 30% by the end of 2013.

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State guarantees allowed banks to obtain over €130 billion in liquidity through the Eurosystem – the Emergency Liquidity Assistance plus the ECB. Apart from their use in compensating for the drain on deposits, they were also used to purchase Greek government bills.10 Greece never stopped issuing short-term borrowing from capital markets, and currently holds approximately €15 billion in outstanding short-term securities, despite failing to borrow long term. The fact that the main buyers of short-term bills are the Greek banks themselves has also heightened the probability of a joint default. Eurozone crisis management overall has achieved this, particularly as a result of the actions of the ECB. The ECB, having first lowered the screening process of what it accepts as collateral, is now providing liquidity as quickly as banks can provide collaterisable assets. The three-year liquidity operations launched in December 2011 are another mechanism for banks to continue buying sovereign bonds and engage in interest rate arbitrage, meaning that banks borrow cheaply and lend the same money at higher costs to governments. The first disbursement of the second bailout package totalled €75.6 billion; it was delivered between March 2012 and June 2012. The second tranche amounted to €52.3 billion in total funds from both the EFSF and the IMF. This disbursement was delayed for months, contingent on the Greek government agreeing €13.5 billion worth of further cuts and completing another restructuring of the debt. It was finally approved in December 2012, only after the next round of restructuring had been completed and further austerity measures pushed through.

Bond buy-back: borrowing money to buy back older debt  The deepening crisis and skyrocketing debt ratios led to another milestone in Greece’s debt arrangements. The Eurogroup meeting held on 26 and 27 November 2012 further restructured the Troika’s own loans, extending fiscal adjustment by two years. A light restructuring included decreasing interest rates on bilateral loans by another 100 basis points, and decreasing fee costs paid by Greece to the EFSF by 1%. Debt maturities on bilateral and EFSF loans were also extended by fifteen years and interest rate payments on EFSF loans deferred

laskaridis  |  165 for ten years. Furthermore, Greece’s escrow account – set up to differentiate debt repayments from other government expenditure – was credited with the profits made by the ECB’s holding of Greek government bonds purchased through the Securities Markets Programme (ECB interventions in the secondary bond market). The segregated account itself was another concession to strengthen creditors’ rights and further curtail domestic control of national finances. It was created to ensure that Greece’s bailout money was being prioritised to repay creditors, and that any proceeds from privatisations would be used to repay debts. The official sector – which consists of the European institutions, the central banks and governments, and the IMF – now more systematically includes itself in restructuring arrangements, albeit hesitantly. The November 2012 commitments strengthened previous commitments, made in March of the same year, to save €1.2 billion accruing from these small official sector involvements.11 These may sound like extensive changes, but they have done little to improve the debt situation. Instead, they indicate once again that the original terms were usurious and unrealistic. Unknown to many in Greece, part of the borrowed money was also used to cover the administrative fees of the bailout fund itself. Originally floated a year earlier, yet another debt restructuring was formalised and launched. This time it took the form of a debt buy-back scheme. This led to Greece’s second official default.12 One condition for receipt of the second disbursement of the second bailout package, worth €52.3 billion, was that part of this borrowed money would buy back post-PSI bonds, an operation for which Greece hired Deutsche Bank and Morgan Stanley.13 In return for selling their existing bonds before 12 December 2012, participants in the scheme received short-term EFSF securities, yielding 0% interest. Greece bought approximately €31.9 billion of government debt securities for €11.3 billion (at an average of about 34% of their original value), hence approximately €20.6 billion was written off. The complication was that the government was now essentially imposing a new haircut on any remaining holdings of Greek debt by Greek residents. Greek banks, reluctant to hand over their holdings of Greek debt, were

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made to exchange them in order to secure a further €24 billion from the next disbursement of the Troika’s bailout, as part of the remainder of the recapitalisation scheme. Once again, public debt rose in net terms; the write-offs were, in fact, conditional on further, greater indebtedness. This latest transformation of the debt profile left public debt now almost entirely in foreign hands, and largely held by the official sector. The overall outcome of the various Greek debt restructuring events became clear. Previously, the vast majority of original foreign lenders were private banks; they were allowed to swiftly and drastic­ ally shrink their exposure to Greece (as well as to other peripheral Eurozone economies) in part by shifting that exposure to the official sector. Their remaining holdings were made more secure and were guaranteed by public money. They benefited from Troika-secured credit enhancements and upfront cash, while vulture funds holding out against the haircuts were paid in full. Greek banks had to suffer a double haircut, but, nominally bankrupt, some were recapitalised with borrowed public funds. On the other hand, pension funds, public institutions (such as universities and hospitals) and small Greek bondholders who had invested in government bonds faced losses.

More restructuring in the pipeline  As the Greek programme completed its third year, total committed funds reached €247.5 billion (109% of 2010 GDP but 130% of 2013 GDP). European and IMF author­ ities repeatedly adjusted their programme outcomes, providing even bleaker predictions. The new aim for debt sustainability is no longer 120% of debt to GDP by 2020 but 124%, with the debt-to-GDP ratio in 2016, the estimated exit year for Greece from the IMF programme, at 175%.14 Each review of the programme has contained drastic revisions to the projections (Figure 4.1), leaving the European authorities’ and IMF’s predictions without credibility. These august institutions proved unable to forecast even six months or one year down the line, let alone several years ahead. Few people seriously expect them now to correctly predict debt ratios for 2020. Furthermore, 124% is hardly a promising target, considering that it is approximately equivalent to the revised ratio Greece had when it entered the programme (and

2012

2014

2016

October 2012

April 2012

September 2011

April 2011

88

92

96

2006

Employment

2008

2010

2012

October 2012

April 2012

September 2011

April 2010 April 2011 October 2010

April 2009 October 2009

October 2008

April 2008

4.1  Changes in forecasts for GDP and employment outlooks for Greece (source: Adapted from Darvas 2012: Appendix 1).

Note: IMF publishes GDP projections five years ahead, while employment projections are published only for two years ahead. The two vertical lines indicate 2007 and 2012 respectively. GDP is measured in constant prices.

80

2010

October 2010 April 2010

April 2009 October 2009

100

70

2008

April 2008

October 2008

104

84

2006

Real GDP

80

90

100

110

120

130

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higher than the original 2009 ratio). This ratio will probably still leave Greece without access to private capital markets at reasonable rates. What the Troika’s policies have helped produce is a general unemployment level of 27%, and more than 25% cumulative loss of national output from the pre-crisis peak, which is a historical record for countries in peacetime. Even three years later, the bottom of this Greek depression is still not yet in sight. Private investors were rescued at public expense by the Greek taxpayers and by other European taxpayers. The IMF’s position on the Greek programme can no longer conceal its unsustainability. Further debt write-downs are already identifiable, but they are now only possible if the official sector takes a sizeable loss. ‘It is inconceivable that Greece will not fully service and repay its official debt and thus inflict losses on the taxpayers of its European partners who have provided support during the crisis,’ declared ex-prime minister Papademos. Many are still trying to pretend that this is the case, but this statement (made in October 2011) will, most likely, soon be proved wrong. An official sector haircut is the main remaining option, and it is expected that this will be pursued now that the 2013 German elections are out of the way. Since the PSI deal, the IMF has been unsuccessfully prompting official creditors to accept losses on their Greek loans. Obliged to push for increased capital contributions from non-traditional donor countries such as Brazil, Russia, India and South Africa, the IMF is bound to attract heavy criticism for lending to Greece well above what Greece is eligible to receive. Since late 2012, the rift separating it from Eurozone leaders has been growing and criticism mounting, as shown by the furious resignation of its veteran economist Peter Doyle, adviser to the IMF European Department, over its failures and mishandling of the crisis. Ironically, the IMF itself may face a quid pro quo situation: having pressed for official sector restructuring, it may itself be cornered into an eventual debt write-down, risking its preferred creditor status.

Restructuring conclusions  This overview of three years of Greek ­ ailouts lays the groundwork for the rest of the chapter. While these b changes were under way in Greece, financing difficulties were also

laskaridis  |  169 ­ eing experienced by Ireland, Portugal, Spain and Cyprus, further b exposing the cracks in the Eurozone. While each country has ­battled with its own domestic problems, efforts are being driven to restructure the Eurozone itself, driving radical changes in its governance. These reforms, such as the fiscal compact and banking union, promote further neoliberal integration in the EU. To some extent they serve to entrench the austerity imposed in Greece, Portugal and Ireland, applying similar regulations across countries regardless of whether they are under a financial assistance programme, and whether or not they are bound by a memorandum. In effect, the crisis in the periphery of the Eurozone has driven a further wave of neoliberal reforms throughout the EU. The social and political impact of the crisis

Collapse in output and employment, resources drained  From autumn 2009 to 2013, public debate was framed in a series of dilemmas: Greece either accepts the conditions of the bailout or defaults; Greece does what it is told and stays in the euro, or returns to using the drachma. The government, the media and the supporters of the austerity programmes, both within and outside Greece, maintain that austerity ought to be accepted because a return to the drachma would impoverish the population. In retrospect, however, some of these dilemmas have proved patently false. What Greece actually got was both memoranda and defaults, while maintaining the euro straitjacket. Whereas the previous section outlined the successive negotiations since 2010, this section focuses on the impact of implementing the memoranda. Greek governments proclaim that rejecting the austerity measures and abandoning the common currency would bring unthinkable misery, but the policies imposed on the population so far have had similar effects and promise little better for the future. Many of the alleged consequences of exiting the Eurozone regarding poverty and lack of resources are already present. The economic and social consequences of the current crisis are dire; their impact is far-reaching, affecting every aspect of life and changing the political and social landscape. The crisis has changed

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Greece, a country in many ways now unrecognisable from what it was like just a few years back. The result of the EU’s and the IMF’s crisis management has been extraordinary, leading to economic declines in the Greek economy at a pace rarely seen except in states facing foreign or civil war. The five-year cumulative loss in real output exceeded 20% up until the end of 2012, and by mid-2013 it had approached 25%. The declining economic activity has led to a GDP contraction of 6%  to 7% per year in both 2012 and 2011, following a contraction of over 3% per year for 2010 and 2009.15 Current statistics for 2013 indicate a GDP contraction of about 4%, with further contraction expected in 2014. Several hundred thousand small and medium-sized enterprises (SMEs) have gone bankrupt. Surveying an Athenian downtown retail hotspot, the National Confederation of Hellenic Commerce (NCHC/ ESEE – a retail lobby group) discovered that more than 30% of the shops were closed. A major confederation of private sector employers (GSEVEE or the Hellenic Confederation of Professionals, Craftsmen and Merchants16) lists 122,000 SMEs that closed between 2009 and 2012, with a further 55,000 at risk of closing in 2013. This destruction of hundreds of thousands of jobs swells unemployment to levels unseen in the West since the 1930s. In October 2008, there were approx­imately 373,500 unemployed, or 7.5% of the labour force, whereas in October 2012 the number was 1,345,700 people, which represents 26.8% of the labour force. Four years of recession and austerity policies have created nearly a million unemployed. Although pensioners and the unemployed are the groups with the highest poverty risk, the numbers of working poor is also on the rise, with 13% of the workforce not earning enough to cover basic needs. Young people, between the ages of fifteen and twenty-four, face a dire situation: two out of every three young people are without a job, their 2013 unemployment rate well in excess of 60%.17 The official debt sustainability analyses by lenders repeatedly underestimate the profundity of the crisis in Greece. They also fail to capture the extent of the drain on resources resulting from debt payments. Greece’s debt burden can be assessed by comparing the amount spent on it vis-à-vis other sectors. What we see is that each year the amount paid on debt servicing rises, while resources chan-

laskaridis  |  171 nelled to public services are curtailed. According to the draft budget of 2012, interest payments absorb 2.5 times more resources than pensions, 3.5 times more than health, or 10 times more than education. It was estimated that in 2011 Greece paid one of the highest interest payments on public debt as a proportion of GDP globally; the Washington-based Centre for Economic Policy Research reported the rate as being some 6% of GDP per year, which rivals Jamaica (Weisbrot and Montecino 2012).

Modernised poverty  The rapid impoverishment in Greece is demonstrated by the data compiled by the EU itself. Poverty data show that Greece has the highest share of its population at risk of poverty or social exclusion (31%) after Bulgaria, Romania, Latvia and Lithuania (the lowest being 15% in the Czech Republic, and 17% in the Netherlands, Sweden and Austria). In Greece, some 15% of the population face severe material deprivation – meaning that they cannot pay bills for rent, electricity or heating, or even consume meat and fish in their weekly diet. This compares with approximately 5% for Belgium, France, the United Kingdom and Germany.18 A new tax levied through electricity bills by the Public Power Corporation (PPC) has sparked social resistance, particularly as the government ordered electricity connections to be cut when the tax (included in the electricity bill) is not paid. In October 2012, PPC announced that it disconnected 30,000 electricity customers that month for failure to pay bills, leaving households in the dark. The power company also reported that debts accumulated from unpaid household bills have doubled in one year, from €300 million in 2011 to €600 million in 2012.19 Similarly, the organisation responsible for vehicle registration and taxation has announced that hundreds of thousands of motorists are handing in their number plates, as they can no longer afford fuel or car tax payments. A Bloomberg survey reported that Greece ranked sixth out of sixty countries for the most expensive petrol, with Greek taxes on petrol the third highest in Europe (Randal 2013). A broad range of figures demonstrates the severity of the social aspects of the Greek crisis. Since 2009, the annual suicide rates have increased substantially, with a 137% increase from 2009 to 2011; this

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trend shows no sign of easing. Greece’s ranking in the United Nations (UN) Human Development Index dropped from seventeenth place in 2008 to twenty-ninth in 2012. Soup kitchens and food handouts have multiplied, with numerous decentralised initiatives all around the country, and a quarter of a million meals distributed by the Orthodox Church alone every day. Thousands of people rely on sifting through rubbish as a primary source of food, a sight unimaginable in Greece a few years ago. According to unofficial estimates (as official data are lacking), the number of homeless people, also non-existent until quite recently, has reached 40,000. A recent UNICEF report detailed that 30% of children live in conditions of poverty or social exclusion, and close to 40% of families are unable to afford utility bills or other basic household expenses.20 A prominent Greek non-governmental organisation (NGO), Méde­ cins du Monde, as well as the professional body the Athens Medical Association state that medical treatment for the sick and the elderly is increasingly available for only a select few. The latter wrote a letter to the UN asking for intervention, as thousands of people – including cancer patients and diabetics, previously covered by their social security contributions – have been abruptly left without medication because social security funds no longer cover it.21 In this new neoliberal Greece, malnutrition has crept into the schools of middle-class neighbourhoods, with children fainting in classrooms due to low calorie intake. The governments perpetrating these policies have not yet seriously addressed this issue. Lack of funding has left hundreds of schools without central heating, while more than a thousand educational institutions have closed in the past three years. In mountainous rural regions, where municipal transport does not exist, children have been excluded from the educational system altogether. Deficiencies in education can have disastrous political consequences, particularly in crisis conditions. Hitler-style salutes have become popular with teenagers in school playgrounds following a vast increase in popularity of the neo-Nazi Golden Dawn party, which received 7% of the vote in the 2012 elections.

Disintegrating the workplace  Labour conditions in Greece have

laskaridis  |  173 deterior­ated dramatically after successive waves of wage reductions, tax increases and institutional reforms. Every major package of conditionalities has focused on dismantling labour and social rights, aiming for the flexibilisation of the workforce. This is being done in four ways: first, full and stable employment is being replaced by flexible forms with lower pay and much reduced legal protection; second, collective bargaining is being abolished and/or weakened; third, working shifts are being made more flexible to suit the needs of employers; and finally, the termination of employment contracts is being facilitated. The end result is that the memoranda and the laws implementing them have not only dismantled collective bargaining agreements but also threaten a workplace culture formed over decades. Working more for less, in worse conditions and with lower legal protection has become the new norm. The labour reforms of the memoranda, with their focus on large wage reductions and tax increases, disproportionally affect those in lower income brackets. Skyrocketing unemployment then traps ­people into accepting much harsher working conditions. It is estim­ated that Greek wages, as a combined result of wage cuts, tax increases and weakened collective bargaining, have demonstrated a three-year decrease of 40%. For some professions the figure is even higher than this, while delayed wage payments are increasingly becoming the norm. Some categories of pensions have shrunk to less than €300 a month, an amount far below the cost of living. Public and private employers are increasingly leaving workers unpaid and often (for example in the case of bankruptcies) wages owed are never paid. The dismantling of state controls on labour conditions and the official climate of toleration of assaults against the weak have also led to some extreme occurrences; in one example, farm employers shot to kill migrant workers who were demanding unpaid wages.22 A further disturbing development is the increasing use of civil mobilisation, a type of forced labour imposed by the state to break industrial ­action, which so far has been used four times to break anti-austerity strikes. Workers who strike as an act of protest against their unpaid wages are being ordered to keep working or face up to five years in prison. This contravenes the government’s commitment to the UN’s

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International Labour Organization, which does not permit the use of such orders in peacetime. Government officials systematically demonise civil servants as ­being responsible for the dire economic situation, thus trying to justify plans for firing or enforcing early retirement on tens of thousands of public employees. The government agreed to shrink the public workforce by 20% by 2015 (150,000 out of a 2010 workforce of 768,000) despite the fact that the pre-crisis proportion of civil service employees (as a proportion of the total labour force) was close to the EU average. Recent legislation has already lowered the minimum wage by 22% (32% for young people), thereby bringing down the entire wage and pension ladder of the private sector. Monthly minimum wages settled at €586 a month in 2012 (rolled back to 2005 levels). Greece has implemented the largest nominal reduction of the minimum wage in the EU, which has now fallen to less than 50% of the equivalent wage in other EU countries, whereas pre-crisis it was above 60%.23 Unemployment benefit has fallen to €356 per month; even so, most of the jobless are ineligible to receive it. It is not only the Troika that is openly demanding further wage decreases. Representatives of eleven multinational corporations, at a meeting with the Greek Ministry of Development in early 2013, attempted to blackmail the government by promising investments if the minimum wage was abolished. It is becoming more apparent that large corporations, such as Nestlé and Unilever, are using their lobbies to roll out a new business model based on unprotected labour (Xiotis 2013). This parallels recent suggestions by the Troika and the Greek government to further reduce the minimum wage.

Crisis, gender and race  As the cuts to social spending degrade social services beyond recognition, the welfare state is withdrawing from even the most basic of services. The neoliberal reforms and state bankruptcy affect everyone in society, but not everyone is affected in the same way. Abolishing responsibility for providing social services means that the weakest lose the most, and here older gendered fault lines reappear, some of the groups most vulnerable to poverty being senior women, single mothers and female migrants.

laskaridis  |  175 Official unemployment in the labour force in early 2013 was close to 27%, but unemployment for women was 31.1% while for men it was 24%.24 There is a disproportionate gender impact of cuts to benefits such as maternal benefits and day-care facilities. Many of these facilities are disappearing, or fees for them have risen steeply. Cuts in benefits mean that people are now being forced to pay for medication, including people with special needs, costly or mental illnesses, or disabilities. With social security no longer covering the costs, the sick are left to fend for themselves; some are served by laudable efforts by community health clinics that have emerged to deal with the exclusion of people from public hospitals. In July 2012, the NGO Women with Breast Cancer explained that cutting supplies and medical subsidies for cancer patients not only assails a patient’s human dignity and affects their personal resources, it is directly life-threatening.25 It is estimated that due to the crisis-induced arrears in national insurance contributions, one-third of the population is locked out of public healthcare. Access to healthcare is a constitutional right but the government, mercilessly cutting down on healthcare expenses, has shut numerous medical centres and clinics. On islands or in mountainous regions, closing medical centres renders medical help dangerously remote. Hospital staff have months of outstanding wages withheld, and even the largest hospitals lack basic provisions. Payment for public hospital services has been introduced and is planned to increase: a €5 to €25 payment for each visit was stipulated in the memoranda, coupled with increased contributions by patients for treatments previously provided free of charge. While the government applauds cost-cutting measures, excluding people from publicly provided healthcare has had tragic impacts that are increasingly documented. Reproductive rights are also being infringed, particularly through the cost of giving birth in a public hospital. This service used to be free of charge; payments now begin at €800. Women are asked to pay in advance otherwise hospitals send them home. Certain hospitals blackmail them, withholding their children until full payment is made. Migrant women and nationals alike have been known to

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escape maternity wards without paying, thus leaving their child’s birth unregistered.26 At the same time, home births are being prosecuted, despite rulings of the European Court of Human Rights that home birth is a basic right (Giannarou 2013). Greece had only moderately developed social services even before the crisis, and informal networks, such as family and friends, that used to provide crucial support are now reabsorbing many functions previously provided by the welfare state. With public services strained to the point of collapse, and decreasing personal incomes, these networks take on an ever-growing burden that also falls disproportionately on the shoulders of women. Their services substitute those formerly offered by hospitals, nursing homes, day-care centres, kindergartens, old people’s homes, unemployment offices and psychiatric wards. All of this work is provided completely for free. All in all, worsening gender inequality and the resurgence of patri­ archal relations reinforce the rise of the far right and are, in turn, reinforced by it. The rise of domestic violence in Greece is severe, with a recent study revealing that one in three women have suffered beatings by their partners, a 50% increase since the beginning of the crisis. The state provides no shelters for victims of family violence, while trained personnel in police stations or hospitals are few and far between. Most of the support comes voluntarily from NGOs or is self-funded. Emergency helplines receive more and more calls regarding gendered violence or domestic violence. Additionally, the official General Secretariat for Gender Equality rarely cooperates with NGOs on such issues, showing the total absence of political will on the part of the state to combat these forms of violence. The neo-Nazi Golden Dawn party women’s group proclaims in its manifesto that it is ‘against any declarations that speak in favour of gender equality’. Yet the party received 7% of the votes in the last elections and twenty-one parliamentary seats, and polls in early 2014 indicate more than 10% support. Such extreme positions, cultivated by many beyond the far right, have turned into undeclared state policies, as many examples show – suffice to mention here one of the most shocking. On the eve of the May 2012 elections, the government chose as a main pre-election tool a classic diversionary

laskaridis  |  177 campaign, presumably to distract people from assessing the government’s real impact on dealing with the crisis. The police arrested HIV-positive women who were believed to be engaged in prostitution, and then released their photographs, names and home addresses.27 Mainstream television channels and other media carpet-bombed the public with graphic details, under the pretext of protecting clients and their families from the transmission of the HIV virus. The women were charged with ‘malicious intent to cause bodily harm’ to their clients. Within three weeks, hundreds had been arrested, mostly immigrants and drug users, with subsequent imprisonment for many. The World Health Organization’s policy for dealing with the spread of the virus lay in tatters, but the right-of-centre New Democracy party increased its popularity, receiving 29% of the votes in the general election a few weeks later. With this move, the Greek government violated rights to personal data and medical confidentiality, as well as international and European treaties signed by the Greek state for the protection of people living with HIV. These women were denied access to medical treatment, to visitors and to resources, and were kept imprisoned in appalling and unhygienic conditions. Their lives were ruined, then, following almost a year of unlawful imprisonment, charges were dropped and they were released in March 2013. This sad saga, which attracted international condemnation, heightened misogyny and racial tensions but had little other explanation beyond distracting people from major economic and social concerns. Among the far-reaching consequences of rising racism, cultivated by the state and the media, is the proliferation of xenophobic and race-related crimes. Representatives from a migrant group, the United African Women Organization, explained that they no longer feel safe to walk the streets of Athens because of the extensive cleanup operations, where police – on government orders – raid homes and shops and detain scores of people. Amnesty International and Human Rights Watch have released numerous reports about the rise in racist attacks and about the activities of far-right and fascist groups in Greece.28

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Social conclusions  This section has tried to highlight how the crisis, far from remaining strictly economic, has had all-encompassing effects. Having completely failed in improving the public debt situation – quite the contrary – the Greek finance programmes have succeeded in creating new norms in Greece. These are characterised by widespread feelings of injustice in an environment of dire and uncertain future prospects, amidst peaks in poverty and deteriorating social conditions, with an escalation of xenophobic and sexist violence, and ever more fragile social cohesion. Policies imposed on governments by the EU, the ECB and the IMF have been vocally resisted, but their impact has been difficult to contain. The bedrock of how people are dealing with the situation is through grassroots initiatives, mutual aid networks and informal support. Meanwhile, the EU’s position appears somewhat paradoxical. In Greece, for decades now, progressive laws promoting human rights and gender equality, or tackling discrimination, have been associ­ated with an EU that has advocated strongly on such policies, and has even played an institutional role in bringing the issues onto the agenda. Today, this same EU is responsible for imposing structural adjustment that is leading to a social relapse with increased poverty and lack of access to basic goods, and for creating conditions that encourage the rise of sexism, racism and documented police torture. Permanent austerity, as spread throughout the EU by means of the fiscal compact, reflects a lack of concern about entrenching these policies, and thus foreshadows similar consequences all across the EU. Whether they will materialise will probably depend on the level of objection to this project that will be demonstrated across Europe in the future. Are there lessons to be learned from the past? The first part of the chapter laid out the various stages of negoti­ ations surrounding the Greek debt since 2010, while the second part discussed changes on the ground over the same period. Both the convoluted responses to the Greek debt crisis and the high social costs of this crisis have been examined. This third section attempts

laskaridis  |  179 to place the Greek debt problem within the wider discussion of sovereign debt resolutions elsewhere.

