Greece - From Hard Money to Fool's Gold
When Greece invented the Olympic Games in 776 BC, the top prize was an olive wreath, not gold. And in those days, Greece sought out the top runners, rather than compete for a discipline not approved by the International Olympic Committee (IOC): governmental financial engineering.
If we only brought the original Olympic spirit back, maybe we could solve the world's challenges. During the ancient Games, Olympic Truce stopped wars to allow safe travel for athletes. Not long after inventing the Olympic Games, Greece was the world's first country to establish democracy in 508 BC. Not long thereafter, after a series of finds, precious metals spread throughout Greece in the 5th century BC. The following centuries represented an era of price stability and resulting prosperity, not seen before, not since: after. Athens managed to gain universal acceptance of their silver coins, by taking every precaution to maintain their integrity: "Even in times of tragic national disaster, when the treasury was empty and Attica occupied by an enemy, Athens refused to debase this silver coinage. As a consequence, the Athenian owl became current in all markets and an article for export. It remained a most acceptable currency throughout the Mediterranean for 600 years."¹ Indeed, our firm's logo is inspired by the ancient Athenian owl.
While ancient Greece may have had sound money, the "good old days" had their share of challenges. Athens, just like any modern city, also spent too much. Stoically, Athens refused to take on debt; direct taxes were not an option as they were considered servile; however, Athens imposed a capital levy to fill its coffers. While it was more common to accumulate treasures as war chests, Greek states outside of Athens frequently borrowed money, albeit they had a reputation for being rather arbitrary with creditors. States often relied on wealthy individuals as guarantors ("foreloaners") to lower their cost of borrowing. Some Greek states became creative financial engineers to raise money, one of them promising 10% interest in perpetuity on loans from citizens (the first perpetuities).
Let's fast forward to this century. Like most countries, Greece spent a great deal of money before and throughout the financial crisis. Governments have started to realize that financing all this debt costs money - and they are shocked. Stronger countries, like the U.S., are borrowing trillions in the market this year, crowding out access to credit for smaller countries. As of this writing, the U.S. government pays 3.64% to borrow money for 10 years; in the eurozone, Germany 3.11%; France 3.40%; Spain 3.90%; Italy 4.03%; Greece 6.64%.
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Let's take a step back to understand the dynamics playing out in how countries cope with the rising debt burden; it should become apparent that Greece is not the only country striving for gold in financial engineering. Countries have different constraints on how to spend money, but the common theme throughout the world - and throughout history - is that it is far easier to ratchet up than to rein in spending:
Keeping spending in check in the U.S. is as difficult as anywhere: the "pay-as-you-go" rules in place when Robert Rubin was Treasury Secretary under Clinton were thrown out the window when they were no longer convenient. The rule stipulated that new spending programs may only be put in place when other spending programs are cancelled or new revenue sources created. The recently re-introduced pay-go rule only has PR appeal, but no substance. More importantly, the U.S. budget has become increasingly inflexible, as the discretionary portion of the budget has shrank to just 12% of the total government's budget these days. As far as creative accounting is concerned, the U.S. is a clear leader in creating off balance sheet vehicles. The government sponsored entities (GSEs) Fannie Mae and Freddie Mac, both put into 'conservatorship' in the summer of 2008 were well known off balance sheet vehicles where government debt is shielded from the public; only after extensive negotiations with the General Accounting Office (GAO) was the GSE debt formally added to the national deficit.
The most powerful off-balance sheet vehicle is the Federal Reserve; when the Fed "prints" money, it does not show up as new debt; in Fed talk, the "resources of the Federal Reserve" are employed to provide support to the markets. As a percentage of pre-crisis levels, the U.S., U.K and Sweden were the leaders in printing money. Note that the European Central Bank did not make it to the winner's podium in this contest, but was relatively restrained.
When faced with a logjam in parliament and an inability to print money, states become creative. California with its dysfunctional budgeting process (a two thirds majority is needed to pass the budget) has in the past issued IOUs; those expecting tax refunds are easy targets for such maneuvers.
In the current budget negotiations, California is getting even more creative: governor Schwarzenegger has proposed to replace the sales tax on gasoline with an excise tax. The reason? Sales tax revenue flows into California's General Fund and is subject to minimum spending requirements on education (52-55 percent of California's General Fund is spent on education); by reclassifying the tax, cuts in education could be implemented without violating state laws. However, unlike most creative accounting, this maneuver is designed to reduce rather than expand government spending.
In the eurozone, member countries have committed themselves, amongst others, to run budget deficits no larger then 3% of the respective Gross Domestic Product (GDP); and if they can't achieve that goal, the countries need to produce a plan showing the path they intend to take to return to this level in due course. While the U.S. faces an unsustainable 11% deficit this year, the eurozone's deficit is closer to 6% (Greece's deficit is about 12%). Germany just announced it had a 3.3% deficit last year.
While everyone has been beating up on Greece, other European countries - large and small - have also engaged in rather creative accounting. The most obvious one may be the many privatizations we saw a decade ago. The sale of government property is counted as revenue and qualifies to meet the eurozone budget criteria. Of course, these sales are one off events, but nevertheless, they helped to fill big holes in government budgets.
Greece is a special case, if only because any published statistics are highly unreliable (for example, Greece 'forgot' to include billions of debt owed by government owned hospitals in its statistics). Well publicized by now are Greece's swap arrangements with a dozen investment banks; these arrangements allowed Greece to postpone recognizing expenditures. Goldman Sachs has since and said these swap agreements had only negligible impact on Greece's deficit statistics; if they were so insignificant, one has to wonder why Goldman Sachs alone has been paid hundreds of millions to set up the swaps.
