Michael Pettis On European Policymakers' "Terrifyingly Low Level Of Sophistication"

Tyler Durden's picture

Excerpted from Michael Pettis' China Financial Markets blog,

Syriza’s challenge

It is useful to remember this history when we confront the consequences of Greece’s recent elections. Syriza’s victory in Greece has reignited the name-calling and moralizing that has characterized much of the discussion on peripheral Europe’s unsustainable debt burden. I think it is pretty clear, and obvious to almost everyone, that Greece simply cannot repay its external obligations, and one way or another it is going to receive substantial debt forgiveness. There isn’t even much pretence at this point as last week's German newspaper Zeit‘s interview with Yanis Varoufakis entitled “I’m the Finance Minister of a Bankrupt Country” shows.

Even if the question of who is to “blame”, Greece or Germany, were an important one, the answer would not change the debt dynamics. It would take the equivalent of Ceausescu’s brutal austerity policies in Romania, which were imposed during the 1980s in order for the country fully to repay its external debt, to resolve the Greek debt burden without a write-down. Given that Ceausescu’s policies led directly to the 1989 revolution, which culminated in both Ceausescu and his wife being executed by firing squad, the reluctance in Athens to imitate Romania in the 1980s is probably not surprising.

But to say Greece simply cannot repay isn’t the end of the story. As Europe moves towards a more rational debt policy with Greece, I would say that there are three important things to remember:

1.  There is an enormous economic cost, not to mention social and perhaps political, to any delay. I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring. Greece’s debt overhang imposes rising financial distress costs and increasingly deep distortions in the institutional structure of the economy over time, and the longer it takes to resolve, the greater the cost.

I think most analysts understand that costs will rise during the restructuring process. I am not sure they understand, however, that delays will impose even heavier costs during the many years of subsequent adjustment. There is a lot of bad blood and recrimination among the various parties. I suspect that some of those who oppose Syriza are probably revolted by the thought that a rapid resolution of the Greek crisis would rebound to Syriza’s credit, but they must understand that dragging out the restructuring process will impose far greater long-term costs on the Greek people than they think.

My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume.

2.  From what I read, much of the focus of the restructuring will be aimed at determining an acceptable and manageable debt-servicing cashflow for Greece. There is a mistaken belief that this is the only “real” variable that matters, and the rest is cosmetics. I don’t agree. Greece’s nominal debt structure will not just affect the debt-servicing cashflows but will also determine future behavior of economic agents.

There are at least two important functions of an economic entity’s liability structure. One is to determine the way operating profits or economic growth is distributed among the various stakeholders, or, put differently, to determine economic incentive structures. The other is to determine the way external shocks are absorbed. This is why the restructuring process is so important and can determine subsequent economic growth. The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value. Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value (this rather obvious point is almost never implemented because economists have difficulty in conceptualizing and modelling reflexive behavior in dynamic systems). Rather than let economists work out the arithmetic of the restructuring based on linear estimates of highly uncertain future cashfllows, whose values are themselves affected by the way debt payments are indexed to these cashflows, Greece and her creditors may want to unleash a couple of options experts onto the repayment formulas and allow them to calculate how volatility affects the value of these payments and what impact this might have on incentives and economic behavior.

3.  In fact the overall restructuring must be designed so that the interests of Greece, the producers who create Greek GDP, and the creditors are correctly aligned. To date sovereign debt restructurings have almost never included the instruments that reflect the instruments in corporate debt restructurings that accomplish this alignment of interests, largely becausse these instruments have not been “invented”. Among other things the negotiating committee might want to dust off the GDP warrants that were included in Argentina’s last debt restructuring.

If the restructuring is well designed, within a year of the restructuring I think we could easily see Greek growth surprise us with its vigor. I was delighted to see that Greece’s new Finance minister agrees. An article in Monday’s Financial Times starts with the claim that “Greece’s radical new government revealed proposals on Monday for ending the confrontation with its creditors by swapping outstanding debt for new growth-linked bonds, running a permanent budget surplus and targeting wealthy tax-evaders.” Today’s Financial Times has an article by Martin Wolf that mentions the benefits of “a growth linked bond”. In The Volatility Machine I spend chapters explaining how to create liability structures that minimize external shocks, align the interests of creditors and citizens, and improve the quality of payments for creditors, and I show why these make a restructuring much more successful for all parties concerned. This is just basic finance theory. Yanis Varoufakis should really take the lead in designing an entirely new form of sovereign debt restructuring, not just for Greece but for the many countries, in Europe and elsewhere, that will soon follow it into default.

Enough people seem to hate or fear Syriza that there will be little attempt to approach Greece’s problems with enough imagination to give either party what it needs, but in fact with the right cooperation, imagination, and intuitive understanding of how balance sheet structures change overall value creation, a Greek debt restructuring could leave both sides far better off than either side might imagine. Of course if done right this matters far more than for just its impact on the Greek economy. While everyone probably agrees that Greece simply cannot proceed without debt forgiveness, less widely agreed, but no less obvious in my opinion, is that there are a number of other European countries that also need debt forgiveness if they are to grow. Because I was born and grew up in Spain, and my French mother founded and ran a successful business there which my family and I still own, I am confident that I know the country well enough to say that even with some impressive reforms having been implemented under Mariano Rajoy, Spain is nonetheless one of these countries. I suspect that many other countries including Portugal, Italy, and maybe even France are too.