Learning from past sovereign debt negotiations  Sovereign defaults and restructuring are usually messy, and discussions of them have resulted in a rich fount of academic literature, several policy recommendations, and action on the ground by people in debtor countries. In light of this new set of sovereign defaults, we are brought back to some familiar questions of the past decades. Why does sovereign insolvency keep occurring? Are established mechanisms adequate in addressing this problem? How successful are they in tackling its sources? And, finally, who should bear the cost? There are several standard problems with the current practice of dealing with sovereign defaults that are frequently highlighted. Negotiations are lengthy and unfair; they have uncertain outcomes; and they do not even necessarily lead to debt relief. Creditors’ coordination is poor and there are incentives for creditors to hold out from negotiated agreements. Politicians delay default, thus often deepening the economic crisis. For a germane discussion and résumé, see the paper by former UNCTAD economist Ugo Panizza (2013). Despite highlighting important lessons from the past, current practices are slow to adapt. After the 1980s debt crisis, it was proposed that when a country has a debt overhang – a debt so high it acts as a disincentive in the domestic economy because households and firms  know that their earnings will be taxed away to service the debt – total and substantial debt reduction could benefit both creditors and d­ebtors (Krugman 1988; Sachs 1989). Following the Latin American  and Asian crises, forceful criticism of the IMF arose that related to the dangerous path of bailing out countries only for them in turn to bail out international investors. Insulating foreign investors by funnelling bailout funds to them, via the government, aggravates the problem of moral hazard – encouraging predatory lending and systematically reassuring the banks that they will be bailed out by taxpayers (Calomiris 1998). After the euro area crisis, we have a situation where ‘too big to fail’, a policy tacitly reserved for large banking institutions with systemic importance, is being applied to sovereigns

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(Schwarcz 2011). As the Greek crisis began to unravel, the option of defaulting was seen as being capable of inflicting significant damage to the financial system and thus restructuring was delayed for two years. However, delayed defaults and restructuring have long been known to be more damaging, as delaying the process deepens the crisis, decreasing both the ability and willingness to pay (Panizza 2013). The Greek example bears important similarities with past experiences, despite differences in the magnitude of the restructuring and in the ample resources committed by the IMF. Evidence from past experiences of defaulting and renegotiating with private creditors in seventy-three countries shows that average creditor losses may have been in the realm of 40%, and may have taken seven years to resolve, yet debt relief was minimal (Wright 2011). Other examples show that large haircuts can correspond to increased debt burdens. To complicate matters further, methodological issues abound, as was the case in Greece (Zettelmeyer 2012). A significant methodological issue during a sovereign debt restructuring is found when estimating how large the investors’ losses will be. In order to calculate the difference between what an investor would have got if there was no restructuring and what they will get after the restructuring (the size of the loss), certain assumptions about the yields of the post-restructured bonds need to be made a priori and discount rates need to be decided. The choice of the discount rate affects the size of the haircut and, by implication, the amount of debt written off (Cabral 2011; Zettelmeyer 2012). The current piecemeal approach to sovereign debt crises has also long been resisted and criticised by people in debtor countries; current processes are described as leaving debtor countries in a ‘debtor’s prison’, where creditors are both judge and jury (Fletcher and Webb 2011). Sovereign workouts are intensely politicised procedures, whose stakes could not be higher. Widespread support for revamping protocols for dealing with sovereign debt crises has not led to any agreement on what the best process should be. Academic and policy discussions about how such crises should be managed fall roughly into three proposals: first, creating an insolvency reorganisation procedure; second, setting up a debt court to supervise the restructuring process; and third, using

laskaridis  |  181 market-based approaches, for example including provisions in bond contracts such as CACs and exit consents. Among the insolvency reorganisation proposals, Anne Krueger, first Deputy Managing Director of the IMF (2001–06) proposed a significant idea (Krueger 2001). Krueger’s proposal was to design a sovereign debt restructuring mechanism (SDRM) to be administered by the IMF, based on internationalising aspects of the US bankruptcy code. Countering this IMF-centric idea of the SDRM was an idea to set up a permanent debt arbitration tribunal under the aegis of the UN (Eurodad 2009). Several proposals to address the deficiencies of the current ­methods have also been made from a debtor’s perspective. Generally, approaches from the debtor’s perspective are against marketled solutions, yet they may vary substantially. They can be broadly divided into two main categories. One favours the creation of a model of international arbitration, either permanently or on an ad hoc basis; the other supports unilateral actions.29 Some proponents of this latter view propose that a debtor country should set up an audit commission to assess the legitimacy of debt obligations, and repay debt on the basis of its legitimacy. The creation of an institutional or somehow structured solution advocated through a debt court or an ad hoc arbitration process, on the other hand, has come up against some standard objections. Advocates of marketled solutions suggest that CACs and exit consents are sufficient, while  institutional arrangements are unnecessary. Concerns that these institutional  arrange­ments might increase borrowing costs are also raised. Other objections stem from the difficulty in setting up such a structure that would be politically neutral.30 As for the second type of proposal, based on an audit commission and using the notion of legitimacy, this is gaining ground, at the level of civil society at least, as a possible method for securing greater participation of those affected by the delayed restructuring process, the prolonged economic crisis, and the conditionalities imposed by interim ­lenders. There have been some global precedents regarding unilateral actions of debt cancellation or suspending payments (as in the case of Argentina), and also for conducting an audit. Examples of using debt audits as a basis for debt cancellation exist in the

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case of both creditor and debtor countries, such as Norway in 2006 and Ecuador in 2007 respectively.31 Norway became the first creditor country to acknowledge the responsibility of the lender in creating unsustainable debts. It conducted an audit of bilateral loans given to several developing countries as part of a failed development policy in the late 1970s, and finally cancelled them. From a debtor’s perspective, Rafael Correa in Ecuador formed a presidential commission to audit public debt inherited from past governments, a procedure to assess the legitimacy of the debt. This led to the cancellation of a substantial part of the sovereign debt by various means. Informal citizens’ initiatives in favour of debt audits are numerous across the globe, stretching from the Philippines to Brazil. Despite being informal processes, they can be used to raise awareness of several issues regarding the debt. Debt is sometimes contracted in ways that are procedurally unsound, or even corrupt. Building awareness of illegalities or different aspects of illegitimacy that debts may have has the potential to provide leverage for more beneficial outcomes to the debtor population. Essentially, this argument puts forward at least two alternatives to the standard practice. The first of these is that using the concept of legitimacy rather than the current criterion of sustainability, narrowly defined by international financial institutions, leads to different analyses and conclusions about accept­able levels of debt. Sustainability as currently defined reflects ratios whose denominators rapidly change during a crisis, making them unreliable to say the least. On the other hand, the issue of legitimacy of debts and their repayment brings to the fore the question of primacy over a state’s resources, and whether repayment of foreign debt should take precedence over other legal commitments of the state, such as guaranteeing and securing access to economic and social rights. This forms the basis of the mandate of positions such as the UN’s Independent Expert on the effects of foreign debt and other related international financial obligations of states on the full enjoyment of all human rights, particularly economic, social and cultural rights, which is currently held by Cephas Lumina.32 The Independent Expert’s recent mission to Greece concluded that the Troika’s policies are in direct conflict with human rights.33 The

laskaridis  |  183 concept of legitimacy opens up space to voice social and political concerns over the issue of public debt. In Greece, a civil society group advocating for an audit formed in March 2011 and proposed the creation of an international and independent audit commission, composed of auditors and econom­ ists, lawyers, representatives of labour organisations, members of civil society, and participants in previous debt audit initiatives.34 This ­audit commission – fully independent from political parties  – would audit  all public and publicly guaranteed debt, and would decide, on the basis of legitimacy, what would be paid and to whom. Legitimacy of debts is a concept with several interpretations, fortified by various legal precedents. The call for an audit was one of the more modest proposals to emerge during the Greek debt crisis; on the one hand, some claimed full debt repudiation; on the other, some demanded not only full repudiation but also full reparations for the drain on resources caused by the debt. It is not an overstatement to say that substantial parts of the public felt that ‘the creditors owe the debtors’ rather than the other way around. Some of the sentiment behind this thinking is explained below.

Misinformation on the crisis  Greece is at the forefront of the Eurozone crisis, but its people have largely been kept in the dark about the nature of the debt and the conditions of its creation. Officials in the ruling parties, who also governed during the previous decades when the bulk of debt was contracted, as well as think tanks and regulating bodies, have deliberately misinformed the population as to what the debt crisis is and how it came about. They have been determined to conceal the impacts of economic and financial decisions made in the past, especially those that led to the steady increase in debt. Media outlets have also refused to cover such matters, destroying any semblance of transparency or the right to information. When debt repayment is prioritised to the extent that it brings about a humanitarian crisis, one minimal demand is for clarity as to whether the claims of the lenders are valid. An audit could answer some of the questions that have arisen in the public sphere about the origins of the debt, by assessing debt origins, ownership, structure and use,

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and by posing various questions. How and why was debt contracted? Was it contracted and managed in legal and legitimate ways? And to where were the borrowed funds eventually channelled? Many questions arise here. For example, how much has the debt been expanded by manipulation by corrupt officials dipping into the fiscal purse? Was there any complicity of lenders in the lax management of loan procedures? How much of the Greek public debt, which originated from international loans, is related to excessive military purchases, some of faulty materials, or white elephant projects benefiting the lenders themselves? How has the tax structure affected the growth of public debt? Many questions remain unanswered, some of which are listed here. Why has there been no judicial pursuit of the window dressing of vital statistics, which European officials knew about perhaps since 2001? When did the European authorities first learn that Greece would need a bailout, and who benefited in the months before the public was told? If all Greek banks have failed, then why is no one being held accountable? Why are banking laws being so laxly enforced throughout Europe, and who benefits from this? What is the justification for usurious interest rates imposed on countries? On the whole, who is profiting from the debt crisis? The above are just some of the questions that could be answered with the help of an audit or any thorough investigation. The poor quality of information on the debt crisis is multifaceted. When people are being forced to bear the brunt of the austerity programmes, all details of the public debt, for which they are being forced to make sacrifices, should be known. Instead, officials are trying to enforce the legitimacy of the debt, insisting on its repayment, while the question remains unanswered as to why this should be the case. Four governments in three years have all been unwilling to open the black box of Greece’s debt, stifling any real debate. Final conclusions A major crisis of unaccountability forms the backdrop to the current economic and social crises; government authority has been severely delegitimised in the eyes of the people, while trust in public

laskaridis  |  185 authorities is at an all-time low. Guided by institutions such as the Euro­pean Commission, the ECB and the IMF, widely accepted as totally unaccountable, the broader political consequences are important. Crisis management has only been possible by severely under­ mining, or even suspending, basic democratic principles enshrined in the liberal parliamentary system. Key examples include the increasing rule by decree as opposed to parliamentary discussion, or rule by an unelected government taking key decisions with long-term effects. This is coupled with various constitutional violations, proving that parliaments, unable to curb the power of governments, act in such instances in contravention of the constitution itself. Passing the reforms has been possible only through the extensive use of force and repression. The result has been that Greece, and presumably other countries in similar circumstances, see themselves as being in a situation with a purely decorative democracy, or pseudo-democracy, with certain key decisions imposed from outside. Who was the Greek government accountable to when run by a prime minister put in place by the creditors? Under what electoral mandate were the second bailout and the PSI agreed and finalised? Under what electoral mandate did the interim government decide the terms and conditions of the Greek bank bailouts, or payments to bondholder holdouts? Who is the government accountable to when a task force based in the country oversees ministerial decisions and approves or disapproves expenditures? Commitments by states to uphold their legal human rights obligations and labour laws have proven to be less important than debt repayments, which seem to have higher seniority (priority) than other legal obligations. The debt management approach chosen for the Eurozone indicates that the primary concern was to protect a vulnerable banking sector exposed by the sub-prime crisis. However, the outcome of these policies did little to strengthen the banks, despite the colossal sums guaranteed and channelled to them. Furthermore, banks are increasingly aided via a lax monetary policy, but have their balance sheets improved? The question remains as to whether sacrifices already made might at least lead to a brighter future. Although the means by which the authorities have dealt with the debt have led to

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a widespread reorganisation of the institutional landscape, some of the most rotten features of the Greek establishment survive or have even worsened. After three years, the end of the recession is still not in sight and social cohesion becomes more and more vulnerable. It is revealing that there is resistance to retrospective accounting to determine how public money has been used, and to evaluating those findings in terms of their social impacts. Decisions regarding societal well-being are further and further removed from those they affect. Processes that encourage participation, democratic control and transparency should be welcomed, not avoided. Notes 1  See the European Commission’s tables ‘State aid in the context of the financial and economic crisis’ in the 31 December 2011 Scoreboard at http:// ec.europa.eu/competition/state_aid/ studies_reports/expenditure.html#II. 2  Memoranda of understanding are documents written by the Troika that list policy conditionalities to which money disbursal is linked. These conditionalities include a mix of structural reforms and austerity measures. 3  There is a fact sheet on stand-by arrangements on the IMF website at www.imf.org/external/np/exr/facts/sba. htm. 4  The rate was based on the threemonth Euribor: in May 2010 this was 0.67%, but a year later it had reached 1.4%, plus 3 to 4.5 basis points. 5  Council of the European Union, ‘Conclusions of the heads of state or government of the euro area of 11 March 2011’. 6  Slovakia, Ireland and Portugal eventually pulled out of the GLF, and so the original €80 billion was reduced by €2.7 billion (see EC 2010). 7  See the Hellenic Republic Ministry of Finance’s PSI launch press release of 21 February 2012 and Bank of Greece 2012.

8  The three credit rating agencies announce a Greek default: see ‘Moody’s: Greece has defaulted’, RT News, 9 March 2012; ‘S&P downgrades Greece to selective default’, Reuters, 28 February 2012; ‘Fitch downgrades Greece to “restricted default”’, Business Insider, 9 March 2012; ‘Hellenic Republic, credit event’, ISDA, 9 March 2012, http://dc.isda.org/cds/ the-hellenic-republic-3/. 9  For more on BlackRock and other Troika consulting contracts, see Pop (2013). 10  See the Global Credit Research’s announcement ‘Moody’s: Greece’s banking system outlook remains negative’, 1 August 2012; Gikas Hardouvelis’s presentation at the European Society for Banking and Financial Law conference (Athens, 5 October 2012), ‘The Greek/ EMU crisis and the need for further unification’; and IMF 2013. 11  See the Council of the European Union’s Eurogroup statement on Greece, 21 February 2012, and EC 2012: 30. 12  Standard and Poor’s, ‘Greece ­ratings lowered to “SD” (selective de­ fault)’, 5 December 2012. 13  Hellenic Republic Public Debt Management Agency’s press release, 12 December 2012. 14  Council of the European Union’s

laskaridis  |  187 Eurogroup statement on Greece, 27 ­November 2012. 15  See the IMF’s World Economic Outlook Database, 2013. 16  See their website in English for further information: www.gsevee.gr/en/ organisation. 17  Hellenic Statistical Authority, Labour Force Survey, September 2012. 18  European Commission, Eurostat news release, 3 December 2012. 19  See the trade union for the Public Power Corporation’s press release of 12 December 2012 (in Greek) at www. genop.gr/index.php?option=com_co ntent&view=article&id=1337:2012-1212-16-12-19&catid=1:2009-08-08-10-2700&Itemid=2. 20  World Health Organization, www.who.int/mental_health/media/ gree.pdf; UN Development Programme, ‘Human development indices’, 2008; UNDP 2013; UNICEF, ‘The situation of children in Greece 2013’ (in Greek). 21  Athens Medical Association, ‘Application to the UN’, June 2012. Available at www.isathens.gr/images/ eggrafa/78oheuneng.doc. 22  This was demonstrated by farm workers in southern Greece, who, protesting against months of working without being paid, staged a strike and refused to work. They were shot at by their employers (Maltezou 2013). 23  For details of the impacts, see: National Centre for Social Research, Social Portrait of Greece 2012; Labour Institute GSEE – ADEDY, The Greek Economy and Employment: Annual Report 2012 (both in Greek). 24  Hellenic Statistical Authority, Labour Force Survey press release, February 2013. 25  See the Pan-Hellenic Associ­ation of Women with Breast Cancer’s website at www.almazois. gr/gr/index.php?option=ozo_content &perform=view&id=294 (in Greek).

26  For a modest account see Hadjimatheou (2012). 27  Further information can be found at news.radiobubble.gr/2012/07/humanrights-group-rings-alarm-bell-for.html. 28  The United African Women Organization’s announcement is available at www.africanwomen.gr/?p=787. See also Human Rights Watch (2012) and the section on Greece in Amnesty International (2012). 29  There is a rich discussion on proposals in favour of arbitration. Examples include Raffer (1990) and Ugarteche (2005). 30  The objections are dealt with in further detail in Panizza (2013). 31  See Ndikumana (2012) and the final report (November 2008) of Ecuador’s Ministry of Finance’s comprehensive audit commission for public credit. 32  Dr Cephas Lumina’s CV is on the UN Office of the High Commissioner for Human Rights (UNHR) website at www. ohchr.org/EN/Issues/Development/ IEDebt/Pages/CVCephasLumina.aspx. 33  See ‘Greece: “Troika bailout c­ onditions are undermining human rights,” warns UN expert on debt and human rights’, 1 May 2013, at www.ohchr.org/FR/ NewsEvents/Pages/DisplayNews. aspx?NewsID=13281&LangID=E. 34  There are two civil society groups that advocate for an audit: the Greek Debt Audit Campaign (ELE) and No Debt No Euro (XXXE).

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188  |  four debt restructuring with no debt reduction?’ Vox, 29 July. Calomiris, C. (1998) ‘The IMF’s imprudent role as international lender of last resort’. Cato Journal 3(17): 275–95. Craig, S. (2012) ‘A Wall St. firm advises Greece, with discretion’. The New York Times, 19 March. Darvas, Z. (2012) The Greek Debt Trap: An escape plan. Bruegel Policy Contribution 19. Brussels: Bruegel. Available at www.bruegel.org/. Donadio, R. and S. Daley (2012) ‘Euro’s medicine may be making Greece’s symptoms worse’. The New York Times, 24 July. Available at www. nytimes.com/2012/07/25/world/ europe/euro-remedy-for-greecebecomes-part-of-the-problem. html?pagewanted=all. EC (2010) The Economic Adjustment Programme for Greece: First review – summer 2010. Occasional Paper 68. Brussels: Directorate-General for Economic and Financial Affairs, European Commission (EC). — (2012) The Second Economic Adjustment Programme for Greece. Occasional Paper 94. Brussels: Directorate-General for Economic and Financial Affairs, European ­Commission (EC). Eurodad (2009) A Fair and Transparent Debt Work-out Procedure: 10 core civil society principles. Brussels: European Network on Debt and Development (Eurodad). Fletcher, L. and A. Webb (2011) Alterna­ tives to Debtors Prison: Developing a framework for inter­national insolv­ency. ACFID Research in ­Development Series Report No. 4. Deakin, ACT: Australian Council for International Development (ACFID) and Jubilee Australia. Giannarou, L. (2013) ‘Prosecu­tions against doctors and parents for home births’. Kathimerini, 2 Febru-

ary. Available at news.­kathimerini. gr/4dcgi/_w_­articles_ell_2_23/02/ 2013_512187 (in Greek). Hadjimatheou, C. (2012) ‘Greek hospitals tighten payment rules’. BBC News, 22 May. Available at www.bbc.co.uk/ news/magazine-18073793. Human Rights Watch (2012) Hate on the Streets: Xenophobic violence in Greece. New York NY: Human Rights Watch. IMF (2011) Greece: Third review under the stand-by arrangement. IMF Country Report No. 11/68. Washington DC: International Monetary Fund (IMF). — (2013) Greece: Ex post evaluation of exceptional access under the 2010 stand-by arrangement. IMF Country Report No. 13/156. Washington DC: International Monetary Fund (IMF). Johnson, S. (2013) ‘IMF Greece report was flawed: EU did even worse’. Bloomberg, 7 June. Krueger, A. (2001) ‘International financial architecture for 2002: a new approach to sovereign debt restructuring’. Presentation given at the American Enterprise Institute, Washington DC, 26 November. Krugman, P. (1988) ‘Financing vs. forgiving a debt overhang’. Journal of Development Economics 29: 253–68. Maltezou, R. (2013) ‘Greece migrant workers shot by foreman on strawberry farm after demanding back pay’. Huffington Post, 18 April. Available at www. huffingtonpost.com/2013/04/18/ greece-migrant-workers-shot-­ foreman-strawberry-farmdemanding-back-pay_n_3108070. html. Ndikumana, L. (2012) ‘Debt audit as social justice, lessons from the Norwegian model’. Triple Crisis, 24 ­December. Available at triple c­ risis.com/debtaudit-as-social-justice-lessons-fromthe-norwegian-model/. Neuger, J. and S. Bodoni (2011) ‘EU sets

laskaridis  |  189 50% Greek writedown, $1.4T in crisis fight’. Bloomberg, 27 October. Norris, F. (2013) ‘Wielding derivatives as a tool for deceit’. The New York Times, 27 June. Available at www.nytimes.com/2013/06/28/ business/deception-by-derivative. html?pagewanted=all&_r=0. Panizza, U. (2013) Do We Need a Mechanism for Solving Sovereign Debt Crises? A rule-based discussion. Working Paper No. 03/2013. Geneva: Graduate Institute of International and Development Studies. Available at repec.graduateinstitute.ch/pdfs/ Working_papers/HEIDWP03-2013.pdf. Pop, V. (2013) ‘Troika consultancies: a multi-million euro business beyond scrutiny’. EUObserver, 16 December. Available at euobserver.com/­ economic/122415. Raffer, K. (1990) ‘Applying chapter 9 insolvency to international debts: an economically efficient solution with a human face’. World Development 18(2): 301–11. Randal, T. (2013) ‘Highest & cheapest gas prices by country’. Bloomberg, 13 February. Reuters (2011) ‘IMF denies pressing Greece to restructure debt’. Reuters, 2 April. Available at www.reuters. com/article/2011/04/02/us-greeceimf-debt-idUSTRE73119920110402. Sachs, J. (1989) ‘The debt overhang of developing countries’. In G. Calvo et al. (eds) Debt Stabilization and Develop­ ment: Essays in memory of Carlos Diaz Alejandro. Oxford: Basil Blackwell. Schwarcz, S. (2011) ‘Facing the debt challenge of countries that are too big to fail’. In R. Kolb (ed.) Sovereign Debt: From safety to default. Hoboken NJ: John Wiley & Sons.