Like California, Greece cannot print its own money; California is stuck with the U.S. dollar; Greece is stuck with the euro. Except that Greek officials wouldn't take no for an answer and found a loophole to print their own money anyway. To understand what happened, here's a crash course on how to print money. In the U.S., it's quite simple: the Federal Reserve buys a security - anything, really, - from a bank and gives them cash in return. That cash is an entry on the balance sheet of the Fed and the bank - voila, that's it, money has been 'virtually' printed. Often these purchases are not permanent in nature, but constitute short-term financing operations where cash is provided by the central bank overnight (these days for longer periods as well).
The "anything" has to be qualified: the Fed is not in the business of taking on credit risk. As a result, the Fed traditionally has bought only government bonds; the credit crisis has watered down the definition of what the Fed may buy, but it remains committed to the principle.
In Europe, there is no central government that issues its own debt. When the European Central Bank (ECB) hands out cash, it is in return for qualifying collateral. Traditionally, government bonds of eurozone governments have been accepted. As a result, when the Greek government would issue debt, a bank that bought the debt could exchange it for cash. For Greece, this mechanism proved too tempting. While Greece can't directly print its own money, it could coerce a local bank to buy its bonds; this bank can then deposit the bonds with the ECB in return for a 'pre-approved' loan. The overall setup is more complex and involved - you guessed it - Goldman Sachs and the National Bank of Greece (NBG), a Greek private bank, were instrumental in the process. In a complex series of arrangements, a special purpose subsidiary of NBG, Titlos, facilitated access to €5.1 billion for Greece.
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While everyone seems to have been calling for the end of the eurozone, we have been far more optimistic than most. The reason is that while everyone seems to be cheating left and right, that's certainly not a European, but a global characteristic. At least Europe has a process to encourage fiscal restraint - in the U.S., the federal government seems only bound by populist support or backlash.
In the eurozone, it is far more difficult to spend or print money than in the U.S.; as a result, we expect economic growth in the eurozone to lag, but the currency to be far stronger. Will Greece default? We don't have a crystal ball either, but do know that a country is different from an investment bank: investment banks evaporate; countries bleed. Greece will never become the poster child of the European Union, but we believe Greece will ultimately be seen for what it is: a country comprising 2% of eurozone GDP. That's because, in our assessment, in case of Greek default, the ECB would provide unlimited liquidity to the banking system to avoid a spillover effect. We have already seen the emergency measures of the ECB in effect and, in our view, they work to keep institutions afloat. We also know that other European countries will do everything in their power to prevent any spillover effect; Germany would, in our assessment, singlehandedly bail out Greece for the sake of preserving peace. However, don't forget Greece hasn't even asked for a bailout at this stage. That's because political reform at home would be impossible to implement if a bailout were lined up.
Greece must be held accountable
That leads us to the one suggestion Greece has made: Greece would like to receive "political support" to lower the country's cost of borrowing; basically, they would like a guarantee by other European countries for their debt. While some sort of guarantee may ultimately be provided to help Greece, we caution that countries should be extremely careful here: in our view, the higher cost of borrowing for Greece reflects the fact that the markets have stepped in where policy makers have failed.
For too many years, countries with irresponsible fiscal policies enjoyed too low interest rates. It should be apparent by now that governments will find ways to bend the rules to spend money. Just as it is impossible in the U.S. to create a watchdog that will prevent the next crisis, it is impossible to successfully implement a regulatory mechanism that forces governments to play by the rules. The only mechanism that works is a market based one: the higher cost of borrowing for Greece reflects their lack of fiscal discipline. Germany, in contrast, enjoys a lower cost of borrowing than the U.S. these days because of credible austerity measures.
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Greece's audacious maneuver to print its own money - fools' gold - by abusing the ECB funding mechanism shows that we must rely on the markets to help where ethics break down. Note that the ECB was familiar with the scheme Greece had devised; we can only imagine that the ECB accepted it because it too believed markets would ultimately price Greece's debt and provide the appropriate answer. At the same time, it is now imperative that the ECB stick by its word to only accept Greece's debt as collateral if its credit rating remains adequate. Greece must be held accountable for its actions. Conversely, it is not helpful for government officials of other eurozone countries to try to micro-manage Greece's fiscal policy. Let Greece manage its own affairs in context of its obligations as directed by the European Commission, but let them pay its price for any mismanagement through a higher cost of borrowing. There are risk friendly investors in the markets that will be willing to extend loans to Greece - at the right price. Money managers from the world's largest institutions are calling for a bailout - of course they are: they own Greek debt and would like European taxpayers to make their holdings appreciate in value.
However, the best incentive for governments to get their house in order is to have the market reward them with a lower cost of borrowing. In practice, the world is not black and white. Let's monitor how Greece's Olympic ambitions play out. While not without risks, we believe the current environment may be a unique buying opportunity for the euro. Throughout the financial crisis, policy makers responded with spending and printing money. As growth is sputtering, we believe the floodgates of cheap money are likely to remain wide open for a considerable period. In that context, the Fed has proved far more "efficient" than the ECB in printing money. In that process, we believe, the U.S. dollar will sooner rather than later resume its downward trend.
We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.
¹ Homer & Sylla, A History of Interest Rates, 1996, p. 35