Cliff # 1

About cliffeconomics

This blog offers original economic thought and policy recommendations on Germany, the euro area, and whatever cliff has on his mind.

Cliff # 3

About cliff

The author is an economist specialized in financial and macroeconomic policy analysis. All posts present a personal opinion, and all analysis is based on publicly available information.

Cliff # 1

About cliff

The author is an economist specialized in financial and macroeconomic policy analysis. All posts present a personal opinion, and all analysis is based on publicly available information.

Friday, August 17, 2012

Euro breakup: Who cares about accounting losses?

With the "Merkel memorandum", The Economist has joined the rows of other commentators on the cost of a euro breakup. The costs are quantified as accounting losses on bailout loans, ECB's bond holdings and Target2 balances, and possibly bank bailouts. Is this all the euro crisis is about? Hardly. The numbers the Economist bases its argument on are accounting losses and fall short of the cost-benefit analysis it claims to be. Here are a few arguments why Frau Merkel will not be impressed by accounting losses:

Losses on bailout loans. It is correct that the paid-out loans may not be repaid as scheduled, prompting Eurostat to reassess their recording as financial investment by creditor countries. But creditor countries could find ways to avoid taking an accounting losses, such as by rescheduling the loans. As the paid-out loans are already funded, a breakup does not increase creditors' gross debt. With debt and deficit not heavily affected, what to fret about these accounting losses? 

SMP losses. It is correct that exiting countries may restructure their government bonds, reducing their face value. But ECB has bought most bonds at prices below their face value, making it unlikely that the accounting loss is as large as the full exposure.

Target2 losses. It is correct that the central banks of exiting countries are likely to become insolvent and may trigger an accounting loss to ECB. But, as with accounting losses on bailout loans, why to fret about it? ECB has large reserves and considerable earning power, and---like other central banks---could remain effective despite being balance sheet insolvent.

Therefore, Frau Merkel will not take interest in accounting losses. She will look at accounting losses in the same way as in other policy areas. And so may her electorate. Who cried out about EUR200 billion or so in subsidies spent on nuclear energy since 1950 when Frau Merkel decided to accelerate the phase-out of nuclear power generation?

Will Germany become Spain?

This great collection of quotes, comprised by an analyst at Fairfax, an investment bank, has made rounds on the Internet:

"Spain is not Greece." - Elena Salgado, Spanish Finance minister, February 2010.

"Portugal is not Greece." - The Economist, April 2010.
"Greece is not Ireland." - George Papaconstantinou, Greek Finance Minister, November 2010.
"Spain is neither Ireland nor Portugal." - Elena Salgado, Spanish Finance Minister, November 2010.
"Ireland is not in ‘Greek Territory.’" - Brian Lenihan, Irish Finance Minister, November 2010.
"Neither Spain nor Portugal is Ireland." - Angel Gurria, Secretary General OECD, November 2010.
"Spain is not Uganda." - Mariano Rajoy, Spanish Prime Minister, June 2012.
"Uganda does not want to be Spain." - Henry Okelo Oryem, Unganda Foreign Minister, June 2012.

And what is Germany?

Let's step back. European integration and the euro created a new economic union, enlarging the market for the German export-driven economy. German surpluses, nourished by higher external demand, were channeled back into deficit countries. The crisis has put an end to this virtuous cycle of self-financing export demand. ECB liquidity provision and international bailouts are helping deficit countries to repay German loans, in addition to financing capital flight to Germany. These flows, together with largely unchanged high German savings, cause a flood of liquidity in Germany which is no longer channeled back into foreign countries. High and increasing risk aversion limits the choice for investments that are deemed safe, such as Bunds and real estate.

Where could this lead Germany to? After decades of stagnation, real estate prices have started to climb. Demand for real estate assets may stimulate construction, pushing Germany's output above its potential. Ensuing increases in wages and prices may erode the real value of savings and reduce Germany's international competitiveness, slowing external demand. In consequence, safe haven flows may reverse, a real estate bubble may burst, and bad loans may cripple the banking system. And someone may say: "Germany is Spain."