Spiegel, P. and K. Hope (2012) ‘New debt forecasts dash Greek hope’. Financial Times, 31 October. Ugarteche, O. (2005) ‘Proposal for a new international financial architecture: towards an international board of arbitration’. In UNCTAD, Proceedings of the Fifth Inter-Regional Debt Man­ agement Conference. Geneva: United Nations Conference on Trade and Development (UNCTAD). UNDP (2013) Human Development Report 2013: The rise of the south: human progress in a diverse world. New York NY: United Nations Development Programme (UNDP). Weisbrot, M. and J. A. Montecino (2012) More Pain, No Gain for Greece: Is the euro worth the costs of pro-cyclical fiscal policy and internal devaluation? Washington DC: Centre for Economic Policy Research. Available at www. cepr.net/documents/publications/ greece-2012-02.pdf. Wright, M. (2011) ‘Restructuring ­sovereign debts with private sector creditors: theory and practice’. In C. Braga and G. Vincelette (eds) Sovereign Debt and the Financial Crisis: Will this time be different? Washington DC: World Bank. Xiotis, V. (2013) ‘Lower wages so we can invest’. To Vima, 3 March. ­Available at www.tovima.gr/politics/ article/?aid=501090 (in Greek). Zettelmeyer, J. (2012) ‘How to do a sovereign debt restructuring in the Eurozone: lessons from emerging market crises’. Paper prepared for the conference ‘Resolving the European Debt Crisis’, Peterson Institute for Inter­national Economics and Bruegel, Chantilly, France, 13–14 September 2011.

5  |  ARGENTINA 2001: A HETERODOX EXIT FROM THE CRISIS

Roberto Lavagna 1 (translated by Tony Phillips)

The Argentine crisis of 2001 and recovery between 2002 and 2006 The year 2001 was when the Republic of Argentina teetered towards its gravest economic crisis in more than 100 years, comparable only with the nation’s economic and political crisis of 1890. In December 2001, the economic programme known as the ‘convertibility plan’ collapsed. Established in 1991, this plan implemented a fixed currency peg, placing the value of the national currency (the Argentine peso) at a one-to-one level with the US dollar.2 The convertibility plan established a form of currency board called the conversion reserve account3 to implement this monetary policy. Argentina was the third largest economy in Latin America, placed between the thirtieth and the thirty-fifth slot in the ranking of the top 200 global economies. That such an economy might collapse wouldn’t necessarily imply a shake-up in the global economy. What Argentina did shake up, nonetheless, were certain intellectual certainties about the preconditions for a major crisis, and suppositions on how to address such a crisis. For many long years, the Argentine economic programme was considered an example to the world, to the extent that in 1998 – precisely the moment when it became clear that the Argentine economy had begun to slip – Michel Camdessus,4 in his all-powerful role as managing director of the International Monetary Fund (IMF), presented Argentina’s then president, Carlos Menem, and described him as ‘exemplary’5 at the annual spring meeting of the IMF and the World Bank. The largest financial policy event on the planet received President Menem with euphoria as the man who had given political visibility to the programme.

lavagna  |  191 In those same months in 1998, the Argentine gross domestic pro­ duct (GDP) began its fall, and, in the first quarter of 2002, produced the crisis, a result of the cumulative effects of more than four years of recession, with more than a 20% drop in GDP, unemployment at nearly 25% and with Argentine society experiencing a rise in levels of poverty and homelessness (extreme poverty) unknown in the country for several generations. Once the crisis hit, all of the forecasts indicated additional falls in GDP, with a minimum of at least a decade before the country could recuperate. They spoke of the inevitability of a period of hyper­inflation, and, as a result, spoke of grave political changes and consequent disruption of people’s lives. Argentina’s most influential economic sectors, both those resident within its borders and those abroad, considered that this path was inevitable. Abroad, it was also believed that the crisis would be even worse, given the idiosyncrasies of Argentine society and a lack of acumen in its political class and in the ruling classes in general. For this reason a leading, globally recognised economist proposed (and indeed managed to attract serious consideration to) an international plan for intervention in the Argentine economy and in the country’s government. This plan was to involve an international group of experts, and, according to contemporary reports, it would be somewhat in the style of the intervention in the Austrian economy after World War One. Going to such extremes in a world in which explicit colonialism was at its minimal expression proved to be over-reaching. The project went no further. There was, however, a more sophisticated alternative to the inter­ vention. This involved finding a prominent national economist, distinguished internationally with experience abroad, who could take the helm to manage the crisis. Years later in the second decade of the twenty-first century, this was the chosen solution, with Lucas Papa­ demos in the case of Greece and Mario Monti in Italy – prominent personalities aligned with the European Central Bank, the European Commission and the international financial system – fulfilling just such a role. In the Argentine case, some ten years before, a prom­ inent Argentine was recommended, contact made, and that person

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summoned. Due to the convoluted and inexplicable turns of internal politics, this resolution, too, was rejected. The personal consequences of that rejection were that, as a nonorthodox economist, I was offered the position of Minister for Economics and Production (Finance), a position I accepted and occu­pied without interruption over a period of nearly four years that spanned two Argentine presidents. I was given absolute freedom to choose my own economic team. However, the task of building this team was not an easy one. A majority of those to whom offers were made preferred to find excuses so as not to have to face the ‘terminal’ situation facing the nation at the time. The highest authority of the national Catholic Church (later to become Catholic Pope Francis) then gave a public warning on the gravity of the crisis, describing Argentina as ‘on the verge of national dissolution’. The normalisation, recovery and growth plan Between May and July 2002, there was a period of normalisation of Argentine economic activity. Normalisation implied such basic tasks as managing to get the banks, whose doors had been intermittently closed for many weeks (since the onset of the crisis), to operate again to restore the payment chain. The federal state also postponed provincial debt maturities (owed to the central government) – a signi­ ficant task, considering that Argentina is a federal nation (similar to the United States of America). Following the normalisation came a period of economic recovery and renewed increases in GDP, with rapid growth beginning in August 2002, all within the framework of firm price stabilisation. In April 2002 inflation levels were 10.4% per month (19.9% in wholesale prices). This fell over a period of a few months, so that price variations were less than 0.5% monthly. Later began a period with average GDP growth at 9% per annum, which continued from the second half of 2002 until the end of 2006. This was achieved with a strong expansion in consumption, and proportionally an even more pronounced rise in investment, combined with a marked recovery in exports. The political economics and the social policies that made up

lavagna  |  193 this ‘normalisation, recovery and growth plan’ were put together by our team on a day-to-day basis. We did not make grandiose formal announcements as these had minimal credibility in a society whose public chant was out with them all!6 This chant, heard on a daily basis in street protests, was explicitly directed at the politicians and the technocrats. These economic and social policies were decidedly unorthodox; they were really a mix of orthodox and unorthodox measures, but the mere fact that they were mixed (that is, not pure orthodox policies) was sufficient for certain domestic sectors, and also some international ones, to view them as heterodox. All things are relative. The core decisions made from April 2002 onwards were then viewed as heterodox; however, from an inter­ national perspective (post 2008–09), they can now be viewed as much less heterodox. The current international crisis (from which the whole world has yet to exit) has obliged many developed countries to take similar steps to those taken in Argentina, some eight years previously, measures that, in our case, had been considered unacceptable. To present just one example: we employed various refinancing systems and alterations of contractual terms on mortgage credits on a single family home up to the value of about $100,000 (mortgages created during the 1:1 convertibility plan). At the highest levels of the IMF, this was considered a violation of those contracts, a violation of property rights and of the basic rules of a capitalist economy. This was one of the main reasons used to criticise Argentina’s economic policy. Just a few years later, schemes of this type are being used by the Obama administration and increasingly used by the Spanish government, to cite just a couple of examples. Everything is now so relative that one could surmise that such measures will be considered – once this crisis passes – as unacceptably heterodox once more. One only has to look at the recovery of financial power,7 the increased dilution of the Basel III rules, or the tardiness in compliance with provisions of the US Dodd–Frank laws to understand that the financial sector will pitch once more in defence of its highly concentrated interests. Despite criticisms applied to the Argentine approach at the time (measures whose greatest fault may lie in their success when ­applied8),

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during the current international crisis much has been said about the successful lessons to be learned from the Argentine experience. If there is one thing that I personally cannot stomach, it is the notion of lessons. Those of us who suffered through the lessons that others purported to lecture us with – the IMF, the G-7, the governments of Italy and Japan (in defence of their savers), the Spanish government (on behalf of private corporate interests in Argentina, many the result of state asset privatisations in the 1990s) – or lessons offered by the British government (in defence of moral order!) must not succumb to the temptation to lecture anybody. What one can do – in certain key economic points noted later in this chapter – is try to reveal certain experiences and reflections that might prove useful to keep in mind should they become pertinent. Of course, the ideal situation is that they never become pertinent. The reflections can be grouped into three categories: those previous to the crisis, those after the crisis has struck, and certain specifics pertaining to sovereign debt and to the rules of the international financial system that govern the restructuring of sovereign debt. Before the crisis

Risk indicators and recommended solutions  Many crises occur without prior notice. Some say that cycles are inherent in economic activity (and in human activity in general), that they have always existed and will continue to do so. Quite so! The cycles themselves are inevitable. However, is this true of deep ruptures and disruptive crises? One would not envision these as quite so inevitable, were it not for the active presence of human error. Animal spirits, sure! Asymmetries, too. Things also get out of phase. There are natural causes, too. All of these indeed form part of the norm. Greed, a lack of transparency, ideological closed-mindedness and white-gloved ‘brigandry’ (bandolerismo) do not! Most financial crises, such as those that have predominated in recent decades, are much more predictable than certain people might wish to admit. If, in the Argentine case, during the convertibility programme, it had been admitted that the economy was slowing down, that the social situation was worsening, that jobs were failing

lavagna  |  195 to be created because the country had lost competitiveness (due to the coupling with the dollar) and, finally, that the three central suppositions of the programme – though somewhat implicit in nature – were not being met, it would have been clear that it was necessary to exit the rigid scheme, begun in 1991. The lack of basic macroeconomic equilibrium made the ongoing political economics unviable. All this could have been recognised early in the last quarter of 1994 or, at the latest, by early 1995. Seven years before the crisis! Not one of the three supposed core assumptions of the programme was being fulfilled: during the 1990s the country never successfully attained a fiscal surplus (excluding one-off privatisations); exchange rate stability disappeared as early as 1992, when the UK devalued the pound and many countries followed; and the end of the Uruguay round of negotiations on the General Agreement on Tariffs and Trade (which agreed the formation of the World Trade Organization) was a disaster when it came to the interests of developing countries, which had been expecting that international agricultural markets would be opened up to them. With none of these three financial conditions met, and with ­neither competitiveness nor balance in external accounts, it became assured (and even inevitable) that the convertibility scheme would become economically unviable. How could it be possible that this scheme would function for seven more years (between 1995 and 2001), with the growing economic and social imbalances that continued to develop on a daily basis? The answer to this question has both financial and analytical components. From a financial perspective, the deficit gaps (both the fiscal deficit and the deficit in external accounts) were filled by taking on phenomenal levels of debt during those seven years. These operations were highly profitable for financial capital leveraging interest rate differentials, which, of course, required absolute stability in exchange rates to take their profits. As for the analytic side, both observers interested in making quick speculative gains and the international financial credit institutions preferred to focus on partial (or even irrelevant) data, detecting short-

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term problems and recommending policies to correct them, and usually aggravating the situation in the process. This is something that has been, and still is, the case in the European economies. Didn’t anyone say that this would happen? Of course, many did; but monolithic thinking (Schopenhauer’s pensée unique9), established by both local and international financial powers, snuffed out all dissidence. They preferred to interpret capital inflows as a demonstration of international good faith in the performance of the national economy, as credibility in the country. Both the fiscal deficit and the current account deficits were financeable. The deterioration in competitiveness, and in employment, were regarded as intrinsic to structural reforms. According to their declarations, the resulting social situation was the price that had to be paid; this combined with the fact that many preferred to consider social problems as divorced from economic issues. And so, the first reflections that can be made from relevant experience would suggest the following: Basic macroeconomic data (GDP, investment, competitiveness, employment, etc.) are all better yardsticks by which to judge the state of a country’s economy than those data based on ‘country risk’ (as published by certain banks) and/or the dubious and selfserving assessments of rating agencies. Also, short-term fiscal and financial data, as prioritised in all of the IMF reports, and by other international financial institutions, are biased and ultimately irrelevant, if they are not reflected in the real economy and in employment.

Growth in the debt  One of the contributing factors – particularly in the case of emerging economies – prolonging social and economic policies with deep macroeconomic imbalances is the failure to take into account the growth in debt and the deterioration of its profile,10 in terms of both cost11 and maturity dates. Much debt is also issued in foreign currencies12 and governed by legislation foreign to the nation taking on the debt.13 Once again, highly concentrated special interest groups, with concrete financial requirements, thereby minimise the risk of debt,

lavagna  |  197 while preventing the adoption of measures such as a realignment of exchange rates, or, at the other end of the spectrum, rules restricting the entry of short-term capital flows. This risk minimisation is a mechanism to safeguard their clearly identifiable business interests. IMF staff are left with the task of articulating arguments for the extension and expansion of indebtedness by means of programmes carrying a ‘seal of quality’, providing specific legal coverage for certain concrete financial operators. The extension or refinancing of macro-imbalances are done under the auspices of so-called structural reforms, which would at some point re-create large-scale macro­ economic balances. Each adjustment programme is followed by another equivalent programme, with each failure to comply with goals – which are themselves impossible to comply with – leading to a new programme with new international financing. The responsibility of organisations such as the IMF is huge, precisely because it is they who provide the ‘seal of quality’ and, ultimately, they also provide coverage to private investors, thus enabling the prolongation of these kinds of processes. In Argentina’s case, over this period of time, these processes resulted in making the country the third largest global IMF debtor, after Brazil and Turkey, with five recently unfulfilled programmes, and with the structural deterioration that led directly to the 2001 crisis. A reflection that could be made, in this case, is that there is a tendency to consider real ‘solvency’ problems as transient problems of ‘liquidity’, thus preventing the confrontation of such imbalances in a timely manner. A lack of solvency requires fundamental changes in macroeconomic policy; liquidity problems, on the other hand, are fixed – at the cost of worsening the situation – by issuing new debt.

In the 1980s, after the first recycling of petrodollars derived from large rises in international oil prices in the 1970s,14 Latin America experienced a crisis of over-indebtedness, which, in the direct in­ terests of the banks holding that debt, was confronted as a liquidity problem through reprogramming and modest improvements in the

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gross commitments of the countries involved. The result of these 1980s manipulations, which culminated in the Brady Plan,15 was that the IMF and the banks succeeded in imposing policies that minim­ ised their losses, even after years of making enormous profits, as the result of interest rate differentials paid by borrowing countries.16 In the same period, Latin American nations had parallel drops in growth rates on a per capita basis (to levels approaching zero) and internal income distribution worsened considerably. The most dynamic sectors of their economies did not recover, interrupting production chains. All of this resulted in what is called ‘Latin America’s lost decade’.

Inevitable restructuring  Insolvency and, eventually, the need for profound changes in macroeconomic policy normally include a requirement to realign overvalued exchange rates with respect to hard currencies. Restructuring the sovereign debt with nominal haircuts17 is another certain and inevitable component of the restructuring. Failure to take this decision means that there is no way to recover fundamental fiscal and/or external balances, leaving no way to avoid a worsening of the internal national social situation. The reflection in this case is quite clear: having reached a certain ratio of debt to GDP, or debt levels with respect to expenditure in the national budget, or of debt with respect to levels of exports, a restructuring of debt becomes inevitable. Moreover, such restructuring should include losses for creditors.

Once the crisis occurs

Adjustment programmes  If anything differentiates traditional IMF adjustment programmes before the crisis from those after the crisis has hit, it is that the latter are even more draconian, for the simple reason that decisions are being made in the context of fewer financing options. In the initial stage of the crisis, and for a long period (as evidenced in the current European context by the Greek and Irish cases), all new funding comes from public multilateral sources. Also, this public multilateral financing serves to allow deleveraging in the

lavagna  |  199 private financial sector. Moreover, post-crisis programmes include, as again evidenced in the case of the PIIGS,18 an ‘implicit intervention’ component in the political economics of sovereign countries.19 The intervention can come to include reform targets in sectors far from the economy, such as reforms in the organisation of a federal system, reforms in the judicial system, or the application of market policies in the education sector. In some cases this even leads (as in Turkey, for example) to requests for commitments to religious reforms. One of the programmes in Turkey in the early 2000s included more than 120 goals encompassing a variety of fields of social organisation, including the relationship between the federal state and its regions. This reality was also corroborated in Latin America in the 1980s and in South-East Asia and Russia in the 1990s, as it was in Argentina in 2001–02 in the periods pre-crisis (with acceptance by the government of the time) and post-crisis (rejected by the new government). With somewhat different characteristics, this has also been the case in the crisis in the developed nations of southern Europe since 2008. These adjustment programmes are by no means neutral in terms of income distribution. They protect foreign creditors but they also protect local stakeholders. In fact, they offload the costs of the adjust­ ments onto the middle-income and the low-income sectors of society. The Argentine case was paradigmatic. The IMF demanded reductions in wages, in pensions, in spending on education and on health, and on all kinds of policy measures promoting development (such as in science and technology). While doing this, the IMF also defended integral respect for debt via loan conditionalities, and compensation for the local banking system – which was largely, though not exclusively, in the hands of large international firms. It also defended foreign currency assurances for the balance sheets of companies in the form of compensation to those companies for effects suffered from currency devaluations. The IMF staff consistently refused to answer a simple question. By how much should one lower wages, pensions, and so on? That is to say, how much should people in society be affected, with the effect of drastically reducing domestic demand, in order to attain

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fiscal balances, while increasing costs by compensating certain large concentrated sectors? In Argentina’s case, just one company (a non-industrial one) cost the treasury $500 million. Estimates of the negative fiscal impact of such compensation have never fallen below 8% of GDP in previous similar crises (such as the crisis of 1982–83). There are clearly quantified experiences on the cost of these recessive adjustment programmes both in Latin America in the 1980s and in Asia in the 1990s (where Indonesia suffered the greatest impact). Curiously, or perhaps not so curiously, Malaysia in the 1990s and Argentina in the 2000s were the countries that exited the crises in the best position, having rejected traditional programmes. The reflection is simple: the IMF’s recessionary ‘adjustment’ programmes serve to deepen crises, causing stagnation for up to a decade in the countries involved, and they have a bias with particularly harsh effects on the mid- and mid-to-low-income segments of society.

Simple macroeconomics versus structural adjustment programmes The current and expanding trend in the IMF, the World Bank and regional multilateral development banks (MDBs)20 has been to counsel structural reforms in policy that is quite clearly distant from the economic sphere (although they might have an indirect impact on the economy). Reforms range from policies that are highly linked to the economy, such as privatising state firms and utilities, to those that are furthest removed, such as reforming national institutions. The degree of homogeneity of the supposedly ‘idealised models’ professed by such policies has reached levels of absurdity verging on the ridiculous. Examples include the application of policies that were successful in smaller countries to large countries such as ­Brazil (with a population of nearly 200 million) and India (more than 1,100 million), even if in some cases the models adopted originally covered an area smaller than a single municipality in those larger nations. The tired example of New Zealand and of certain small Baltic econ­ omies has been echoed in all developing economies, generally with disastrous results.

lavagna  |  201 These homogeneous structural adjustment programmes, coming in tandem with those of the IMF, end up being a sort of distracting diversion to avoid addressing real macroeconomic problems, for the simple reason that addressing such issues would generally imply affecting the interests of financial sectors. As previously mentioned, realigning exchange rates – first with strenuous resistance, then with attempts to delay as long as possible – is one of those taboo topics about which one does not speak. Yet, without such a necessary (though insufficient) component, it is generally impossible to design consistent macroeconomic policies. The reflection that can be made here is that macroeconomic recovery programmes must focus more on the examination of key economic variables (fiscal data, competitiveness, external balances, etc.) than on ‘structural changes’.

Having said that, this does not imply that societies can ignore the structural side. The argument that profound changes, even cultural ones, cannot and should not be addressed following externally imposed models, nor in the midst of a deep crisis, is itself the result of flawed policy and erroneous political economics. Quite the contrary: one has to recognise the enormous value of society’s internal reflections – which obviously need to take into account the international context – and of consensus seeking. This can hardly be done while individuals are busy struggling to survive, to protect the essentials – their house, their work, and so on. Nor is it easy while people are still expressing their anger in various ways, such as crying ‘Out with them all!’ in street protests. Serious reflection and consensus should be sought when the worst of the crisis has passed and when spirits are calmed.

Sustainability or acceptability  In the same way that extreme situ­ ations almost certainly lead to the consideration of an exchange rate realignment, it is also highly probable that there will be a need to have debt restructuring, involving nominal haircuts. Obviously, established financial powers form a common front against such types of debt restructuring, relying on international

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communications generating powerful pressures on countries. These powers operate in two different gears: the first consists of measures to prevent changes to the conditions governing how sovereign debt is issued, and (when such changes become unavoidable) the second is stalling for time to transfer the majority of the cost to the multinational public system.21 During the inevitable restructuring process, two opposing concepts for policy design face off: there are those who signal that the restructuring offer must be ‘acceptable’ to the markets; and those – such as ourselves in the Argentine between 2002 and 2005 – who give priority to the criterion of ‘sustainability’. ‘Acceptability’ involves minimising the haircuts that favour creditors. In most cases, these lead to incomplete and insufficient resolutions, resulting in an endless series of ‘acceptable’ restructuring processes. These prove market friendly for the creditors, for banks and for intervening commissionbased brokers, but useless for the countries in crisis. The alternative approach is to develop a medium-term sustainability programme. Such a programme implies sufficient nominal debt reduction so that it can be possible to combine growth with repayment of the new debt,22 thereby avoiding recurring crises and the repetition of successive macroeconomic imbalances. This was the Argentine approach, establishing a model timeframe to determine what haircut would be required to promote moderate growth while complying with medium-term commitments (the results of changes in the original terms of debt issuance). Put another way: avoid commitments whose effect would be to stifle the possibility of future growth. In the Argentine case, and as a sign of good faith, which is essen­ tial in the international arena, we established a growth premium so that, were national GDP growth to be in excess of a certain level (3.2%), we were willing to share 5% of the additional GDP growth with creditors, allocating 90% to sustain local growth and 5% to an early repurchase of performing debt securities. In synthesis, when sovereign debt needs to be renegotiated, the criterion of ‘sustainability’ should prevail over that of ‘acceptability’ to the markets.

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Voluntary or compulsory  Exit procedures from deep crises typically necessitate capital losses, not just for foreign creditors but also within the country itself. In Argentina, certain governments proposed the compulsory transformation of bank deposits and other kinds of credit into medium-term bonds.23 Clearly, the operational costs and practicability of compulsion hold an attraction for governments, and for the IMF; however, compulsion brings very high costs in credibility terms, and, in many cases, impediments to the ability to reconstruct, for example, the financial system and/or the tax system. The alternative – voluntary exchanges – are slower, and sometimes involve two or three successive staged swaps, but being voluntary adds both political and social value, creating (within the narrow confines dictated by the crisis) some capacity for individual choice. Such was the case with Argentine actions in 2002, when compulsory exchange schemes for (unavailable) bank deposits were rejected, contravening recommendations from the IMF and most orthodox sectors. Argentina preferred to enter into a voluntary exchange process for deposits and domestic debts, a process that required several rounds, but that, in turn, enabled these swaps to be combined with measures to enhance demand for productive sectors with a high propensity for multiplier effects. For example, the swap involved converting unavailable frozen bank deposits to bonds that, in certain ways, could be used to foment demand in the automotive or the housing sector, with the positive impact that this had on economic activity levels. This method proved much more effective than offering rediscounts24 to the banking system to ensure the demand for deposit reimbursement requests – requests that were, in turn, the result of litigation by affected individuals. The conclusion is simple: when measures to be taken might involve important alterations in levels of capital, priority should be given to ‘voluntary’ schemes (even within the limits of narrow constraints) over ‘compulsory’ ones.

Social participation While crisis exit programmes require macroeconomic consistency, they also require a degree of societal participation; even if they

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attain only passive participation, this avoids outright rejection of government proposals or programmes. One part of the success of the Argentine exit was precisely that the social response went from an open confrontation of the leadership to resigned acceptance that government measures at least brought a chance of seeing light at the end of the tunnel. Were the levels of social upheaval seen in late 2001 and early 2002 to have continued, change would have been impossible. Alternatively, such change would have necessitated a political environment far removed from democratic norms. Put another way, the consequences of more pure economic orthodoxy would have been the repression of minimal conditions of democracy. In other words, the degree of social acceptance of a programme does not only reflect ethical imperatives; rather, it also reflects the programme’s capacity for success.

Flexibility or ideology  One final reflection with respect to the need for flexibility when one is trying to emerge from a deep crisis. For those who seek success, conceptual flexibility with regard to both the ‘timing’ and the ‘sequence’ of the measures adopted is an essen­tial component. Ideological preconceptions or presuppositions conspire against an exit from the crisis, as they limit the arsenal of tools available to social and economic policy makers. In many cases, rather than brutal ‘shock’ programmes (common in Argentina post-1990), gradualism, and the finessing of both the timing and the chrono­ logy of problem resolutions, usually provide better results.

Restructuring sovereign debt The theme of sovereign debt in general and, more specifically, how to confront changes in contract terms, coupled with issues of investment guarantees, even today require a number of changes to existing regulations at an international level.

Collective action clauses  Collective action clauses (CACs) are funda-

lavagna  |  205 mental to the process of debt restructuring. The fact that Argentina received more than 92% acceptance of its offer for the emission of new debt (76.5% in the original grand swap25 in 2005 and the rest in a mini-swap in 2010) and yet still remains under pressure from large hedge funds violates any reasonable measure of rationality.26 Greece has retrospectively27 introduced these kinds of restructuring clauses (CACs), a recourse to which (for various legal reasons) is not, nor was not, available in all countries in the past.

Just a few years ago, IMF staff found themselves facing massive rejection, from the United States but also from the developing world – including, among others, one rejection on the part of Argentina – when they proposed a sovereign debt restructuring mechanism (SDRM). The SDRM proposal had one good criterion, among other decisions: it did not require unanimity even in those cases where there were no existing contractual CACs. However, it made the grave error of wanting to place the IMF in the role of ‘administrator’ and ‘arbiter’ in such proceedings. SDRM acceptance would have implied that countries renounced their capacity to design their own economic policy, and would have made it impossible to reject recessive adjustment programmes. This recourse to CACs, which oblige all bondholders to accept a renegotiation once an offer attains a certain percentage of acceptance (75% is more than reasonable) – the holdouts having to accept the decision of the majority – should be a required instrument (insufficient of itself) to facilitate orderly restructuring processes. Decisions that protect speculative (hedge) funds – usually with minority holdings – have a systemic risk that cannot be ignored.

In the absence of CACs, there was a recent legal attempt in the US courts (clearly without the acceptance of the US government) to establish a strange criterion relating to the pari passu rules placing minority creditors – in the case of claims made on Argentina in 2012 – in a clearly privileged position, raising their interests above the clearly established interests of the majority of creditors. As a consequence, ample majorities who have already accepted

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restrictive terms run the risk of being unable to collect on payments that a country makes, so that the minorities who do not accept the debt swap (holdouts) could possibly receive their claims for a 100% payout.

Categorising bonds in terms of justice  Apart from the essential issues mentioned above, during the negotiation process prior to the first swap in 2005, Argentina also tried to introduce various bond ‘justice’ criteria. The yardsticks for these criteria were based on the following: • giving better terms to minority retail bondholders; and • giving preferential conditions to original holders of bonds – those who subscribed to the bonds and paid 100% of face value – compared with those who transformed themselves into creditors of the state after the crisis and once default had occurred, by buying sovereign bonds in many cases at values at around 15% of face value. It proved impossible to introduce either of these changes given international investment rules at the time, which are still in force. In our opinion such norms are necessary in defence of small creditors, retail investors and long-term investors. Another proposition that we were successful in implementing (though not without enormous difficulties) was the principle of first come, first served within the period of the swap offer. In Argentina’s case, quick acceptance in the first few weeks (even in the first few days) of the offer helped to create a favourable climate for acceptance; there was above 76% acceptance for a restructuring that involved a nominal haircut, in terms of face values28 of the bonds, of more than 75%. The international financial system should make explicit changes to the ‘pari passu’ criterion in favour of certain creditor categories, certainly for retail (minor) investors or long-term investors, and discriminating against recent investors since these (speculative) newcomers specialise in blocking agreements.

lavagna  |  207 Principal creditors and active entities in the restructuring procedure Given that a significant proportion of debt is in the hands of international financial institutions,29 debt restructuring has implications for the relationship between these agencies and the country undergoing the restructuring process. The IMF shields itself via its policy of lending into arrears30 to intervene in the debt-swap process, interposing itself between creditors and governments, acting in ­favour of the former when its preferred creditor status disqualifies it from playing this role. It is not possible to be both a preferred creditor and a central actor in a restructuring process.

For the Argentine government, this was both a controversial and a conflictual aspect of the negotiations. Argentine did not accept that the IMF could participate as a third party in the process of the debt swap. The IMF tried to do so by imposing obligatory goals on fiscal deficits (in our case on fiscal surpluses) so as to maximise the ability to pay creditors and meet other milestones. Had Argentina accepted IMF participation, the swap would not have been successful and high economic growth rates in Argentina, which began in mid-2002, would have been noticeably affected.

Development banks  Reconsideration and reanalysis of the role of development banks are especially important. These banks, which emerged as development funding agencies via infrastructure projects – vital precisely because of their opportunity to accelerate growth – have slowly allowed themselves to become converted (at the insistence of the IMF) into simple annexes of the IMF, acting as lenders helping with balance of payment difficulties under the pretext of financing programmes of structural adjustment. Argentina asserted, with the support of certain European nations, that these banks should return to their role of financing development projects and not act as another arm of finance programmes used to fund structural changes which, in general, do nothing more than assist with balance of payments issues.31

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Protection agreements and dispute resolution  Finally there is the issue of legal treaties for investment protection32 and their associ­ated tribunals for dispute resolution. Profound financial crises generate unavoidable and diverse changes in, and modifications of, con­ tractual conditions. This tends to lead to legal demands being made by international investors in the countries where the crisis occurs, which are heard in tribunals such as the International Centre for Settlement of Investment Disputes33 (ICSID) – the dispute resolution channel of the World Bank. In the majority of cases, these demands usually purport to give international investors better investment conditions (protection) with more legal rights than local investors in the countries in crisis. Obviously, this situation is unsustainable both economically and politically. When the political economics to exit the crisis are unbiased and macroeconomic in nature, demands for damages arising out of a devaluation are unacceptable, as are those against restrictions on the remittance of profits due to the effects of no longer charging for public utilities in hard currencies (de-dollarization of invoices/ statements in Argentina’s case34). Ordinary government decisions (political economics) should not be actionable in the ICSID. Arguments – some of which have actu­ally been proposed – that the change in the general economic circumstances of a country alters the business environment and this therefore constitutes ‘indirect expropriation’ should be rejected outright. They contradict even the most rudimentary common sense. International Centre for Settlement of Investment Disputes  With res­ pect to the aforementioned point regarding government decisions, and particularly in the case of the ICSID, certain specific anomalies deserve mention: • Acting as both judge and party: The ICSID acts as both judge and party in the case of demands from companies with World Bank participation in their financing, either as a shareholder or as a lender.

lavagna  |  209 • Minority shareholders: The ICSID accepts demands from minority shareholder groups over the heads of government bodies that regulate those companies. The US had similar dispute settlement cases in its agreements with Mexico, and those demands were rejected since, among other issues, accepting litigation by minority shareholder groups against third parties creates a dangerous precedent in matters of corporate governance. In contrast, the first ICSID ruling that went against Argentina was one in favour of such a minority group. • The lack of an appeals mechanism: Another issue of particular interest is the lack of an appeals procedure. There is a case concerning a claim against Argentina where the ICSID itself con­ sidered that its tribunal was responsible for manifest injustices, but, due to the absence of a formal appeals body, it was argued that the decision could not be reversed. In any legal system a court of appeal is central. • Ad hoc tribunals: Last but not least, the lack of transparency and the constant revolving door of lawyers from major law firms becoming ad hoc ICSID tribunal judges and vice versa create apparent opportunities for collusion. Added to this is the difficulty faced by interested third parties in being heard in these procedures. The ICSID has a peculiar modus operandi with negative con­ sequences for countries, and, in the medium term, above and b ­ eyond any individual decisions, these dysfunctions also have negative e­ ffects on genuine international investors and on the necessary and bene­ ficial effects of capital movements. The ICSID authorities themselves have acknowledged some of these shortcomings; however, unwillingness on the part of domin­ ant nations in the World Bank has delayed reform that has been recognised as being necessary. Untoward protection of the investor at the expense of countries, especially when those countries resort to neither discrimination nor arbitrary injustices, implies a co-option of these multilateral organisms by specific interests and certain rent-seeking groups that has little to do with competitive capitalism.

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Conclusion Argentina’s experience since April 2002, when a decision was made to walk a path different from that which the IMF proposed, thereby recovering the design and management of the nation’s own political economics, demonstrates in the period between 2002 and 2006 its own seal of quality, not that of the IMF. It can be summarised as follows: • • • •

five years with average growth of 9% per annum; price stability in the context of a major currency devaluation; record primary fiscal surplus of 4% of GDP; surplus in the current account and in balance of payments of about 3% of GDP; • growth in investment above 25% per year, fundamentally as a result of decisions made by private investors; • a social evolution that enabled the nation to move from 20 million people below the poverty line (exceptional as this represents over 50% of the Argentine population) to fewer than 10 million; and • a debt restructuring that caused a sharp drop in its ratio to GDP and to exports and in its costs in the national budget.35 Inevitably, such an experience, while providing no room for lessons, does leave room for certain reflections, some of which have been briefly touched upon in the notes above. This experience also has certain conditionalities of its own in order to attain results. They are none other than technical rigour (even where that flies in the face of orthodox norms), negotia­ting skills, and being as good as one’s word. At a national level, it is of course necessary to have both social and political backing, without which victories are impossible, given the tacit wrangling involved. It is also necessary to maintain both a cooperative and an auton­ om­ous ­relationship with international or local actors that  defend ­orthodoxies. Argentina was unfortunate to have to confront a crisis seven or eight years before the crisis that developed nations now face, where all of the measures that have proven effective – not to exit the crisis, as it still continues, but to contain it – have been heterodox measures,

lavagna  |  211 albeit dressed up as orthodox formulations so as to facilitate their acceptance. Today’s monetary and financial policies or the confrontational stances on capital flows, differing from those that have been recom­ mended for many long years, are clear. As somebody once said: ‘Reality is the only truth.’36, 37 Notes 1  Roberto Lavagna was Argentine Minister for Economy and Production (Finance) between late April 2002 and December 2005. 2  One Argentine peso, in Argentina, was inter-convertible with one US dollar. 3  In Spanish, a caja de conversión. 4  His biography is on the IMF website at www.imf.org/external/np/omd/ bios/mc.htm. 5  Carlos Menem was president for two consecutive terms in the neoliberal 1990s. While president, he decreed most of Argentina’s bilateral investment treaties into law (see the section on the ICSID tribunal below). Menem was an extreme neoliberal. He signed bilateral investment treaties (which were essentially unilateral in nature as the investments were principally in Argentina) that later exposed the country to future litigation, especially in the ICSID; he also privatised almost every public industry, from the national oil company, YPF, to the Argentine national post office and the television airwaves. During Menem’s presidency, the Argentine sovereign debt increased considerably. 6  In Spanish: ¡Que se vayan todos! 7  This was after the extreme US phase of the crisis in 2007–08. 8  From 2007 onwards, taking advantage of the large margins for political manoeuvring built between April 2002 and 2006, the Argentine administration entered into a highly interventionist ‘populist’ scheme, unpredictable in

its decisions. This has now led to high inflation, with GDP growth of no more than 4.5% per year and falling, low investment and low private job creation, and it has interrupted the process of the recovery from poverty, fiscal deficits and in the current account of the balance of payments. 9  Radical orthodoxy is an economic derivation of Arthur Schopenhauer’s pensée unique. 10  The profile of debt can have aspects to do with the exchange rates but relates mainly to the terms of the debt (five-year bonds, ten-year bonds or thirty-year bonds, for example). 11  The cost relates particularly to interest rates (bond ‘yields’), but also includes exchange rate costs, the cost of commissions, etc. 12  The euro is neither a national nor a foreign currency. 13  Even debt issued in euros can be subject to jurisdiction in the country that issues the sovereign bonds, and therefore can be subject to, for example, English law or the laws of the federal court for the Southern District of New York. 14  In South America, this period – the result of the enrichment of oilproducing states after the 1970s oil crisis and the resulting spike in oil prices – was called the ‘plata dulce’ (literally ‘sweet money’). Excess dollars from oil sales were re-deposited in (mainly) US banks and in turn loaned out at low interest rates as sovereign debt, hence

212  |  five ‘recycled’. When interest rates rose, this ‘sweet money’ (cheap debt) became somewhat bitter. 15  See www.emta.org/template. aspx?id=35&terms=brady+plan. 16  The difference in interest rates is sometimes called a ‘risk premium’; in this case, the risk was covered by the interest rate and then nullified by the Brady Plan and other restructuring. Paul Volcker, then chairman of the Federal Reserve, pushed the US federal funds rate up over 20% in 1981, which meant that the costs of debt taken on in the 1970s became exorbitant in Latin America and beyond, causing a debt crisis. 17  A haircut is a reduction in the principal of the debt owed, i.e. a nominal reduction in debt (in this case sovereign debt). 18  The PIIGS countries are Portugal, Italy, Ireland, Greece and Spain. 19  As defined by national memoranda of understanding (MoU). 20  Examples of MDBs include the Inter-American Development Bank (IDB/ IADB) in Latin America or the Asian Development Bank (ADB). 21  This is generally the IMF. In the European context, it is the IMF and two other Europe-specific arms of the European Union (the Troika). 22  This is the new ‘restructured’ debt after the haircuts have been ­applied. 23  These are being referred to in Europe as bail-in procedures (as opposed to bail-out), such as the extraordinary bail-in in Cyprus in 2013 that required compulsory haircuts on deposits (without bond conversion). 24  Rediscounts are operations commonly performed in orthodox economics by the central bank, with the aim of obtaining supplementary liquidity by granting loans. 25  The debt swaps were the emission of new debt for the retirement of

old debt (the restructuring process in action). The first one happened in 2005 (the end of the ‘default’). It was called the mega-interchange or mega-swap (‘mega canje’ in Spanish). It was a ‘swap’ in the original sense of the word (i.e. an interchange of new debt under new conditions in a new currency for old debt in default) and had nothing to do with a swap in the financial sense of the word, which is commonly an unregulated insurance contract. 26  With CACs in place, then an acceptance rate of 70% or more would force the holdouts to accept the majority decision and the current Argentine situation (with lawsuits taken out by holdouts) would not happen. 27  The use of retrospective CACs is an unusual restructuring technique. 28  Note that it is common for the face value to be reduced in a bond swap, especially one that swaps long-term bonds for short-term bonds as the investors get the advantage of receiving their money earlier. 29  The IMF, the World Bank and MDBs. 30  See the IMF policy at www.imf. org/external/pubs/ft/privcred/073002. pdf. 31  This refers to where funds from MDBs, such as the IDB in Latin America, are sometimes diverted to fund nondevelopment core government funding so as to enable the nation to pay back debt by helping artificially balance the budget. 32  Typically, these take the form of bilateral investment treaties. Where these occur between developed countries and developing countries, they tend to be used to protect investments by corporations in developed countries making investments in developing countries, as, in reality, investment flows are often markedly unidirectional, hence the misnomer ‘bilateral’.

lavagna  |  213 33  See http://icsid.worldbank.org/. 34  One example relates to electricity rates. When prices for electricity were dollarized (one peso = one US dollar), the concessions to run these natural monopolies were typically more profitable (in dollar terms) for foreign investors in privatised utilities than they were after the break with the dollar, when the devaluation of the peso meant that prices dropped considerably (in dollar terms) as price controls remained denominated in pesos. 35  Favourable conditions created an exceptional improvement in terms of trade for global reasons (increasing prices of commodities such as petroleum and soya beans, for example) from 2007 onwards. This gave rise to shortterm policies of a populist nature in the

period 2007–12, plunging Argentina once more into serious imbalances, both economic and social. This has nothing to do with the mixed heterodox/orthodox policies followed between 2002 and 2006. Rather, this a classic syndrome of boom mismanagement (Dutch disease), as happened during the oil shocks in many countries that also mismanaged revenue. The perspective at the end of 2012 was that of a country that had wasted an opportunity that could have allowed it a long period of development and growth. 36  In Argentina, this saying is attri­ buted to former Argentine president Juan Perón (1895–1974), who adapted it from Aristotle. 37  This chapter content was submitted in December 2012.

EPILOGUE

Tony Phillips Oh, what a tangled web we weave, When first we practise to deceive!  (Sir Walter Scott, ‘Marmion’, 1808)

Problems seeking solutions In this book our authors show how structural competitiveness issues in the European Union (EU) have led to external imbalances. Nations with deficits in the periphery financed this gap, generating more private and public debt. These problems still need to be fixed, but not only with austerity. We also show how self-regulation of the private financial sector has spiralled out of control, creating massive quantities of toxic debt in Europe and across the globe. Toxic debt in the private sector includes defaulting loans that weakened banks. Banks have been rescued by public funds, resulting in vast increases in unproductive sovereign debt. For the moment, nations in the European centre (the ‘core’ in financial terms) thrive on flight-tosafety financial flows from the periphery, but this too has its limits. In Europe, as in the US, public bank rescues have had a huge cost, but many nationalised banks continue to operate at a loss. They are suffering further mortgage defaults and problems with other bad debt, the result of negative reinforcement of problems in the periphery’s shrinking economies. The private banks – many now publicly owned – still fail to provide productive loans to the real economy, so small businesses cannot access credit to stimulate local employment. Large European banks are being provided with essentially free credit, but recent evidence shows that much of this is being recycled into speculative activity rather than being used to make loans to the nation’s productive sectors or to purchase national bonds. Neither national governments nor the EU have limited the excesses of the financial industry. Instead, they have transferred the losses

phillips  |  215 incurred through speculative financial activities onto the public. Rather than guaranteeing deposits, allowing inefficient banks and their creditors to fail, bank debts have been paid and losses have been ‘socialised’. A collapse in speculative activity has led to a really deep recession in the periphery with little sign of recovery. Neoliberal economics, which we show is partially responsible for the crisis, fails to provide economic policies to solve the crisis. It has, instead, deepened the problems in the periphery with austerity and huge increases in public debt. Contagion continues, stratifying the EU and dividing its shrinking centre from an expanding periphery. Human costs continue to increase, with cutbacks in the welfare state. Mounting political risks are evident from the continuing paralysis in national and in EU public policy. This final section takes a look at recent investigations into corruption in both the public and the private sectors, and how, rather than these issues being dealt with, they are instead sidelined as inefficiencies or ‘human error’ and are left to fester. We also ask what will be the cost of failing to deal with these issues for the EU itself, and for her people. Human error: a primer on the neoclassical mindset In order to understand the inadequate reaction of orthodox economics to solving the European crisis, it can be instructive to understand, at a superficial level at least, how a neoclassical econom­ ist views the economy and their simplistic and artificial models of reality. In particular, it is instructive to see how corruption is treated as ‘human error’ in these amoral mathematical models. In the virtual world of neoclassical economics, the human is not a citizen. We are, rather, economic agents selling our labour in order that we might have the capacity to consume, or to save (in order to consume later). There is no religion, no art, just work, money and consumption. Consumables include products and services. They are traded by firms on optimally efficient markets. Who produces these services is irrelevant, as is whether they are imported or produced locally.

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Also irrelevant is the geographic location where salaries are paid to produce the products and services. It is all down to price and profit – the cheaper the better – while maximising return on capital. Neoclassical economics is about supply and demand; the firms supply and we demand. There are no courts, no votes, no civilisation, just firms and potential consumers (supply and demand). Humans make decisions on consumption largely based on price. Choices are made based on quasi-perfect information due to market transparency – which makes information available to inform that consumer choice. If something is wrong with these highly tuned, market-driven economic systems, the glitches are referred to as market ‘imperfections’, or simply inefficiencies. In this totally amoral world, there are no bad actors, nor can markets themselves be ‘bad’; however, models are adjusted to take ‘imperfections’ into account to try to explain why things go wrong. Neoclassical economics is an externalising machine. Many imperfections can be eliminated outright, becoming ‘irrelevant’ because they are ‘outside’ the economic system. These they call external­ ities. Pretty much everything can be externalised that doesn’t have a price: examples include climate change, pollution, or the social cost of imports (in terms of reduced employment or profit outflows). Externalising costs does not imply that the costs don’t matter, but it often means that they are not part of the model driving economic policies. Externalities eliminated, two important market inefficiencies remain: transaction costs and human error. Neoclassical economists don’t like transaction costs. Like any other market inefficiency, these, they argue, need to be minimised. Markets must be as ‘free’ as possible (of transaction costs) to maximise competition. A protected market is a distorted market. In the EU, customs duties within the Union have been eliminated. This EU is a ‘free’ trade zone, further reducing transaction costs between ­nations in the Union. Eliminating duty has also reduced government tax­ation and has created more competition. This is good in the simple neo­ classical model, even though, in the real world, uneven competition can lead to external deficit problems. The elimination of duties in the EU leaves governments more dependent on other forms of taxation,

phillips  |  217 such as taxes at the point of sale, including value added tax (VAT), or property taxes, and personal taxes (such as income tax) and corporate tax­ation. The Troika typically recommends raising income tax, property tax and VAT in their ‘rescues’; true to their neoliberal roots, they do not seem to offer much help with optimising corporate taxation. Increased personal taxation, it seems, is OK when a sovereign debt needs to be repaid. As we shall see below, high transaction costs in real life can also result from paying bribes. Neoclassical economics finds this difficult to model in an amoral (but quasi-perfect) market, hence corruption is modelled as an error. The final flexible category of market imperfections is called ‘­human error’. As we mentioned, sometimes this is a euphemism for real world corruption. Market transparency enables the detection of human error. Audits also allow ‘errors’ to be detected in retrospect, so it is important to have transparency to eliminate human error (at least in theory). Unfortunately, transparency is absent in many private financial transactions. Banks prefer self-regulation to publicly regulated exchanges, especially when it comes to financial innovation (the derivatives markets, for example) where banks promote the efficiency of over-the-counter (OTC) transactions on opaque private markets. Back in the simplistic world of neoclassical economics, we have a few limited choices: to enjoy leisure, to work to consume now, or to save for ‘postponed’ consumption. Consumers do not go to the bank for a loan because ‘banks’ per se do not exist, only ‘firms’ exist. A bank is modelled as a special kind of firm. Banks, like any firm, offer products and services, such as pension funds, loans and mortgages. As we have seen above, transparency helps with the detection of ‘human error’. Exchanges are designed to be transparent, but OTC transactions are governed by private contracts invisible to regulators, being self-regulated by the financial industry itself. If there is litigation, OTC contracts and master agreements from the International Swaps and Derivatives Association (ISDA) can be made available in a court case, but otherwise they remain private – even to governments. Many of the financial services that caused the global financial meltdown are not traded on open markets but, strangely, neo­classical

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theory chooses to make no judgement on the opacity of these markets; rather, it is assumed that the investors – the consumers of these sophisticated financial services – are privy to the information required to make an optimal choice. Also, by implication, the quality of the information provided (for example, by rating agencies or by the sellers themselves) should also be close to perfect. Unfortunately, theoretical models do not reflect real life. For example, should a rating agency rate a fund (or a sovereign state) ‘AAA’, then it is a sure thing. The AAA rating implies that the seller of the bond is guaranteed to pay it back with interest. Default is almost impossible, which is why the price of insuring against default (via a credit default swap) should be negligible. Also, in order to ensure the quality of market information and the security of the transaction, markets have operational rules and controls. From a neoclassical perspective, whether these controls are governmentregulated controls or private self-regulation is unimportant as long as they work. The ultra-free-market doctrine of neoliberalism tends to prefer that governments refrain from interventions in ‘free’ markets.1 Trust in the market is implied; it doesn’t matter who controls it – a neoliberal will argue – as markets are quasi-perfect and would work anyway (or so the theory goes). Again, history has shown that this has not worked out well in real life. In 2008 in the US, and in the following years in Europe, we have seen that certain ratings were inaccurate (usually being overrated) and that self-regulating markets were, in fact, out of control. What about the concept of banks being ‘too big to fail’? Well, for a neoclassical economist this concept does not exist; rescues are just plain wrong since they are anti-competitive and they distort markets. In this virtual world, banks – like any other firm – compete with others that offer similar services. Competition rules imply that better firms thrive and the suboptimal firms should be allowed to fail: they are not rescued, forced to merge, or nationalised (with the public paying off their debts). Quite the contrary: they thrive or they go bankrupt – that’s it! Innovative entrepreneurs with capital and ‘animal spirits’ may choose to fill the gap in the banking market with better technology, price or productivity and the market will self-correct.

phillips  |  219 Competition between banks in such a world view is ­almost perfect; collusion is impossible as it would be anti-competitive. ­Oligopolistic behaviour is not a free market concept, and it is therefore largely ignored. ‘Too interlinked to fail’ would be impossible, and bank rescues would not be allowed. Now back to reality. Remember those ‘market participants’ who don’t follow the rules, instead producing ‘human errors’? If the ­human is a hedge fund manager and the error is gaming the system by shorting a fund using insider knowledge, is this too a ‘human error’? If a corrupt politician is convinced – by a secret payment to a numbered Swiss bank account – to buy from a specific armaments manufacturer, does this reflect the high transaction costs of the arms market? In this virtual neoclassical world there is no room for corruption, so there is no need for regulation – the perfect information available to the market participants will enable self-regulation and infinitesimally better consumer choices will converge on perfection. The corrupt politician would be censured for taking bribes from the arms manufacturer and, once the derivatives trader was convicted, he (or she) would join the politician in jail. The system would be self-correcting as the sanctions – the retribution for human error2 – would be sufficiently onerous that the personal transaction costs of corruption would be too high. It just wouldn’t happen. In such a perfect neoliberal world, neither political corruption nor financial crises are possible. Modern European reality does not reflect this perfect economic theory, nor do the actions of governments in rescuing banks and failing to prosecute corruption. However, neo­ classical theories continue to shape the economic policies governments apply to resolve the crisis. Small wonder they’re not working. Very few police investigations into human error are under way and even fewer end up in court. Prosecutions are conspicuous by their absence. If anything, the situation in Europe is worse than in the US, which has been dismal. Iceland is the exception that proves the rule, a country where both bankers and government collusion have been punished, at least partially. Also, the canny Icelandic people, against all advice, were successful in avoiding at least some unnecessary sovereign debt, when they decided not to pay all of the

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costs of the private financial crisis that occurred in their banks. Current EU banking regulations are light touch, focusing on ephemeral issues such as attempting to limit executive salaries and reprivatising nationalised banks. There is a complete absence of structural change – that would require a change of tactics that the EU has chosen not to make. Existing measures are far from sufficient, being largely ineffective. However, from that same innocent neoliberal viewpoint, this is OK. The mantra remains that the markets must be left to themselves, to self-correct, free of government intervention even if this means running the risk of systemic corruption in the financial system. Having provided this short review of the imperfect theory of perfect markets, the next section discusses a little about how the financial industry puts this neoclassical theory into practice.

Imperfect information  In an article entitled ‘The domino defect: five years after crisis, banks no better off’, Der Spiegel journalist Martin Hesse interviewed Harald Hau, a financial expert from the University of Geneva, to investigate why European banking has still not been fixed. ‘The lack of market transparency is intentional on the part of the major banks,’ said Hau, ‘because that’s the basis of their information advantage and the profitability of their trading activities’ (Hesse 2013). So there you have it. The beautiful theory of market transparency breaks down. The banks are just in business to make money. Selfregulated financial markets were insufficiently regulated; markets are opaque by design! The former governor of New York, Eliot Spitzer, puts it another way: ‘Don’t forget [the pre-crisis noughties] was a period when the mantra, self-regulation, had carried the day.’ He gave his opinion on self-regulation in an extended interview for the film Inside Job:3 Now I happen to think self-regulation is an oxymoron! It doesn’t work! You shouldn’t expect it to work! You’re expecting people to act completely contrary to self-interest.

So much for the theory! When financial markets collapse and are rescued by the public,

phillips  |  221 the cost of the rescue is imposed on taxpayers by their own government representatives, with the backing of the Troika. European and national courts are not prosecuting the banks, failing to protect the public from social and financial losses. If these losses are the result of corrupt speculation in the financial sector, then European courts should treat this behaviour like any other form of theft, litigating against those responsible. Unfortunately, it seems that in the neoliberal world view, justice too is an externality. But the problem is hardly restricted to Europe.

Global banking reform: absent  Banking reform is quite clearly necessary to avoid future crises and to punish those institutions and individuals responsible for the current crisis with fines, jail time or other sanctions, such as applying levies on the banks, or keeping them public (at least until they repay the losses they passed to the state). In 2013, any such reform is insufficient, delayed or non-existent. Reform is subject to the same competitive constraints that led to financial deregulation in the first place. Neither European nations nor the EU itself want to be the first to regulate. Political leaders give speeches at the G-20 about regulation of the financial sector, but laws are watered down, delayed, or simply not enforced. Interminable loopholes are provided as concessions by policy makers in government regulatory agencies when banks warn that applying the regulatory change will cause them more problems – these loopholes could be seen as proof that the banks are the real policy makers. Politicians’ standard retort to delays in effective systemic, and socially beneficial, financial regulation is: ‘It’s complicated.’ Is it really that complicated after all? Financial institutions can also resist re-regulation by lobbying or threatening to move from London or Frankfurt to New York or Singapore. One might argue that Europe could regulate its own finan­ cial markets, but that would imply re-establishing cross-border ­financial  controls, and global finance will fight tooth and nail to defend its global reach. The EU has also signed the World Trade Organization (WTO) service agreement called the ‘Understanding on commitments in financial services’, clause seven of which states:

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A Member shall permit financial service suppliers of any other [WTO] Member established in its territory to offer in its territory any new financial service.4

WTO agreements such as these make national regulation impossible or ineffective, as the government that imposes such controls might face enforcement litigation. Argentina faces more litigation than any other nation on the planet in tribunals at the World Bank’s International Centre for Settlement of Investment Disputes, where firms often litigate against sovereign nations for non-compliance with international financial agreements such as the WTO agreement above or bilateral investment treaties. Scrutiny and transparency Outrage over economic losses and national financial collapse has led to demands for greater transparency in public funding and for greater democratic control over public finances. If sovereign debt is going to be paid off (with interest) from taxation, then shouldn’t voters be asked whether they agree with rescuing the private financial sector, or at least be presented with options as to how this could happen? Europe’s governments should encourage retrospective determinations of what went wrong by being protagonists in audits of public debt,5 as President Correa did in Ecuador when he set up a presidential commission to audit past debt. Instead, citizens’ audit committees have had to conduct their own inquiries in various European nations without the advantage of government access to res­ tricted information. Limited government and central bank inquiries have been conducted that have pored over redacted documents on national financial collapses (more on this below). This information, combined with leaks to the press, is beginning to reveal the scale of the corruption involved, both in the private financial sector and in the public sector. We now know that national regulation of the private financial sector in some European nations has been grossly inadequate: the financial regulators almost seem to have been acting as a service industry to the private financial sector. Light-touch regulation meant hands-off regulation (which is minimal regulation or no regulation at all).

phillips  |  223 Government controls to eliminate systemic financial risk should be put in place immediately, before the next crisis occurs, but this isn’t happening because the banks continue to resist such controls. Public contract disbursements, a major source of deficits and therefore of sovereign debt, should also be more transparent. One illustrative example comes from defence spending in Greece. Former Greek Defence Minister Akis Tsochatzopoulos faces charges relating to cash payments of €8 million connected with the purchase of four German-manufactured submarines and other arms purchases from Russia (Schmitt 2010).6 Evidence from various European nations indicates that this is just the tip of the iceberg. The scale of corruption in the public sector, however, is insignificant when compared with the scale of corruption in the private financial sector. A defence minister, even with a quasi-religious trust in ‘free’ markets, doesn’t operate in a free market. NATO members, even if they do have a few options, cannot just go out and buy any old fighter jet or submarine to add to their fleet. Also, as the Greek example above shows, bribery and corruption create their own market distortions. Sunshine laws7 and public audits, backed up by the political will to prosecute those responsible, could indeed reduce corruption. In Europe, however, governments willing to do this are the exception rather than the rule. Government debt does not only accrue at a national level; in some parts of Europe, bonds can also be issued by cities and states. Italian cities have been exposed to losses partly from recent investments in derivatives (as was the bankrupt city of Detroit in the US). Some Italian cities have decided to prosecute the banks that advised them on innovative derivatives strategies, such as currency hedging. Milan seized €476 million in assets belonging to UBS AG, Deutsche Bank AG and JPMorgan Chase & Co., alleging irregularities in a derivatives purchase in 2005. Milan was just one out of 600 Italian cities that had made these kinds of risky innovative investments. Litigation typically cites inadequate risk assessment by credit-rating agencies of the real risk behind these derivative-based complex investments. Also in northern Italy, the world’s oldest bank, Monte dei Paschi di Siena – founded in 1472 and Italy’s third largest – cites derivatives

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trades with Japanese bank Nomura as one of the reasons for that bank’s near collapse. A €3.9 billion bailout in the form of bank bonds bought by the government was approved by the Italian parliament in December 2012. According to the Financial Times (2013), the bank may need another €2.5 billion in rescue funds to survive. Nomura spokespersons ‘vigorously contest any suggestions of wrongdoing’. The Japanese bank is pressing to defend its innocence in British courts, rather than be prosecuted in Italy, Nomura claiming that ISDA master agreements pertaining to the deal should be made available to the British courts rather than to Italian courts.

Government inquiries  The democratic credentials of government rescues both before and after Troika interventions have already faced public scrutiny in many nations. In Ireland, the damage done to public finances by rescuing the private financial sector was extreme. Between 2008 and 2013, the ratio of national debt to gross domestic product (GDP) rose 400%, from 25% to 125%, mostly as a result of rescuing the private financial sector. A subsequent government inquiry noted that the government consulted with private financial firms before conducting a blanket public rescue of the private financial sector, and that this happened before the Troika intervened. In 2010, the Irish parliament – the Dáil – launched the Commission of Investigation into the Banking Sector in Ireland8 to look into the ‘blanket [bank] guarantee’. Redacted documents revealed that the Irish government received advice from Merrill Lynch, Goldman Sachs and PricewaterhouseCoopers, among others.9 As the Dáil committee investigated the creation of Ireland’s new sovereign debt – a direct result of the blanket guarantee – the Troika was already writing Ireland’s first memorandum of understanding (MoU)10 to prioritise repayment. In Ireland, as in the rest of the rescued periphery, certain banks were saved and others wound down. Speculative investors that had borrowed from these banks were also indirectly rescued using future national tax revenues, supplemented by the European Commission’s new rescue funds provided as loans and liquidity.11 Diverting national taxpayer funds to debt repayments heightened social misery in the intervened states, but this didn’t seem to matter to the Troika. A

phillips  |  225 self-reinforcing vicious circle of economic crisis was the economic result. Unemployment and emigration increased, lowering wages for the working poor. In neoliberal terms, this leads to competitiveness and market efficiency.

Fraud and collusion between banks and their regulators  Formal banking inquiries, and leaks to the press, have begun to reveal details of the collusion between executives in private banks and government officials in financial regulatory agencies. This information continues to come to light as public anger and investor lawsuits lead to more investigation of the banking industry and its public regulators. Some of the most spectacular evidence of collusion came out in mid-2013 in Ireland, where Anglo Irish Bank (Anglo) had its headquarters in Dublin. The British Independent Commission on Banking had examined ‘Losses suffered by [European] banks in the crisis as a percentage of risk-weighted analysis (RWA)’.12 Their study confirmed that Anglo was the worst bank in Europe, making the greatest cumulative loss between 2007 and 2010 according to this measure. Anglo represents a case study in the corruption of the European banking sector. In 2013, Irish national newspapers leaked the ‘Anglo tapes’, ­audio recordings of meetings and phone conversations in the final few weeks of bank operations at Anglo (before it collapsed). They included phone conversations between officials in the bank and government financial regulators who, at least theoretically, regulated Anglo and other Irish banks. The tapes demonstrate the complete disdain shown by bank executives over the inevitable fallout from their corrupt business practices. Executives speculate on how the private financial collapse might ‘play out’, hoping that the Irish Central Bank officials would ‘decide they’re willing to put their hands in their pockets and support the financial sector’. They are heard discussing tactics to ‘reel in’ public rescue finance from the national central bank, a few thousand million euros at a time.13 This is exactly what happened: the Irish government threw more than €40,000 million into Anglo, a bank that had only a few thousand customers. Anglo no longer exists, its former chairman, Seán

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Fitzpatrick, has been arrested three times on related charges, and David Drumm, a former chief executive, faces extradition to Ireland. He is currently facing charges by Massachusetts state tax authorities over alleged irregularities in his bankruptcy filings.14 Scapegoating Most European citizens rely on the media – as the fourth estate – to provide a rationale for these unsuccessful and rather painful ‘rescues’. In this book we have taken pains to separate myth from reality, but it is also revealing to examine how national politicians divest their responsibility, deflecting public anger right back onto the public themselves. This pattern is repeated all across the periphery. The angry public is typically looking for someone, or some tangible organisation, to blame. The media oblige with a scapegoat. In Europe we see that blame has been deflected from those who actually caused the crisis to the societies in the periphery themselves. Stereotypes are constructed about the Greeks, the Irish, the Portuguese and the Spanish. The tabloid press uses archaic language to defame the national character, feeding on ignorance and hiding behind complexity. Who would have thought that postmodern Europe would use such an unsympathetic term for public policy as austerity? In Ireland, the late Brian Lenihan, an astute politician but an inept Minister for Finance, was one of the key decision makers in the crucial period just before, and immediately after, Ireland’s first Troika intervention. Lenihan preferred to frame Irish societal guilt in lighter, less austere terminology. In a 2010 public interview on national TV, he replied to allegations made against the nation’s blanket bank guarantee, defending his policy by deflecting the blame for the crisis onto the general population: Our problems are not just banking problems. We developed a serious problem as a state, we began to spend far more on ourselves than we could afford. Let’s be fair about it, we all partied!

Similar arguments were used in Greece and other intervened ­nations by politicians, when, in fact, the corrupt speculation of a very small well-connected elite, leveraging contacts with local banking

phillips  |  227 associates (usually funded from abroad and taking full advantage of lax government financial regulation), was really responsible. It was they who had created dangerously high levels of toxic private debt; it was their defaults that led directly to financial collapse and to public rescues. In cynical Ireland, Minister Lenihan’s moral tale fell rather flat – his ‘we all partied’ video went viral on social media. The Irish people were surprised and angry at his delusion. Politicians usually have media advisers, professional public relations experts. Lenihan’s spin doctors seemed to believe that by repeating a lie often enough, it becomes the truth, creating a common fallacy that all the periphery’s taxpayers share the blame for the largest financial collapse in recent history. This is simply not the case. In Iceland, Greece, Portugal and Ireland, only a few corrupt individuals were indicted for their part in damaging public finances. In Ireland, some have done jail time for contempt of court, usually for refusing to reveal offshore assets. They have proven difficult to keep behind bars. They, too, have a tendency to be bailed out. Democracy in crisis Increased levels of activism and political activity, especially among European youth in the periphery – who are among the worst affected by increased levels of unemployment – may offer hope for viable solutions to Europe’s problems and an end to the continent’s financial exhaustion. Fixing Europe’s financial issues is not enough, and the young people know it, but it would be a start. Street protesters would prefer austerity for banks and rescues for the unemployed. Voters are focused on economic issues. Fighting cutbacks caused by austerity measures is of paramount importance, but privatisation is also questioned. Neoliberal policies have led to states being forced to consider privatisation on a grand scale, often counter to public will. The following is a partial list of public sector entities that were recently designated by various governments as possible assets to be auctioned off: • Greece: water, islands, ports, energy, transport, state buildings.

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• • • • •

Ireland: energy, forestry, transport, water, public pensions, banks. Italy: public buildings, water, transport, postal service. Portugal: banks, energy, water, transport, postal service. Spain: transport, water, health services. UK: health, legal services, welfare, police, banks.

Also, environmental factors, public subsidies, taxation, mining royalties and privatisation are being debated in Greek gold-mining projects, such as Skouries in Poligiros, northern Greece,15 and in the new offshore oil and gas discoveries off the Irish coasts.16 Recent elections in Europe and increasing levels of youth participation in political mobilisation have taken traditional political and economic models to task. In peripheral Europe, politics (and political parties) are in extreme flux: evidence for this is also to be found in certain states in the centre, such as France and Austria.17 Election results demonstrate a loss of confidence in the political centre and in the parties that oversaw the build-up to the crisis and the subsequent collapse. Votes are shifting to the extreme right, especially in Hungary and Greece, and to the extreme left or to independent candidates without party affiliations. Extreme economics and street protests have forced traditional political parties in the periphery to rethink their alliances and to question their relevance for the future. Proto-political movements have begun to develop from coordination of what were diverse and largely apolitical protest movements. ­Although austerity is a fiscally conservative reaction to financial crisis, both the far right and the far left reject it. Movements are especially difficult to map onto the traditional left–right political divide, and this is complicated by the differences between the centre-left and  centre-right parties who presided over Europe’s financial fiasco. Sharp swings in recent peripheral elections, evidence of voter concern, were not evident in the 2013 German elections, where parties in the centre maintained support. However, in the  periphery, most incumbent parties that signed the MoUs with the Troika were removed from office. The undemocratic influence of the private financial sector on Europe’s institutions has rarely been so visible; it was bound to result in public scrutiny.

phillips  |  229 Possibly the worst demonstration of the Troika’s utter contempt for democracy was seen in Greece in 2011. At first, TINA18 railroading of Greece’s national economic policy did not go smoothly for the Troika. Whether George Papandreou intended his move as a crude election ploy, or whether it reflected an old-fashioned belief in direct democracy, in November 2011 the Greek prime minister made a very bold suggestion indeed. He argued that voters should be offered the chance to confirm their support for MoU policies via a national referendum. The Troika was horrified and took swift action, straight from the playbook of 1990s International Monetary Fund (IMF) ‘shock doctrine’ interventions in South America (see Klein 2007). First, Papandreou was lectured regarding the error of his ways. He was somehow convinced that the decision to hold the referendum was a big mistake. He reversed his decision and formally resigned on 10 November. An interim government was formed on 11 November under Prime Minister Lucas Papademos, a technocratic leader and a former vicepresident of the European Central Bank (ECB). ‘We are living through critical and historic times,’ said Papademos, ‘and it is imperative that we co-operate’ (Smith 2011). The office of Greek President Karolos Papoulias issued a statement confirming Papademos’ appointment and adding that the ‘chief role of the new interim administration will be the implementation of the decisions of the European Union summit of Oct. 26 and the policies that are connected to this’ (Kitsantonis and Daley 2011). The die was cast – TINA was out in the open – the Troika does not tolerate alternatives. The Papademos interim government offered a window of opportunity, through which the Troika shoved Greece’s second rescue and the MoU – without the referendum – while the police dealt with tens of thousands of Greeks protesting in the streets. Athens in 2011 was compared with Buenos Aires ten years earlier. Troika realpolitik was a little crude and somewhat risky, but it was ruthless in its contempt for democracy. What form of European Union might evolve from the crisis? The current crisis has revealed certain democratic and institutional inadequacies in both the EU and the Eurozone. One clear financial

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omission was the lack of a mechanism for the ECB to intervene directly – neither to prevent nor to resolve – in problems in national EU central banks, particularly in nations that adopted the euro. The ECB has been stunted from birth by neoliberal theories advocating private sector alternatives. The neoliberal ECB created cheap loans to private banks (LTROs19) and then requested them to buy bonds from governments in crisis – a profitable, if costly, architectural flaw reflecting the EU’s neoliberal roots. This ultimately has had little success for those who fund the ECB, the European people. The crisis has also revealed a serious lack of democratic control in certain key institutions, sometimes called a ‘democratic deficit’. The European Commission, which expanded its remit to include ‘rescues’, is one example. It has shown scant regard for national democracy in the rescues to date. Interactions between the Troika and nationally elected governments have been much less than transparent and largely devoid of democratic control. Reinforcement and rebalancing of national and EU democratic controls will be necessary to regain public confidence. Also, in diplomatic terms, the EU has faced huge hurdles in making hard decisions, resulting in costly delays in effective actions such as bond buybacks, for example. The time lost due to inaction has been costly for the EU and for peripheral taxpayers. As to the future of European integration, it might go either way. Many EU nations consider EU limits to supranationalism as a blessing rather than a curse, particularly certain countries not among the founding members of the common market. Other political actors press for a federal Europe. If this is accepted it will require rebalan­ cing the current democratic power in the EU, especially between the European and national democratic institutions and the peoples of Europe. Regional agreements, like the EU, suffer inherent conflicts between the retention of national controls versus supranational (regional) control of, for example, taxation and regulation. Standardisation of national government controls over private banking across the EU – and particularly in the Eurozone – will probably be required to prevent future crises. Corporate taxation and financial regulation should probably converge across the EU, but this approach

phillips  |  231 faces challenges from many onshore–offshore legacy agreements and resistance from certain governments that refuse to tax multinational profits at a common rate across the whole of the EU. This problem is not a European one; in fact, Europe faces a common global phenomenon of trying to tax multinational corporate profits and combating sophisticated global tax avoidance schemes. These too are responsible for starving governments of funds, aggravating fiscal problems. There is scope for the EU, with its huge internal markets, to confront this issue, but it is difficult to see how this could be done within the current restraints of free market ideology. Rebuilding confidence The Troika has failed to convince the European people that it acts in the interests of political and economic union; saving the euro is hardly enough. Its policies clearly show a lack of both solidarity and cooperation for the common good of the people living in the periphery. Neoliberal EU structures currently see competitiveness as the essence of political and economic cooperation. In competition there are winners and losers, with an inherent dynamic that runs counter to unity and cooperation. Future European community relations could expand cooperation and limit raw competition for the common good. Changes to the current institutional architecture of the Union should recognise that necessity; alternatively, Europe risks shifting back towards national divisions that might undo much of the stabilisation that has occurred in international relations within Europe since World War Two. The Troika also faces its own internal crises, with inter-agency clashes between the ultra-neoliberal ECB and the European Commission – organisations with little or no relevant experience in resolving sovereign debt crises – and the slightly less conservative IMF, with vast experience of crises but little or no historical success. The IMF and the EU institutions reflect a common neoliberal heritage, leading them both to propose solutions that depend on the benevolence of the private financial markets. This has failed to work for the people but it has worked for some of the banks. On a global level, none of these institutions is completely

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i­ ndependent; they, too, have their hands tied by international central bank agreements, the WTO, the US Treasury and the Federal Reserve, the G-20 Financial Stability Board agreements, relationships with the Basel-based Bank for International Settlements, and other, less transparent, accords. Democracy is a Greek concept, and Europa is a Greek goddess who lent her name to a continent and to a regional currency. If the current European Union is to survive in some form, it will need to demonstrate to the European people, both those living in the periphery and those in the centre, that membership of the regional group is really in their interest. With regard to the current financial crisis, adjustments to the burden-sharing policies of the Troika will be necessary, finding a better balance between public and private losses, and the writing off of more debt, sometimes called restructuring, is urgently required. Democracy in Europe should not be taken for granted; it is, indeed, a relatively new phenomenon in many of the affected peripheral ­nations. The British non-governmental organisation Demos published a 2013 report discussing backsliding democracy in Europe (Birdwell et al. 2013). This report cited a ‘crisis of values’20 in Europe, and particularly in Greece. It associated democratic backsliding with government failures in correcting economic issues, noting: The 2008 financial crisis and the crisis in the Eurozone have also created pressures that are straining democratic government and society across Europe. The inability of democratically elected politicians to resolve Greece’s debt problems, for instance, led to the formation of a ‘technocratic government’ and the rise of populist and extremist political parties, combined with widespread unemployment and poverty. Concerns over sovereign debt and continuing banking crises – and the possible impact that they could have on social unrest – remain for countries such as Cyprus, Italy, Spain, Portugal and Ireland.

European democracy need not backslide. Indeed, if this financial crisis has taught us anything, it has taught us that democracy needs to improve – implying better democratic controls and transparency

phillips  |  233 in the public sector and in the private banking sector. Europe’s current dilemmas need to be resolved; it is time for action. Maybe it is also time for European politicians to look to their own people for lessons in solidarity and peace, even if this runs counter to the interests of global bond investors. Notes 1  Except, that is, when markets have a systemic failure, made possible by deregulation loopholes. In this case, socialism for corporates is OK: although it is anti-neoliberal, it becomes policy nevertheless. 2  The retribution is the cost of being caught and convicted. 3  See criticism and more information on the film at www.metacritic.com/ movie/inside-job. 4  See www.wto.org/english/docs_e/ legal_e/54-ufins_e.htm. 5  For more on Irish public debt, see www.debtireland.org/download/pdf/ audit_of_irish_debt6.pdf. 6  Litigation continued into late 2013. See www.ekathimerini.com/4dcgi/_w_ articles_wsite1_1_19/09/2013_519378. 7  Sunshine laws require transparency. 8  The banking inquiry was known as the Nyberg Commission after the Finnish doctor of political sciences Peter Nyberg, who was appointed as the sole member of the Commission of Investigation (Banking Sector). See www.banking inquiry.gov.ie/. Brian Lenihan, who was then Minister for Finance, wrote a letter on 11 February 2010 appointing Klaus Regling to the Commission. Mr Regling had been Director-General of Economic and Financial Affairs at the European Commission. 9  Examples of redacted documents used to advise the Irish government can be read at dail.ie/documents/ committees30thdail/pac/reports/ documentsregruarantee/document11.pdf (Morgan Stanley); dail.ie/documents/

committees30thdail/pac/reports/ documentsregruarantee/document10. pdf (Goldman Sachs); and dail. ie/­documents/committees30thdail/ pac/reports/documentsregruarantee/­ document4.pdf (Merrill Lynch). 10  The Irish MoU (‘Ireland: Memorandum of understanding on specific economic policy conditionality’), which was in its eighth revision in 2013, can be found at www.finance.gov.ie/sites/ default/files/mousearchmarch2013.pdf. 11  There was to be multilateral funding for the Commission’s funds for ECB liquidity measures, for example, all guaranteed by taxpayers across the EU, including those outside the Eurozone. 12  This report can be downloaded from the archive of the former Independent Commission on Banking’s website at http://webarchive.national archives.gov.uk/+/bankingcommission. independent.gov.uk. For more information, see Phillips (2012). 13  In his article, Tyler Durden (2013) analysed secret recordings made in 2008 and leaked by the Irish national newspaper The Irish Independent. The conversations were between senior management in the Anglo Irish Bank and their contacts in the government financial regulator. The senior manager recounts to the regulator how he had recently gone to the Irish National Central Bank and asked for a bank bailout fund of €7,000 million. When the regulator asked where he had got this number, the executive admitted that he had pulled it ‘out of my arse’.

234  |  Epilogue 14  See www.irishtimes.com/ business/sectors/financial-services/ drumm-bankruptcy-trial-delayed-againin-boston-1.1386416. 15  These issues are primarily being debated between the mine owners and the government with local people and ecologists, and they are resulting in assaults, various illegal actions, lawsuits and arrests. See Greg Palast on Skouries and privatisation in Greece at www. truth-out.org/news/item/18069-whyare-the-greek-people-agreeing-to-theirown-destruction. There is also a film project on this in English at www. indiegogo.com/projects/the-battle-forskouries. 16  The ownouroil.ie website debates the value to Ireland’s economy of oil revenues that will accrue from future exploitation of offshore oil and gas. 17  France is of particular relevance among those nations that have not yet received ‘help’ via Troika interventions, nor balance-of-payments (BoP) assistance funds to date (2013). 18  TINA stands for There Is No Alternative. 19  LTROs are long-term refinancing operations, for liquidity purposes. 20  It cited the Transparency International term as used in the survey ‘Greece: the cost of a bribe’. See www. transparency.org/news/feature/greece_ the_cost_of_a_bribe.

References Birdwell, J., S. Feve, C. Tryhorn and N. Vibla (2013) Backsliders: Measuring democracy in the EU. London: Demos. Available at www.demos.co.uk/ publications/backsliders. Durden, T. (2013) ‘Anglo-Irish picked bailout number “Out of my arse” to force shared taxpayer sacrifice’. Zero Hedge News, 24 June. Avail-

able at www.zerohedge.com/ news/2013-06-24/anglo-irish-pickedbailout-number-out-my-arse-forceshared-taxpayer-sacrifice. Financial Times (2013) ‘Monte dei Paschi: going in circles. Threat of nationalisation looms for world’s oldest bank’. Financial Times, 9 September. Available at www.ft.com/intl/cms/ s/3/9412a680-1948-11e3-83b9-00144 feab7de.html. Hesse, M. (2013) ‘The domino defect: five years after crisis, banks no better off’. Der Spiegel, 4 September. Available at www.spiegel.de/ international/business/bankreforms-needed-five-years-afterfinancial-crisis-a-919725.html. Kitsantonis, N. and S. Daley (2011) ‘Greece selects former European Central Bank official for new prime minister’. New York Times News Ser­ vice, 10 November. Available at www. truth-out.org/news/item/4756. Klein, N. (2007) The Shock Doctrine: The rise of disaster capitalism. New York NY: Henry Holt and Company. Phillips, T. (2012) ‘Irish public debt: a view through the lens of the Argentine default’. In B. Lucey, C. Larkin and C. Gurdgiev (eds) What if Ireland Defaults? Dublin: Orpen Press. Schmitt, J. (2010) ‘Complicit in corruption: how German companies bribed their way to Greek deals’. Spiegel Online International, 11 May. Available at www.spiegel.de/international/ europe/complicit-in-corruption-howgerman-companies-bribed-their-wayto-greek-deals-a-693973.html. Smith, H. (2011) ‘Lucas Papademos sworn in as Greece’s prime minister’. The Guardian, 11 November. Available at www.theguardian.com/world/2011/ nov/11/lucas-papademos-greeceprime-minister.

ABOUT THE CONTRIBUTORS

Anzhela Knyazeva is assistant professor of finance at the University of Rochester. She holds a PhD from New York University. She has worked on issues related to boards of directors, dividend behaviour, acquisitions and bank lending and has taught investment and international finance courses. Her work has been published in the Journal of Financial Economics, the Review of Financial Studies, and the Journal of Banking and Finance.

Diana Knyazeva is assistant professor of finance at the University of Rochester. She earned her PhD at New York University’s Stern School of Business. She has research interests in corporate finance, corporate governance and banking and teaches courses on financial institutions and capital budgeting. Her papers have examined corporate boards, payout policy, investment decisions and analyst following. Her most recent work is published in the Review of Financial Studies.

Joseph E. Stiglitz is a professor at Columbia University, the winner of the 2001 Nobel Memorial Prize in Economics, and a lead author of the 1995 Intergovernmental Panel on Climate Change report, which shared the 2007 Nobel Peace Prize. He was chairman of the US Council of Economic Advisers under President Clinton and chief economist and senior vice-president of the World Bank from 1997 to 2000. He was appointed by the president of the United Nations General Assembly as chair of the Commission of Experts on Reform of the International Financial and Monetary System, which released its report in September 2009. He is the author most recently of The Price of Inequality: How today’s divided society endangers our future (W. W. Norton & Company, 2012).

Mariana Mortágua is an economist and a PhD candidate at the School of Oriental and African Studies (SOAS) at the University of London. She is a member of the Portuguese parliament for the Left

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Block (Bloco de Esquerda), where she sits on the Commission for Economic Affairs. Among other publications she has published The Debt: Portugal in the euro crisis with Francisco Louçã (in Portuguese, Bertrand, 2012).

Christina Laskaridis holds an MSc from the School of Oriental and African Studies (SOAS) at the University of London. Her economics research includes the impact of exchange rate movements on national external accounts. Laskaridis researches relevant international experience, applying this to the Greek debt crisis. She has been active in the Greek debt audit campaign since its inception, and is a researcher on the European debt crisis in Corporate Watch. Other interests include community finance schemes, cooperative structures and environmental education.

Roberto Lavagna was Argentine ambassador to the European Union and to the World Trade Organization. In 2002 he began four years as Argentine Minister for Economics and Finance at the height of the ­political crisis, his team negotiating the largest sovereign default (until the Greek default) with creditors and with the International Monetary Fund. He published A Challenge to the Will: Thirteen crucial months in Argentina’s history, April 2002–May 2003 (in Spanish, Sud­ americana, 2011). Dr Lavagna was a candidate for president in 2007. He continues his political and economic work from the Ideas Institute in Buenos Aires.

GLOSSARY

Asset  An item owned by an individual, a corporation or a government that provides a monetary benefit, has economic value and could be converted into cash. For businesses an asset generates cash flow, so assets are listed on the company’s balance sheet. An asset might be a physical asset, such as a property (which might be a cash-flowproducing asset by generating rent), or it could be a purely financial asset such as holdings of stocks or bonds, but it also plays a role in asset-backed securities. For more on financial assets, see also Assetbacked security (ABS). Asset-backed security (ABS) and mortgage-backed security (MBS)  Tradable securities backed by pools of assets, such as loans, leases or other cash-flow-producing assets, which were at the centre of this crisis. An ABS entitles its owner to payments derived from the underlying assets. MBSs are special ABSs where the assets include mortgages. MBSs were at the centre of the sub-prime crisis in the US, as defaults on sub-prime mortgages destabilised the MBS securities and the banks that owned them failed. A collateralised debt obligation (CDO – see below) is often a structured ABS. Austerity, adjustment, conditionalities and memorandum of understanding (MoU)  The Troika’s austerity policies are similar to those recommended by the International Monetary Fund (IMF) elsewhere in the world when it was acting on its own and not within the EU Troika. The IMF generally refers to these austerity programmes using the phrase ‘adjustment programmes’, such as those implemented in Argentina in the 1990s and early 2000s. In Europe, Troika inter­ventions require ‘rescued’ governments to enter into an MoU with the Troika, typically requiring the national parliament to ratify the MoU; these, too, are equivalent to the IMF’s programmes. The MoUs are lists of

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policy adjustments (austerity measures and other economic adjustments referred to as structural reforms), adjusting what were previously ‘national’ economic policies. The IMF called these austerity clauses ‘conditionalities’ in the 1990s as disbursement of IMF financial aid was conditional on the implementation of such policies. Economic adjustments typically shrink public spending while increasing noninvestment income taxation and attempt to encourage exports. Bond and bondholder  Sovereign (treasury) state and municipal bonds are public bonds. Bonds issued by banks or other firms are private bonds. Bonds are securities that pay a periodic fixed rate of interest until they mature, which is when they pay their ‘par value’ (the repayment of the principal on the bond). In many peripheral nations, private bonds – especially those issued by banks to increase their capital – were at the centre of the European debt crisis while it was still (primarily) a private debt crisis. Now public bonds are at the centre of the public phase of the European sovereign debt crisis. Banks issue bonds to supplement deposits (and other financial assets) so that they can leverage the new capital to create even more loans (effectively borrowing to loan on to their clients). When these loans default (especially in the periphery), the banks can no longer make payments on bonds to bondholders. Hence these private (inter-bank) bonds themselves went into default. In Europe, this has led, in many cases, to public rescues; ironically, this process is referred to as ‘social­isation’ of debt, although there is nothing very social or socialist about it – quite the opposite. See also Credit event. Bond (sovereign)  A debt (security) issued by a national government, in a local, common or foreign currency, that is effectively a loan to that government by the buyer of the bond. Bonds pay interest that is often referred to as the yield on the bond. In the Eurozone, recent sovereign bonds have been issued in the common currency, the euro. In general, governments try to issue bonds in their national currency, but this is no longer possible for Eurozone members. Bonds in foreign currencies can be problematic as they are sensitive to currency fluctuations, such as when a local currency devalues relative to the foreign currency

glossary  |  239 in which the bond is denominated. Local currency devaluation signifies a relative increase in the value of the bond to be repaid in local currency terms. In a common currency such as the euro, unilateral currency devaluations are not possible, which sometimes results in internal devaluation (via austerity measures, for example); however, this is partially offset by zero currency risk on the bond. If any nation with a large sovereign debt obligation in euros were to leave the Eurozone, the relative value of its ‘foreign’ debt (denom­ inated in euros) would multiply by the inverse of the devaluation its currency would effectively sustain when it left the currency union. To illustrate this, consider a devaluation of the local currency (relative to the euro) of 50%. This would imply that euro-denominated debt ­doubles in the new currency units (a bond issuance with par value of €100 million would now cost 200 million new currency units). By extension, a devaluation would also increase a nation’s ratio of debt to gross domestic product (GDP): the GDP would be in the local devalued currency and the new, higher, debt would still need to be paid in euros. This could lead to a default on sovereign bonds if a peripheral nation were to unilaterally leave the Eurozone. If, on the other hand, the German mark (or another core currency) were to leave the Eurozone, and assuming that the euro survived such a drastic shock, heavily indebted nations in the Eurozone would possibly be able to stay in the devalued euro and pay without defaulting. Carry trade  An international investment strategy whereby an investor takes advantage of differences in interest rates (arbitrage) between two, or more, currencies. The trader borrows money in one currency at a low interest rate then re-invests the money at a high interest rate in another currency. On a more general level, a carry trade is a technique, or investment strategy, for borrowing low and selling high. This was used by European banks to increase leverage – European banks borrowed cheaply (sometimes in US dollars) and lent that money (to other banks in the periphery, for example) at higher rates in euros (often by buying private bonds from those banks and so becoming bondholders). This risky investment strategy is sometimes described in this book as a

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US dollar carry trade. The risk comes from the currency risk and the difference in the loan repayment terms (short-term borrowing with longer lending terms), which means there is a vulnerability to an abrupt drop in liquidity in short-term debt. Collateralised debt obligation (CDO)  A CDO is a bundled, structured, asset-backed security (ABS). The collateral is the asset, which might, for example, be a student loan, a credit card debt or pretty much anything else. In a basic CDO, a pool of bonds, loans or other assets are bundled and issued as a named (CDO) security. CDOs are split into tranches with different risk profiles and different yields. Unscrupulous investment banks sometimes used CDOs to bundle (and hide) bad debt. By bundling bad debt into a security, the owner of a (toxic) CDO was able to sell on the risk to other investors (sometimes in Europe). CDOs and credit derivatives on CDOs were one of the main mechanisms for the contagion of toxic securities between financial institutions in the United States resulting in the US sub-prime mortgage scandal. Originally designed to spread risk between institutions, the low quality of certain debt bundled into securities meant that CDOs were cited as a negative influence in the sub-prime mortgage scandal – so negative, indeed, that the crisis became systemic in nature. See also Systemic risk. Collective action clause (CAC), pari passu and holdout  A CAC is a legal clause in a sovereign debt contract. It can trigger when a majority of bondholders agree to a debt restructuring, forcing the remainder (the holdouts) to join with the majority (and thereby force a higher settlement rate, possibly 100%). A CAC makes the restructuring terms agreed by the majority legally binding on all bondholders in a resolution. The majority required is generally more than a simple majority (over 50%): the required majority is sometimes known as a qualified majority or a supermajority. Pari passu is a Latin phrase meaning ‘on equal footing’ or ‘equally and without preference’. In a bankruptcy (or a sovereign or private debt restructuring), pari passu means that creditors are paid pro

glossary  |  241 rata in accordance with the amount of their debt holding. A pari passu clause in a sovereign debt issuance ranks the debt on a par with other debt owed by the sovereign. For examples of pari passu clauses and their uses by vulture funds, see William Wilson Bratton (2010; available at scholarship.law.georgetown.edu/cgi/viewcontent. cgi?article=1052& context=facpub). A holdout is typically a speculative investor (sometimes a vulture fund) that refuses a restructuring offer; instead, they hold out for a greater profit and hence they typically do not like to buy bonds that are subject to collective action clauses. Sometimes, holding out is a strategy enabled by credit default swap (CDS) coverage, which may guarantee a high payout in the case of a credit event. Paradoxically, holdouts often buy debt at very low prices then hold out for the highest resolution payouts. Convexity and bond convexity  The origin of the term ‘convexity’ comes from the shape of a convex curve, for example the curve of the surface of a magnifying glass. More specifically, in bond finance, convexity is a term derived from the C-shaped curve that hypothetically results from plotting bond yields on the x-axis and the price that the bond sells for on the y-axis of a graph. Conventional economic models include the supposition that the steeper the curve of the resulting ‘C’, the higher the convexity, and so the riskier the bond. Therefore, the degree of convexity of a bond portfolio should be a measure of exposure to market risk. In a more general sense, convexity reflects the idea that averages are better than extremes, and so sharing risk is beneficial. This microviewpoint, it can be argued, ignores systemic risk. By extension, some authors argue that the creation of certain credit derivatives, such as credit default swaps (CDSs), helped to spread risk between organisations, thereby increasing stability. This is true, up to a point. That point may have been reached when the US insurance giant American International Group (AIG) nearly collapsed and was rescued by the US government because it was exposed to risk in this unregulated CDS insurance market. In general, bankruptcy and default are illustrative examples of ‘non-convexities’.

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For more on CDSs and on AIG, see the graphical presentations in the film Inside Job (2010). An illustrative video clip is available that shows the interplay between collateralised debt obligations (CDOs) and CDSs at www.wingclips.com/movie-clips/inside-job/aig-and-creditdefault-swaps. See also Credit default swap (CDS). Credit default swap (CDS) and naked CDS  Bilateral, privately regulated (or government unregulated, over-the-counter) swaps. A swap is an insurance contract in everything but name. Swaps are called swaps (and not insurance contracts) for legal reasons – insurance is subject to government regulation whereas swaps are not. A CDS contract is used to provide (swap) protection; this could take the form of a payment in the case of a specified credit event occurring (in this case a default, which could be a failure to pay interest or to repay the principal) on a given security, such as a collateralised debt obligation (CDO) or a bond. The swap is offered by an ‘insurer’ (such as AIG), for whose coverage the buyer pays a periodic fee. If the owner of the CDS contract does not own the underlying (protected) ‘asset’, they have a ‘naked’ CDS; that is, they have insurance in the form of a CDS for an asset they do not own. Naked CDS contracts are a speculator’s tool and are sometimes used by vulture fund investors. Such investors may buy bonds at a discount after a high default risk is recognised by the seller who had previously bought the naked CDS coverage. Holders of CDS coverage have less incentive to negotiate a bond restructuring as they may be able to make more money if a credit event (such as a default) occurs. They therefore may ‘hold out’ for a default that might pay more from the seller of the CDS. EU authorities maintain an outright ban on certain kinds of naked CDS contracts. See also Collective action clause (CAC), pari passu and holdout and Vulture fund. Credit event  A credit event is a change (usually for the worse) in a borrower’s credit standing, such as a decline in a credit rating or a defaulted payment that leads to questions as to the borrower’s ability to repay the debt. For example, when a bank fails to make a payment on a bond, it may generate a credit event. A credit event may be a ­trigger

glossary  |  243 for a credit derivative – such as a credit default swap (CDS) – and could lead to the payment of the swap (coverage). The International Swaps and Derivatives Association (ISDA) decides whether or not the event has occurred (see below). Credit rating and rating agency  A credit rating is an external assessment of the creditworthiness of a nation, a firm or a security and is a financial indicator of assumed credit risk. In the case of nations, this is sometimes called ‘country risk’. Credit ratings are commonly made by (private) rating agencies, such as Standard & Poor’s (S&P), Moody’s and Fitch. Rating agencies have been severely criticised in the US in the recent sub-prime mortgage crisis for overly high ratings on debt obligations, some including sub-prime mortgages, just months before they proved to be essentially worthless. The EU has targeted rating agencies, too. Currency peg  The value of any currency can float with respect to ­other currencies, or it may be anchored to the value of another currency, such as the US dollar or the euro, or to a weighted basket of multiple currencies. There is also a hybrid exchange rate regime called a ‘dirty float’ that lies somewhere between fixed and floating exchange rates. In a dirty float, a government attempts to keep a ­national currency within a range of values relative to an anchor currency. Finally, there is also the special case of the common currency, the euro, where national currency adjustments are no longer possible. In the past, the anchor currency was metallic or bimetallic – gold or both gold and silver. Since 1971, the value of paper (fiat) currency is no longer backed by gold or silver, although in certain countries one can still buy gold or silver as a store of wealth. When President Nixon abandoned the US dollar’s peg to gold, the values of all fiat currencies became established relative to each other and the dollar came off the gold standard. This effectively replaced the gold standard with the US dollar as the currency of commodity trades, with oil playing a crucial role. Current examples of fixed exchange values include various currencies that are pegged to the euro (such as the Swedish krona or the

244  |  glossary

Danish krone) or those pegged to the US dollar (such as the Hong Kong dollar) or the Chinese yuan. During the Argentine convertibility scheme (in the 1990s), the value of the peso was pegged to the dollar, fixed at a ratio of one dollar to one peso. Between 2002 and 2013, the value of the Argentine peso was partially managed with respect to the US dollar, and so could be considered a dirty float; in 2014 this regimen was dropped and the peso is again a floating currency. Debt to gross domestic product (GDP) – a ratio  The ratio of a country’s public national (sovereign) debt (i.e. the sum of a given sovereign’s outstanding national bonds and other forms of debt, expressed as a percentage of one year’s national GDP) is used as a partial determinant of the risk of a sovereign default. This ratio does not take into account interest rates on bonds or the residence of the owners of the sovereign bonds, nor does it take into account political bias by rating agencies who interpret risk: it is simply a percentage (debt divided by GDP). The theory goes that the higher the debt-to-GDP ratio, the less likely it is that the country will pay back all of its debt, and the higher its risk of default, and so the higher the interest rate asked by new buyers of new sovereign debt. If the ratio gets too high, the country can enter into a debt spiral – the creation of more debt or a drop in GDP (or both) leading to higher interest rates for refinancing – where, eventually, restructuring of the debt becomes quasi-inevitable. It is generally considered safer for a nation to sell sovereign debt to residents, as there is a lower default risk and no currency risk. One example often cited is the ownership of Japanese sovereign bonds (largely held in Japan). See also Bond (sovereign) and Debt (sovereign). Debt (sovereign)  National treasuries emit sovereign debt to bridge the gap between the costs of imports and those of exports (the external deficit) and also to cover overruns in the national budget; these can be the result of increased costs, such as funds used for development, to combat a natural disaster or to fight a war, or due to a drop in taxation income. Alternatively, bonds may also be issued

glossary  |  245 in financial rescues when private debt is ‘socialised’. In ‘developing’ countries, including some European economies, sovereign debt may also be emitted for development loans, sometimes from a development bank. Bond yields (interest rates paid on newly emitted bonds) are agreed with private bond markets (the purchasers) before the bonds are ­offered for sale to ensure levels of take-up. These yields are also affected by the neoclassical risk assessments undertaken by policy analysis by private rating agencies, sometimes called country risk. Default  Defaulting on a debt obligation happens when a periodic debt payment is missed, such as when the borrower (the sovereign) cannot make a payment or when it makes a decision not to do so. Defaults are credit events and may attract the interest of the Inter­ national Swaps and Derivatives Association (ISDA). A default continues until it is resolved. If the debt obligation is a sovereign bond, the country in default may choose to stop sovereign debt payments in an emergency such as a war or another catastrophic event (an economic collapse, for example) and that typically leads to a period of restructuring the defaulted debt. See also Credit event. Derivative and over-the-counter (OTC) trade  Derivatives are financial instruments deriving their value from another financial asset. Some derivatives are relatively simple, such as a futures contract (fixing a future price) between a ‘long’ buyer and a ‘short’ seller. These are often used to purchase wheat or other grains or to buy airline jet fuel, fixing a price on a given date in the future. Such futures have an obvious social function. In credit derivatives, such as credit default swap (CDS) contracts, the cost of the derivative is derived from the perceived risk of the underlying asset (the credit): the higher the perceived likelihood of default, the more expensive the swap coverage. A derivative is typically traded OTC. This implies a private contract that is not traded on a publicly regulated exchange. See also Inter­ national Swaps and Derivatives Association (ISDA).

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European Financial Stability Facility (EFSF)  A facility or fund created by the EU. The EFSF still exists but is now closed to new rescues (­having been replaced by the European Stability Mechanism). The EFSF is a special-purpose vehicle (SPV) managed by the European Investment Bank. The fund raises money by issuing debt, and distributes the funds to Eurozone countries. See also European Stability Mechanism (ESM) and Special-purpose vehicle (SPV). European Stability Mechanism (ESM)  The ESM is a ‘permanent’ crisis resolution mechanism for the euro area, inaugurated by order of the European Council. The ESM issues debt instruments in order to finance loans and other forms of financial assistance to euro area member states. New rescues (since 2012) may apply for ESM funding. Eurozone and Eurosystem  The Eurozone is the subset of the EU consisting of the nations using the euro as their currency. The Eurosystem is the system of Eurozone national central banks plus the European Central Bank (ECB). Gross domestic product (GDP)  A measure of domestic national output produced by both resident and non-resident institutions. GDP is assessed as the sum of all goods and services produced (plus taxes and less certain subsidies) within the nation in a given year. This very rough indicator estimates the earnings base from which the government could draw revenue (from taxes, for example). GDP includes personal consumption expenditure, gross private domestic investment, net exports of goods and services, and government consumption expenditure and gross investment. See also Gross national income (GNI) or gross national product (GNP). Gross national income (GNI) or gross national product (GNP)  The value of all final goods and services produced by labour using capital supplied by residents within a country in a year. The value of the GNI/ GNP is at least conceptually equal to the sum of incomes accruing to residents and to gross domestic product (GDP) less primary incomes payable to non-residents plus primary incomes receivable from non-

glossary  |  247 residents. Certain exports from a nation by non-resident companies (or subsidiaries) ‘adding value’ to products or services within the country are added to GDP but not to GNI/GNP – therefore a country’s GDP is sometimes much higher than its GNI/GNP and sometimes it is lower. A higher GNI than GDP occurs in the EU in certain exportoriented countries with a high presence of non-EU multinationals, the non-resident companies using national residency to export into the rest of the EU. One example is Ireland, which offers low and flexible corporate taxation to multinationals; another is Luxembourg. See also Gross domestic product (GDP). Hedge fund  A pooled investment vehicle managed to maximise absolute returns. Hedge funds are typically not offered to the public but are funds managed for sophisticated investors, or so-called ‘high net worth’ or ‘very high net worth’ individuals. In general, a hedge fund is a highly leveraged investment vehicle that often makes use of derivatives instruments and techniques, such as margin trading. Some hedge funds can also be vulture funds. See also Vulture fund. Heterodox and orthodox economics  Two classifications of economic theories. Economics, like theology, is a discipline that has a sharp division between orthodoxy and (various) heterodox doctrines. By definition, a heterodox economic theory represents a departure from orthodoxy (it is by definition unorthodox). In economics (as in theo­logy), orthodoxy is what is academically and politically accept­able, and so it defines the limits of ‘orthodox’ economic policy. Various institutions in the international sphere also exhibit and define an inter­national orthodoxy; these include the International Monetary Fund (IMF), the World Bank, the World Trade Organization (WTO), Central Bank Conferences, the G-8 and the G-20, and the Basel a­ccords. The EU has similar orthodox institutions, such as the European Commission and the European Central Bank (ECB), which are both ultra-orthodox. A heterodox capitalist economic doctrine exhibits certain small deviations from pure orthodoxy while at the same time avoiding ‘heresy’ (examples of heresy in capitalist economic theories might

248  |  glossary

include communism). One of the central themes of this book is that certain heterodox economic adaptations to purely heterodox policy can, and do, work. Hyperinflation  When inflation is recognisable in daily price changes for goods and services, the resultant loss in the value of money is called hyperinflation. High inflation is the enemy of fixed-rate investors (savers) and those on fixed incomes not indexed to real inflation. Hyperinflation has been defined as beginning in the month in which prices rise 50% or more in that month. Argentina has had a disastrous inflation history, with various bouts of extreme inflation. Germany too had extreme hyperinflation between the two World Wars. In the Argentine case, just after the 1976–83 dictatorship, the country suffered from hyperinflation. Although this period of hyperinflation was by no means the first in its history, it affected the governance of the country. Argentine hyperinflation returned before the elections in 1989, when monthly consumer inflation rates (approaching 200%) obliged President Alfonsín to resign six months before term. His elected successor, President Carlos Menem, instituted the extraordinary measure of the convertibility scheme (the 1:1 dollar peg) in 1991, partially in order to curtail inflation. After Menem’s two-term ten-year presidency, the currency peg collapsed in a sovereign debt crisis and Argentina went through five presidents in one week. The last of the five presidents was President Eduardo Duhalde (2002–03), who offered author Roberto Lavagna the post of Minister for Economics and Production (Finance) in his gove­rnment in 2002. Duhalde too stepped down and Néstor Kirchner won the presidential elections in 2003; in 2015, Néstor Kirchner’s wife is scheduled to step down as president. Inflation is again high, with estim­ates for 2013 of 25% to 30% (not hyperinflation but high ­inflation). International Swaps and Derivatives Association (ISDA)  A private ­financial association of more than 800 international banks and ­other financial institutions, originally formed as a lobbying associ­ ation. The ISDA still considers itself ‘The Voice for the Global ­Derivatives Marketplace’. For information on ISDA deregulatory

glossary  |  249 ­lobbying activities, see the organisation’s own report on lobbying published at www.isda.org/wwa/retrospective_1999_master.pdf. The ISDA manages, standardises, documents and adjudicates the self-regulation of the swaps and derivatives markets internationally and is the arbiter of conflicts over over-the-counter (OTC) contracts for derivatives via its Credit Derivatives Determinations Committee. See also Credit default swap (CDS), Credit event and Derivative and over-the-counter (OTC) trade. Leverage (gearing)  A nebulous general term for a measure of multiplying gains (or losses) for a given investment base (capital invested) or for a technique for doing this. Leverage is attained by an investor by obtaining the right to a return on a capital base that exceeds the initial investment. Certain forms of bank leverage are currently regulated, such as the ‘Tier 1 leverage ratio’ for banks. Leverage can be increased greatly by ‘leveraging’ derivatives. Bank leverage can also appear to be lower due to off-balance-sheet liabilities such as specialpurpose vehicles (SPVs), which are sometimes used to avoid audit, regulation or scrutiny of leverage. Higher leverage, in general, implies higher risk; in the case of banks, higher bank leverage means that there is a higher risk of bankruptcy of the bank. For this reason, various means of calculating and regulating banking leverage are being discussed by the Bank for International Settlements (BIS) to reduce financial volatility and systemic risk as part of the Basel accords. Liquidity  The measure of the extent to which a firm, such as a bank, has (or has not) got sufficient cash to meet immediate and short-term obligations. It is also a measure of a company’s ability to get access to money to meet short-term demands for funds. A run on a bank can be the cause of a short-term liquidity crisis. The EU reacted to reduced liquidity via various mechanisms in different countries and across the EU. See also Long-term refinancing operation (LTRO). London Interbank Offered Rate (LIBOR)  The interest rate at which banks borrow unsecured funds in the London wholesale money ­market. The mechanism for determining this rate was at the centre

250  |  glossary

of the LIBOR scandal, one of many interest rate and interest rate derivatives scandals recently investigated by the US Department of Justice and for which significant fines have been imposed by national regulatory authorities, including those of the UK and the US, such as the Federal Deposit Insurance Corporation (FDIC). Various UK, US and other European (mainly Swiss) banks were implicated in the LIBOR scandal and many have been fined. LIBOR control was later transferred to the British Bankers’ Association (in response to the Wheatley Review). Plans are in place for future LIBOR regulation by the New York Stock Exchange’s Euronext. Long-term refinancing operation (LTRO)  A European Central Bank (ECB) mechanism to finance banks in the Eurozone. The stated aim of the LTRO mechanism is the maintenance of liquidity for banks holding illiquid assets (such as toxic assets) to add liquidity to interbank lending. One stated intention of LTRO financing provided to Eurozone private banks was the purchase of periphery sovereign debt (in ECB repurchasing agreements designed to move weaker assets off banks’ balance sheets), thus, theoretically, reducing speculation and increasing banking stability (and profits). This is an indirect (and private) alternative to ECB direct support for banks and for Eurozone central banks (which is explicitly disallowed by the ECB charter). Money market mutual fund  US funds that invest solely in money market instruments, including government securities, certificates of deposit, commercial paper and other short-term and low-risk securities. The fund was a source of short-term loans for European banks in dollars from the US in the 2000s until that source froze in the Wall Street crisis in 2008. Privatisation  Refers to any process aimed at shifting functions, res­ponsibilities and public ownership, in whole or in part, from the government to the private sector. This is a neoliberal policy as ad­ vocated in a Troika or an International Monetary Fund (IMF) ‘rescue’. Selling a public asset provides a one-off payment to the government. Privatisations of utilities, land, resources or public firms are usually

glossary  |  251 conducted at below market values (as fire sales) and may be paid for in public bonds bought at a discount. Sometimes the public firm may be loaded with debt beforehand, and, when it is sold, the government often cancels part of the debt as a sweetener in the deal. South American and many Third World nations have had a strong tendency to nationalise industries involved in the extraction of natural resources and natural monopolies, such as those providing services including electricity and water. Public firms are fiercely criticised by neoliberal economists, which has led to the sale of various large firms into the private sector. In Argentina, the Spanish multinational Repsol purchased much of the state oil company YPF in 1999. In Brazil, Vale, the iron and steel company, was privatised in 1997, and the Brazilian national oil company Petrobras was also partially privatised. Many privatisations have since been reversed – recent examples include the Paris water utility Eau de Paris, or the partial renational­ isation of YPF by the Argentine government – but in Europe the Troika (and particularly the European Commission) continues to push for privatisations in the current crisis. More information on privatisation in the context of the European debt crisis is available at www.tni. org/briefing/privatising-europe. Public–private partnership (PPP)  Under a PPP ( joint venture), a contractual arrangement is made between public and private sector partners for the provision of, for example, public services such as an infrastructure project like the construction of a new bridge. Both partners in the PPP receive advantages: the private partner gets a public guarantee, and the public partner is able to defer payment, sometimes by more than one political cycle (and therefore after the next elections). PPPs also have some disadvantages: overall costs are typically higher than simply having the public sector itself execute the project, and PPPs can also be a source of ‘crony capitalism’ and corruption, with less than transparent tenders. In the UK, Spain and elsewhere, PPPs have been central to the neoliberal policies referred to as private finance initiatives (PFIs) – mechanisms that allow for the creation of ‘off-balance-sheet’ debt for public projects.

252  |  glossary

Reserve currency  An international currency used as a mechanism for government savings and as a buffer against speculation on national currencies in order to manage the value of a nation’s currency. Third World – and particularly BRIC (Brazil, Russia, India and China) – ­nations may maintain high levels of public reserves in foreign currencies. Membership of the Eurozone offers the great advantage of keeping reserves in the common currency of the euro. The US dollar is the world’s dominant reserve currency, with the euro as the current number two. Secondary market (for bonds)  An exchange, or marketplace, on which a bond (either public or private) can be traded. Bonds are resold here by primary bond dealers and others, some of whom may have bought the bonds direct from governments or corporations. When a bond is seen to have a default risk, the owner may choose to sell it in the secondary markets, where it is offloaded at a discount. See also Vulture fund. Securities and Exchange Commission (SEC)  A US government agency that regulates against, and sometimes prosecutes (via enforcement actions), fraud in the publicly regulated US financial sector. Its formal mission is to ‘protect investors, maintain fair, orderly and efficient markets and facilitate capital formation’. For a spotlight on recent enforcement, see www.sec.gov/spotlight/enf-actions-fc.shtml. Securities and securitisation  Securitisation is a process of pooling debt obligations and then dividing the pool (usually by risk) into layers, called tranches. These debt obligations – such as collateralised debt obligations (CDOs) – can then be sold. Financial institutions (such as investment banks) use securitisation to bundle and to transfer credit risk. Securitisation has been recognised as a major channel for exchanging and hiding risk; when misused on a grand scale, this has had systemic consequences. See also Sub-prime mortgage. Special-purpose vehicle (SPV) or special-purpose entity (SPE)  A legal entity (usually taking the form of a limited partnership or a limited company) created by a firm (often a bank) for a specific financial

glossary  |  253 purpose or activity, often resident in a zone (or nation) with flexible taxation or banking enforcement laws. SPVs are typically used by a firm to isolate itself from financial risk, to spread that risk or to hide it from scrutiny, hence the term ‘shadow banking’. Curiously, in the European context, the European Financial Stability Facility (EFSF, a Troika fund) is itself an SPV set up in Luxembourg. SPVs can be, and have been, used fraudulently by banks and other firms. The most spectacular misuse of SPVs uncovered in recent history was the case of the US energy company Enron. Sub-prime mortgage  A classification of mortgages sometimes sold to borrowers with a tarnished or limited credit history, or those with no credit history at all, i.e. ‘below prime’ clients of the mortgage broker. Mortgages originated for clients with such credit histories in the early 2000s, and they continued until 2007 in the build-up to the ‘sub-prime crisis’. Figure 5.2 in The Financial Crisis Enquiry Report (p. 70) provides an illustration of the sub-prime build-up (available at www.gpo.gov/ fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf). Borrowers classified as ‘subprime’ have a recognisably higher default risk and so the lender typic­ ally compensates for this risk by driving up the cost of the mortgage to the buyer – thereby also increasing the likelihood of default due to higher interest payments. Sub-prime mortgages were a feeder system for generating new credit and repackaging it – via securitisation into mortgage-backed securities (MBSs) – then selling it on to other financial institutions. Defaults in sub-prime mortgages had severe knock-on effects in the financial sector worldwide. See also Systemic risk. Systemic risk  The risk to an entire financial system or an entire market in certain goods or services. In the financial sense, a systemic risk to the financial system refers to the potential for a catastrophic failure to the system itself, rather than a risk to an individual part of the system (such as the bankruptcy of an individual, a bank or a firm). Since late 2007, there have been various instances of systemic risk; these have included the risk that led to the collapse of the entire investment banking sector in the US, or that which led to the collapse of most of

254  |  glossary

the national private financial sectors in both Ireland and Iceland and many other large banks across Europe. There were also various risks that were considered by some analysts as systemic threats to the euro and, by extension, to the Eurozone; in retrospect, these may or may not have been truly systemic in nature. Certain state and regional financial institutions are responsible for preventing systemic risk. At a national level, these are the central banks, the treasuries and/or the national ministries of finance. In the case of the Eurozone, the European Central Bank (ECB) is also responsible for preventing systemic risk; in addition, the European Commission took on certain responsibilities for avoiding systemic risk to the Eurozone as part of the Troika with the ECB and the International Monetary Fund (IMF). At a global level, the prevention of risk to the international financial system is the job of the IMF in Washington and of the Bank for International Settlements (BIS) in Basel. For the new derivatives financial sector, the role of prevention of systemic risk via regulation has been given to the private International Swaps and Derivatives Association (ISDA). Toxic assets  An asset that becomes illiquid when its secondary market disappears. Toxic assets are called toxic because nobody wishes to buy or hold them. The term ‘toxic asset’ was used primarily in the US phase of the financial crisis of 2008–09 with regard to mortgagebacked securities (MBSs) and collateralised debt obligations (CDOs). These securities contained bad debt (assets such as sub-prime mortgages in default) that was worth much less than its face value and so the securities were described as toxic. See also Asset-backed security (ABS) and mortgage-backed security (MBS) and Collateralised debt obligation (CDO). Troubled Asset Relief Program (TARP)  A US government programme created to establish and manage a US Treasury fund in an attempt to curb the financial damage caused to the US financial sector by the issuance of sub-prime securities in the US phase of the financial crisis of 2008–09. TARP gave the US Treasury purchasing power of about $700 billion to buy up mortgage-backed securities (MBSs) from institutions

glossary  |  255 across the US, attempting to add liquidity and to free up US money markets. The fund was created by US law HR 1424 enacting the Emergency Economic Stabilization Act of 2008. See also Sub-prime mortgage. Vulture fund  A colloquial term for private equity (or a hedge fund) specialising in speculative short-term investments in distressed bonds, especially sovereign bonds. Vulture funds focus on speculation in Third World sovereign bonds, and now also in peripheral European sovereign bonds. The fund’s capital is leveraged to buy up bonds that are close to, or actually in, default, then they sue the issuing government for a payment – often claiming settlements that represent multiples of the price they paid for the bond. Vulture funds are the scavengers of the ­secondary bond markets. See also Credit default swap (CDS). World Trade Organization (WTO) and General Agreement on Tariffs and Trade (GATT)  The final round of negotiations on GATT in 1989 was called the Uruguay Round. It terminated with the agreement to form the WTO. The WTO continued the neoliberal GATT global trade agenda liberalisation policies, adding enforcement and the institution, the WTO itself, which is headquartered in Geneva. One of the main complaints of large developing countries, especially large food-exporting countries, was that agricultural market protection in place in the EU and the US (high internal agricultural subsidies with high barriers against extra-regional agriculture imports from outside) was to be reduced. Industrial and services exports (including certain financial services) had already been liberalised in the Uruguay Round and before, mainly benefiting the industrialised (developed) nations. Agricultural liberalisation was deferred as part of the Doha (development) Round of the WTO negotiations, considered (by the global South) as necessary to rebalance WTO terms of trade. The Doha Round began a few months after the founding of the WTO, but it took more than a decade to negotiate – a compromise was finally reached in late 2013. Yield  In the context of this book, a yield refers to the interest rate on a bond.

INDEX

Abacus 2007-AC1 bond, 5 ABN Amro bank, 5 acceptability of measures to markets, 201–3 accountability, 145, 184; crisis of, 184 adjustment programmes see structural adjustment Allied Irish Banks (AIB), 60–4; nationalisation of, 75 alternative deposit receipts (ADR), 20 American International Group (AIG), 56, 58, 66; collapse of, 49, 55, 112; rescue of, 11 Amnesty International, 177 Anglo Irish Bank, tapes leaked, 225 animal spirits, 194, 218 Argentina, 98; considered as economic model, 190; default of, 13; economic crisis in, 190–213; litigation against, 222; normalisation of, 192–3 Asian financial crisis, 76, 78, 88, 95, 96, 97, 98, 101 Athens, clean-up operations in, 177 Athens Medical Association, 172 auditing of public debt, 181, 182–4 austerity, 2, 12, 25, 27–8, 29, 43, 68, 75, 76, 86, 111, 113, 114, 115, 123, 124–5, 129, 131, 132, 135, 136, 139, 146, 151, 169, 170, 214, 226, 228; breaking with, 143; permanent, 178 authoritarian governance, 115 automatic budget stabilisers, 113, 131 automatic fiscal transfers, 145 balancing of trade, 43 Bank for International Settlements (BIS), 3, 52 bank leverage, calculation of, 2–3 Bank of America, 58 Bank of Canada, 51 Bank of England, 51

Bank of Greece, 163 Bank of Ireland, 47 Bank of Japan, 51 Bankia bank, collapse of, 7 banking laws, lax enforcement of, 184 banking reform, global, 221–2 banking union, in Europe, 102, 103 bankruptcy: cascades of, 87, 94; costs of, 94, 95, 103; of Greek small and medium enterprises, 170 banks: absent from neoclassical economic theory, 40–1, 217; bailing out of, 7, 11–12, 13, 25, 150, 179, 214 (resistance to, 26); information advantage of, 220; nationalisation of, 47; peripheral, collapse of, 10–11; private, 33, 35; recapitalisation of, 160, 162–4; stateowned, creation of, 146; withdrawals from, 83 see also development banks Barclays bank, 54; investigation into, 55 Barofsky, Neil M., 11 Barroso, José Manuel, 30 Basel III rules, 193 BlackRock fund, 163 Blankfein, Lloyd, 45 Bloomberg report on Greece, 171 Blundell-Wignall, Adrian, 64 bond buy-back, 164 bonds, sovereign see sovereign bonds Borges, Antonio, 156 Brady Plan, 198 Brainard, Lael, 18, 21, 25, 42–3, 60, 63, 65 Brazil, 83, 97, 200 bubbles, 33–7; bursting of, 88; dot-com, collapse of, 122; in housing market, 88 (collapse of, 86; in USA, 150); in real estate market, 38, 77, 89 see also credit bubbles Buffett, Warren E., 34 burden sharing, 1–15, 18, 28–32, 70, 232

index  |  257 Calyon Securities, 58 Camdessus, Michael, 190 capital controls, 79–80; as circuit breakers, 100 capital flight, 97 Catastroika film, 28 Center for International Finance and Development, Global Money, the Good Life and You, 57 Centre for Economic Policy Research, 171 changes in sentiment, role of, 87 Chase Manhattan bank, 50 Chicago School of Economics, 1 China, membership of World Trade Organisation, 119 CitiGroup, 24 civil mobilisation (forced labour), in Greece, 173 Cleary Gottlieb Steen & Hamilton, 23 climate change, 216 Clinton, Bill, 4, 23 collateralised debt obligations (CDO), 56, 84 collective action clauses (CAC), 59–60, 160–1, 181, 204–6 collective bargaining, abolition of, in Greece, 173 collusion, between banks and regulators, 225–6 Commerzbank, collapse of, 7 Commodity Futures Modernization Act (2000) (USA), 4, 23 Commodity Futures Trading Commission (CFTC), 23; banking inquiry, 55 Common Market, European, 37 compensation of companies, 200 competitiveness, 120, 125–6, 135; in EU, 231 compulsory measures, 203 conditionalities of loans, 199, 210 confidence, loss of, 82–3; rebuilding of, 231–3 consumption, choices of, 217 contagion, 28–32, 63, 69–70, 215; and liberalisation, 98–9; disease theory of, 98; pure, 92; quarantine response, 79– 80; role of derivatives in, 46–9; survey of, 74–110; via bond speculation, 44–5 contractual distortions, effects of, 95

Correa, Rafael, 182, 222 corruption, 66, 184, 219, 222; in markets, 55; in private financial sector, 223; in public services, 223; investigation of, 215; modelled as error, 217 countercyclical fiscal policy, 142 credit bubbles, 1, 2–3, 4, 5, 37, 50, 51, 56, 68, 85; bursting of, 6, 8, 10, 11, 69, 112; responsibility for creation of, 70 credit default swaps (CDSs), 5, 19, 31–2, 37, 45, 48, 49, 51, 56, 69, 151, 161; ban on some contracts, 53; coverage of, 31, 61, 69; default on, 29; market in, 52–4; ‘naked’, 53, 57–60 (ban on, 57–8, 69) see also over-the-counter transactions ‘credit events’, 57–60, 61, 66 creditor responsibility, 10, 70 ‘creditors owe debtors’, 183 crisis: causes of, 81, 82–91; mathematics of, 81; management of, 185; predictability of, 194; spread mechanisms of, 91–8; taxonomy of literature regarding, 80; theories of, 74–110; transmitted via real sector, 97; vulnerability to, 76 Croatia, 8–9 cross-border financial flows, 4, 39, 40, 95, 99, 103; controls of, 101, 221; transAtlantic, 49 cutbacks, resistance to, 227 cyclical nature of bank lending, 87 Cyprus, 25, 102; sovereign debt of, 76 Darling, Alistair, 63 debt, 195, 197; cancellation of, 181; immorality of payment of, 147; individual, in Portugal, 133–4; multiplication of, 196–8; private, 45, 121 (becomes sovereign liability, 66; socialisation of, 122); public or socialized, 12, 13, 18, 40–1, 66, 215; reduction and cancellation of, 179; regional crises of, 47; repackaged combinations of, 37; repudiation of, 183; restructuring of, 157, 166, 201; securitised, 49; servicing of, 140–2, 146; sovereign see sovereign debt; toxic see toxic loans; trade in, 49; unhedged short-term, 101

258  |  index debt courts, setting up of, 180 debt crisis: misinformation on, 183; profiting from, 184 debt deflation, 136–7 debt-to-GDP ratios, 38, 44, 45, 47, 48, 76, 124, 131, 139–40, 142, 161, 162, 166, 171, 198, 210, 224 ‘debtor’s prison’, creation of, 180 default, 179, 180, 218; of private banks, 60–4; on mortgage repayments, 6; on private debt, 67 deficit, reduction of, in times of recession, 139–47 democracy, 204, 232; backsliding of, 232– 3; crisis of, 227–9; pseudo-democracy, 185; suspension of, 185; versus creditor rights, 159–62 democratic control, need for, 186 democratic deficit, 230 Demos organisation, report on democracy in Europe, 232 DEPFA company, 7; rescue of, 25 deregulation, 3–6, 23, 34, 70, 112, 134; of banking, 2, 4; of derivatives, 4–5; of financial markets, 130; of labour markets, 143 see also regulation derivatives, 37, 42, 223; as weapons of mass destruction, 34; banning of, 23; creation of, 49, 56; growth of, 49–50; regulation of, 18, 65–6; role of, in contagion, 46–9; unregulated, role of, 52–60 see also deregulation, of derivatives Deutsche Bank, 58, 165, 223 devaluation, 8–9, 43, 136, 155; of Mexican peso, 82 development banks, 207 Dexia bank: collapse of, 7; rescue of, 25 disposal of assets, 86 dispute resolution, 208 diversification see risk, diversification of Dodd-Frank Reform Act (USA), 19, 42, 64, 193 dollar: as reserve currency, 20; peso coupled to, 190, 195 dollar carry trade, 50–1 dollar denominated markets, 20 dot-com bubble, bursting of, 36 Doyle, Peter, 168

drachma, replaced with euro, 8–9 Draghi, Mario, 24 Drumm, David, 226 Ecuador, 182, 222 education sector, cuts in: in Greece, 172; in Portugal, 139 educational levels of labour force, 116–17 ELSTAT organisation (Greece), 152, 153 Emergency Liquidity Assistance, 164 endogenous shocks causing crisis, 81–2 equilibria: multiple, 98 (models of, 82–3); steady state, 80, 81 escalation, 28–32 escrow accounts, 13 escudo, Portuguese, overvaluation of, 130–1 Euribor, 122 euro, 38, 42, 43, 69, 120, 122, 128, 157; as reserve currency, 20; saving of, 29 Eurobonds, 29–30, 33; creation of, 145 Eurogroup, 154, 164 European Aeronautic Defence and Space Company, 43–4 European Central Bank (ECB), 1, 3, 7, 8, 9, 18, 24, 26, 32–7, 45, 46, 47, 48, 68, 74, 75, 114, 120, 122, 124, 140, 142, 154, 159, 160, 164, 178, 191, 229, 230, 231; accountability of, 145; changing the rules of, 145; Securities Markets Programme, 165; structural problems of, 69 European Commission (EC), 1, 4, 7, 9, 11, 18, 26, 27, 48, 154, 156, 224, 230, 231; transferring powers of, 145 European Court of Human Rights, 176 European Financial Stability Fund (EFSF), 10, 29, 47, 135, 158, 160, 163, 164, 165 European Financial Stability Mechanism (EFSM), 10, 75, 158 European Monetary Union (EMU), 111, 116, 117, 122; option of exiting from, 143–4; structural flaws in, 119–20 European Securities and Markets Authority (ESMA), 23, 53 European Shadow Financial Regulatory Committee, 22 European Stability Mechanism (ESM), 10, 25, 29, 158

index  |  259 European Union (EU), 17, 74, 101, 111, 150, 169, 170, 178, 214, 220; Cohesion Policy, 145; crisis in, 7–9; elimination of customs duties in, 216–17; enlargement into Eastern Europe, 119; evolving forms of, 229–31; financial architecture of, 6; institutional reform of, 145; neoliberal roots of, 230; structural flaws of, 1 Eurostat organisation, 1, 152, 153 Eurozone, 8, 76, 135, 137, 143, 166, 168, 169, 229; crisis management in, 151, 164; Portugal’s entry into, 120; restructuring of, 68; structural flaws in, 32–7, 102, 115, 150; summit of heads of state, 158 exchange rates, 82, 88, 92, 120, 129, 197; adjustment mechanisms, 90; fixing of, 190; realignment of, 201; short-run interventions, 98–9; stabilisation of, 117; stability of, 195; sudden changes in, 78 exit consents, 181 exogenous shocks producing crisis, 80 export-led growth strategy, 136 externalities, costs, 216 fallacy of composition, 142 Federal Deposit Insurance Corporation (FDIC), 24 Federal Reserve (FED) (USA), 7, 18, 20, 23, 35, 36, 54, 56 financial innovations see innovation, financial financial lobbies, 2–3 financial services: as legislative blind spot, 40; growth of, 42 Financial Stability Oversight Council (FSOC), 64 fire sales, 95, 112 firewalls, 48; necessity of, 26–7 ‘first come, first served’, principle of, 206 Fitzpatrick, Seán, 225 flexibilisation of labour, 27, 111, 173; see also labour markets flight-to-safety of capital, 214 Fortis Bank Netherland: collapse of, 7; rescue of, 25 fossil fuels, replacement of, 68

France, 21, 64, 151 Francis, Pope, 192 fraud, 225–6 free market, theories of, 2 Friedman, Milton, 1 futures, 52 G20, Los Cabos meeting on derivatives regulation, 30, 65–6 Garicano, Luis, 41 Geithner, Timothy, 21–2, 51, 62, 63, 65–6 gender issues, in Greece, 174–83 General Agreement on Tariffs and Trade (GATT), Uruguay Round, 195 general equilibrium models, 88 Georgiou, Andreas, 152, 153 German Democratic Republic, 8 Germany, 21, 29, 30, 42–3, 151; economic surpluses of, 120, 130; elections in, 228; intervention in Venezuela, 66–7; unification of, 8; unit labour costs in, 127 Glass-Steagall Act (1933) (USA), 4; repeal of, 23–4 Golden Dawn party (Greece), 172, 176 Goldman Sachs & Co., 23, 24, 45, 58, 62, 152, 224; prosecution of, 5–6 government, delegitimising of, 184 Gramm-Leach-Bliley Act (1999) (USA), 4 grassroots support initiatives, 178 Great Depression, 41 Great Recession, 17–23, 86, 101, 112, 123, 136 Greece, 8, 13, 21, 22, 25, 28, 38, 44–5, 64, 69, 83, 111, 113, 124, 198, 226, 227, 228, 232; bailing out of, 11, 58–60, 153, 156, 168, 169 (pre-knowledge of, 184; first, 154–7; second, 157–9, 163, 164, 165; terms and conditions of, 163); collective action clauses in, 205; debt crisis in, 74–6, 150–89 (social and political impact of, 169–78); default of, analysis of, 31–2; losses on bonds, 102; privatisation in, 227; true size of deficit, 151 Greek Loan Facility (GLF), 154, 158 Greenspan, Alan, 3, 23, 87 gross domestic product, 38–42 Grupo Santander, collapse of, 7

260  |  index gunboat diplomacy, 66 haircuts, 157, 162, 165, 166, 168, 180, 198, 201, 202, 206 Hau, Harald, 220 Hayek, Friedrich, 1 HBOS bank, collapse of, 7 healthcare, exclusion from, in Greece, 175 hedge funds, 2, 5, 161 Hellenic Confederation of Professionals, Craftsmen and Merchants (GSEVEE), 170 Hellenic Financial Stability Fund, 163 HIV-positive women arrested in Greece, 177 Hollande, François, 30 home births, prosecution of, 176 House Financial Services Committee, 18 human error, use of term, 215–22 Human Rights Watch, 177 human rights, preservation of, 182 Hungary, 228 Hypo Real Estate Bank (HRE): collapse of, 7; rescue of, 25 Iceland, 12, 25, 47, 101, 102, 227; collusion of bankers punished in, 219 imports and exports, structural imbalances, 37–8 India, 200 Indignados movement (Spain), 115 Indonesia, 200 Industriekreditbank (IKB), 5 inflation, 191, 192 information: asymmetries of, 95–6; imperfect, 220–1; misinformation, on crisis in Greece, 183–4 information contagion, 93 informational friction, 101 innovation, financial, 2, 3, 34, 36–7, 49, 54, 57, 89, 217 Institute of International Finance (IIF), 157 integration: asymmetric, into EU, 119–22, 122–4, 130; financial, 99–103 (benefits of, 102–3) Interbank links, problem of, 93 interest rates, 34–5, 36, 37, 38, 44, 46, 77, 83, 91, 113, 118, 122, 151, 155, 157, 164,

171, 184; impact on debt s­ ervicing, 140–2; leveraging differentials of, 195; negative, 46 international arbitration, proposed model, 181 International Centre for Settlement of Investment Disputes (ICSID), 208–9; cases against Argentina, 222 International Financial Services Centre (IFSC), 7 International Labour Organisation (ILO), 174 International Monetary Fund (IMF), 1, 7, 18, 26, 30, 47, 48, 62, 74, 75, 98, 100, 101, 150, 151, 153, 154, 156–7, 158–9, 166, 168, 170, 178, 180, 190, 193, 196, 197, 198, 199, 200, 203, 210, 229, 231; as third party in debt swaps, 207; changing position of, 80; criticism of, 179, 205; World Economic Outlook, 136 International Swaps and Derivatives Association (ISDA), 4, 51, 61, 69, 161, 224 investor privacy, laws governing, 20 Ireland, 3, 8, 13, 21, 22, 25, 27, 28, 38, 45, 48, 51, 64, 69, 75, 76, 79, 198, 224–5, 226–7; audit of banking sector in, 56; bonds issued by, 44; financial crisis in, 17–73, 81, 85–6; housing market bubble in, 88; nationalisation of banks in, 47; oil and gas discoveries in, 228; privatisation in, 228; property boom in, 77; real estate investment in, 3, 89; sovereign debt in, 224 irrationality: in investor panics, 93; of individuals and markets, 87–90, 98; of investor perceptions, 101 see also rationality Italy, 21, 30, 38, 49, 64, 74, 76, 102, 111; privatisation in, 228; prosecution of banks in, 223–4 Johnson, Simon, 155 Jones, Sam, 53 JPMorgan Asset Management, 50 JPMorgan Chase & Co., 6, 49–50, 223 jubilee, for debt, 67 justice, criteria in categorising bonds, 206

index  |  261 Kamin, Steven B., 36, 64 Kaupthing bank, collapse of, 7 Keen, Steve, 41 Kelly, Morgan, 62–3 Krueger, Anne, 181 Krugman, Paul, 2 Krupp Great Venezuela Railway Company, 67 labour conditions, in Greece, 172–4 labour costs, reduction of, 114, 125 see also real unit labour costs (RULC) labour markets: deregulation of, 143; flexibilisation of, 135; restructuring of, 111, 124–5, 136 Landesbanks, 7 LAOS party (Greece), 159 Latin America, debt crisis of, 76 learning of lessons, 178–84, 194 left–right political divide, complication of, 228 legitimacy of debt obligations, 181, 182, 183 Lehman Brothers, collapse of, 2, 7, 55, 112 lending into arrears, policy of, 207 Lenihan, Brian, 62, 63, 226–7 liberalisation of capital markets, 79, 98–9 LIBOR markets, collusion in, 54–7 ‘living beyond one’s means’, 131–4 Lloyds TSB bank, collapse of, 7 lobbying, 24 London Interbank Offered Rate (LIBOR), 55 London School of Economics (LSE), 49 long-term contracts, promotion of, 146 long-term refinancing operations (LTRO), 10, 46, 230 Lumina, Cephas, 182 Luxembourg, 9; funds based in, 11 Maastricht, Treaty of, 120, 129, 152 macroeconomics, versus structural adjustment, 200, 200 Magnetar Capital, 6 Maiden Lane funds, 9 Malaysia, 200 market frictions model of crisis, 83–4 market information, 82; asymmetries of, 84; quality of, 218–19

market processes, destabilising, 90 markets: free markets, 218; imperfections of, 80, 216; prone to overshooting, 99 Médecins du Monde, 172 medical treatment, cutbacks in, 172 memoranda of understanding (MoU), 12, 13, 124, 135, 139, 154, 155, 159, 169, 173, 224 Menem, Carlos, 190 Merkel, Angela, 29, 30, 58 Merrill Lynch & Co., 58, 224; collapse of, 112 Mester, Jens, 156 Mexico, 209; crisis in, 82 military industries, 44 military purchases, debt ensuing from, 184 minority shareholder groups, 209 Minsky cycles, 87 misinformation see information momentary equilibria of models, 80 money market funds (MMF), 35 monopolies, natural, 28 Monte dei Paschi di Siena bank, 223–4 Monti, Mario, 30, 191 moral hazard in debt contracts, 67–8 ‘Morgan Mafia’, 49 Morgan Stanley, 165 mortgages, altering terms of, 193 Moyers, Bill, 11 multinational companies: pressure on Greek government, 174; taxation of, 231 multiple equilibria models see equilibria, multiple mutual aid networks, 178 Myerson, J. A., 45 NASDAQ market, 53 National Asset Management Agency (NAMA) (Ireland), 75, 85–6 National Bank of Greece, 152 National Confederation of Hellenic Commerce (NCHC/ESEE), 170 nationalisation: of Allied Irish Banks, 61; of banks, 47, 68, 214 (reprivatisation, 220) neoclassical economics, 6, 17, 23, 40–1, 78, 215–22

262  |  index neoliberalism, 2, 27, 32, 115, 169, 172, 174, 215, 217, 218, 227, 231; in construction of Eurozone, 69 Nestlé company, 174 Netherlands, 76 New Democracy party (Greece), 177 New Zealand, 200 Nomura bank, 223–4 non-convexities, 94, 95 Northern Rock, rescue of, 25 Norway, 182 Obama, Barack, 24, 30, 193 oligopolistic behaviour, 219 orbits of attraction, 90–1 Organisation for Economic Cooperation and Development (OECD), study of debt crisis, 63–4 Orthodox Church, distribution of free meals, 172 orthodox economics, 6; critique of, 2, 215 Osborne, George, 62 ‘out with them all’, 193, 201 outsourcing of services, 39 over-the-counter (OTC) credit derivatives, 23, 40, 54; regulation of, 4 over-the-counter transactions, 56–7, 152; alleged efficiency of, 217 Paes Mamede, R., 116–17, 123–4 Panizza, Ugo, 179 Papaconstantinou, George, 156 Papademos, Lucas, 159, 168, 191, 229 Papandreou, Giorgos, 74, 154, 159, 229 Papoulias, Karolos, 229 Paulson, Henry, 24 Paulson & Co. Inc., 5–6 pension funds, in Greece, 162–4, 166 pensions, reduction of, 199; in Greece, 173 periphery, 25; use of term, 21 petrodollars, recycling of, 197 Pickel, Robert G., 4 PIIGS countries, 21, 26, 29, 64, 86, 97, 130, 199 political activity, growth of, 227, 228 political parties, loss of confidence in, 228 Portugal, 3, 8, 13, 21, 22, 25, 28, 45, 64, 75, 76, 102, 227; Carnation Revolution, 117;

debt crisis of, 111–49; entry into EEC, 116; internal structural problems of, 130–1; privatisation in, 228; real estate speculation in, 3; ruling class of, 116, 119; sovereign debt of, 121 poverty, 136, 143, 153, 170, 178, 191, 210; in Greece, modernised, 171–2; in Portugal, 133–4 precarious work, fighting against, 146 predatory lending, 179 PricewaterhouseCoopers company, 224 private financial sector, 231; bailout of, 47–8, 222, 224; nationalisation of losses of, 112; responsibility in eliminating debt, 70; undemocratic influence of, 228 private investment, between EU and US, 49–50 private sector involvement (PSI) agreements, 160–1, 162 privatisation, 12, 27–8, 135, 143, 157, 195; resistance to, 227–8 productivity of labour, 128–9 property ownership, promotion of, 134 protection agreements for investments, 208 Public Power Corporation (PPC) (Greece), 171 public sector: cuts in, 135; protection of employment in, 146; sackings in, 174 quantitative easing, 3 Que Se Lixe a Troika movement (Portugal), 115 race issues, in Greece, 174–83 Rajoy, Mariano, 30 Rand, Ayn, 23 rating agencies, 44, 86, 114, 146, 196, 218, 223; downgrade Greece, 161 rationality, 102; of markets, 80 see also irrationality re-regulation, resistance to, 221 real unit labour costs (RULC), 126–30 recapitalisation, 166 regulation, 33–6, 85, 221, 225; light-touch, 222; of all financial institutions, 102; of derivatives, 52–60, 65–6; of global finance, 22–4 see also self-regulation

index  |  263 regulatory capture, 22–3 Rehm, Hannes, 7 reparations for debt-associated resources drain, 183 reproductive rights of women, infringement of, 175–6 Research on Money and Finance (RMF) report on Eurozone crisis, 127–8 responsibility, 226–7; of IMF, 197 retrospective accounting, resistance to, 186 revolving doors, 209 risk: appetite for, 34; distribution of, 69; diversification of, 79, 80, 81, 92, 94, 97, 100, 102; indicators of, 194–6; willingness to bear, 101 risky behaviour, 55–6 Rosengren, Eric, 35–6 Roumeliotis, Panagiotis, 156 Royal Bank of Scotland, 5; collapse of, 7; rescue of, 25 Rubin, Robert, 23–4 rule by decree, 185 Russia, 97, 98 Sachsen LB bank, rescue of, 25 scapegoating, 226–7 Scott, Walter, 214 scrutiny, 222–6 Securities and Exchange Commission (SEC) (USA), 5, 6, 53, 54 securitisation, 34–5, 56 self-regulation, 217; of financial markets, 5, 6, 214, 220 Senate Agriculture Committee, 18 Senate Banking Commission (SBC), 17, 18, 36, 64; televised debates of, 19–22 shadow banking system, 34 shock doctrine, 229 shocks: amplification of, 83, 91, 92, 94, 100; endogenous, 81–2; smoothing of, 103; transmitted across borders, 96 Skouries gold-mining project (Greece), 228 Slovenia, 49 social participation in crisis programmes, 181, 186, 203–4 social protection, elimination of, 143 social spending, cuts in, 124

Société Générale, 58 sovereign bonds, 1–16; default on, 27; Greek, 102, 156, 160, 161, 162, 164, 168; Portuguese, 140 sovereign debt, 222, 232; control of, 202; negotiations over, 178–83; odious, 48; of Portugal, 111–49; purchase of, 30; renegotiation of, 202; restructuring of, 160, 162, 194, 198, 204–6 (creditors’ interests in, 207–11; methodological issues of, 180); seen as immoral, 114 sovereign debt crisis, 1, 3, 10, 231; European, 17, 18, 19, 20, 44, 38, 52, 68, 70, 111, 115; Greece, 153, 154–69 sovereign debt restructuring mechanism (SDRM), 181, 205 Spain, 3, 21, 25, 38, 45, 48, 49, 64, 74, 76, 102, 111, 137, 193; bailing out of, 11; high-speed rail link, 139; housing market bubble in, 88; privatisation in, 228; real estate investment in, 3 Special Bank Rescue Fund (Germany), 7 special purpose vehicles (SPV), 42 speculation, 70, 134, 161, 214; as source of debt burden, 146; in bonds, 38, 44–5; in real estate, 3; rescue of speculators, 224 spillover effects between USA and Europe, 17–73 Spitzer, Eliot, 220 Stability and Growth Pact, 118, 129, 133 Stanford Finance Forum, 35 Stanwick, David A., 55 state, reducing size of, 125 statistics: for Greek financial crisis, 151–4; window dressing of, 184 stereotypes, construction of, 226 stress tests of bank stability, 42 strikes, penalisation of, in Greece, 173–4, structural adjustment, 12, 134–9, 178, 197, 198–200, 200–3, 207; effect of deepening crisis, 200 structural imbalances: alternatives to, 42–4; in imports and exports, 37–8 sub-prime mortgages, 5, 37, 112, 150; bubble, 36, 185 (bursting of, 6) suicide rates, in Greece, 171 sunshine laws, 223 supply and demand, 216

264  |  index sustainability of restructuring measures, 182, 201–3 Swiss National Bank, 51 Switzerland, 24 Syriza organisation (Greece), 144 systemic crisis, models of, 86–7 tariff barriers: adjustment of, 43; freedom from, 42; zero, 39 tax havens, 9 taxation, 135, 142; avoidance of, 9, 231; corporate, 9, 217 (convergence of, 230); minimum levels of, 145; of petrol, in Greece, 171; personal, 217; through electricity bills, in Greece, 171; transforming systems of, 147 Tett, Gillian, Fool’s Gold, 49 Thatcher, Margaret, 12 TINA (There Is No Alternative), 12, 15, 229 ‘too big to fail’, 89, 103, 179, 218 tourism, 8–9 toxic loans, 5, 6–7, 214 trade unions, laws against, 12 trader behaviour around market panics, 82 transaction costs, 216, 219 transparency, 78, 183, 186, 222–6, 230; of markets, 216 (absence of, 217–18) trend reinforcement, 90–1 Troika, 7, 12, 18, 62, 66, 122, 124, 131, 135, 142, 154, 155, 159, 162, 168, 230, 231, 232; non-tolerance of alternatives, 229; policies clash with human rights, 182 Troubled Asset Relief Program (TARP), 9, 11 Truman, Harry, 18 Tsochatzopoulos, Akis, 223 Turkey, 8–9, 199 UBS AG, 223 unemployment, 123, 124, 125–6, 135, 136, 142, 153, 227; cutting of benefits, 174; in Greece, 170, 173 UNICEF, report on poverty in Greece, 172

Unilever company, 174 United African Women Organization, 177 United Kingdom (UK), 21; privatisation in, 228 United Nations (UN): Human Development Index, 172; Independent Expert on effects of foreign debt, 182; proposed debt arbitration tribunal, 181 United States of America, 3–6, 30, 44, 62–6, 219; CDS exposure of, 64; dispute with Mexico, 209; economic downturn of, 97; exposure of (to European ‘core’, 25–7, 60; to European periphery, 21); housing market bubble in, 88; US Treasury, 18, 20, 30, 54, 56 unpaid working hours, 124 unprotected labour, business model of, 174 Van Rompuy, Herman, 30 Venezuela, debt crisis in, 66–7 Venizelos, Evangelos, 59 violence: domestic, rise of, 176; racial and gender-related, 153 Volcker rules, 42 voluntary processes for debt, 203 wages: convergence in, 144; growth of, 125–6 (myth of, 128–9); minimum, 145; reduction of, 135, 136, 137, 139, 143, 173, 199 (of minimum wages, 27, 174) Wall Street crash, 24 water utilities, privatisation of, 28 ‘we all partied’, 226–7 welfare systems, 125, 132, 147; cutting of, 27, 114; destruction of, 146, 174; preservation of, 144 white elephant projects, debt ensuing from, 184 women migrants, 174–5; arrest of, 177 Women with Breast Cancer, 175 World Bank, 200, 208–9 World Trade Organization (WTO), 195; service agreement, 221–2