I also know, however, that Spanish debt prospects are an extremely sensitive and emotional topic, and I will be roundly condemned for saying this. Today’s Financial Times has a very worrying article explaining why Madrid wants to be seen among the hardliners in opposing a rational treatment for Greece: “when it comes to helping Greece, there will be no such thing as southern solidarity or peripheral patronage.” This is the reverse of what it should be doing. In an article for Politica Exterior in January 2012, I actually proposed, albeit without much hope, that Spain take the lead and organize the debtor countries to negotiate a sustainable agreement, but in its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the “virtuous” countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter.

As it is, and for reasons that may have to do with recent history, Francisco Franco, and the psychological scars he left among those of my generation, any discussion in Spain is likely to be subsumed under non-economic considerations, especially angry denunciations of moral virtue and moral turpitude. These non-economic considerations are irrelevant. In fact some of them are very important and even admirable. But they must be understood within a more neutral context.

As far as I can tell there are at least four important reasons that opponents of debt forgiveness, not just in Germany but also in Spain, have proposed as to why demands for debt forgiveness would be a long-term disaster for Spain:

1.  Spain’s economic future depends on its remaining a member of Europe in good standing. To demand debt forgiveness (let alone a renegotiation of the currency union) would cause a financial crisis and relegate Spain to backward country status.

2.  If Spain fails to honor its debt commitments it will be considered forever an unreliable prospect and will be frozen out of future investment and trade.

3.  More importantly, it would be morally wrong. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity.

4.  Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless invest projects. It got itself into this mess only because of the very poor economic policies a corrupt Madrid implemented. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of tis leaders, but ultimately they are responsible.

These four arguments, which are the same arguments made about other highly indebted European countries, have been made not just by the greedy Germans of caricature, but also, more importantly, by indignant locals. They genuinely believe that their country behaved stupidly and must pay the price, and it is hard not to respect their sincerity.

*  *  *

In summary, I think there are several points that those of us who want “Europe” to survive should be making.

1.  The euro crisis is a crisis of Europe, not of European countries. It is not a conflict between Germany and Spain (and I use these two countries to represent every European country on one side or the other of the boom) about who should be deemed irresponsible, and so should absorb the enormous costs of nearly a decade of mismanagement. There was plenty of irresponsible behavior in every country, and it is absurd to think that if German and Spanish banks were pouring nearly unlimited amounts of money into countries at extremely low or even negative real interest rates, especially once these initial inflows had set off stock market and real estate booms, that there was any chance that these countries would not respond in the way every country in history, including Germany in the 1870s and in the 1920s, had responded under similar conditions.

2.  The “losers” in this system have been German and Spanish workers, until now, and German and Spanish middle class savers and taxpayers in the future as European banks are directly or indirectly bailed out. The winners have been banks, owners of assets, and business owners, mainly in Germany, whose profits were much higher during the last decade than they could possibly have been otherwise

3.  In fact, the current European crisis is boringly similar to nearly every currency and sovereign debt crisis in modern history, in that it pits the interests of workers and small producers against the interests of bankers. The former want higher wages and rapid economic growth. The latter want to protect the value of the currency and the sanctity of debt.

4.  I am not smart enough to say with any confidence that one side or the other is right. There have been cases in history in which the bankers were probably right, and cases in which the workers were probably right. I can say, however, that the historical precedents suggest two very obvious things:

First, as long as Spain suffers from its current debt burden, it does not matter how intelligently and forcefully it implements economic reforms. It will not be able to grow out of its debt burden and must choose between two paths. One path involves many, many more years of economic hell, as ordinary households are slowly forced to absorb the costs of debt — sometimes explicitly but usually implicitly in the form of financial repression, unemployment, and debt monetization.  The other path is a swift resolution of the debt as it is restructured and partially forgiven in a disruptive but short process, after which growth will return and almost certainly with vigor.

Second, it is the responsibility of the leading centrist parties to recognize the options explicitly. If they do not, extremist parties either of the right or the left will take control of the debate, and convert what is a conflict between different economic sectors into a nationalist conflict or a class conflict. If the former win, it will spell the end of the grand European experiment.

*  *  *

Read more of Pettis' epic rant on Europe here...

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Joebloinvestor's picture

What a bunch of clap trap.

For one, Ceausescu and wife were not executed for austerity policies, he fucked up his whole country by being a brutal dictator.

(remember the famous line about the anti-Christ being executed on Christmas day?)

Two, Greece has gone BK multiple times and never fixed its' core problems of nepotism and tax assessment and collecting.

Even Tsipras in his manifesto declares corruption a core problem, but has proposed nothing to fix it.

zeropain's picture

greece is greece, argentina is argentia, germany is germany... when you expect different, you suffer.  europe are separate countires with patterns of behavior and deep nationalism that has been fostered by generations of war... central control is blind and always fails.

Self-enslavement's picture
Self-enslavement (not verified) zeropain Feb 7, 2015 10:42 PM

Why don't the Greeks just do as WE do and print itself a shipload of GLD. They could lend it to Germany with interest. Germany would not be able to pay the interest and would need Greece to bail them out. End game. Check mate. Throat that trolls.

doctor10's picture

"they won't believe our line of shit anymore-so they must be stupid!"

nmewn's picture

Hollande seems like a likeable enough fella, a "populist" and what not, why not have Yanis ask him to front him a little cash to tide him over, till payday? ;-)

ebworthen's picture

The purpose of the ECB, the FED, Central Banks, and their bankster masters is to delay.

They use the public treasury to enrich themselves while impoverishing 90% of citizens.

They want to delay any reform just as a slave holding plantation owner would.

zeropain's picture

the american slaves are given corn syrup and dvd's to convince them that they are not slaves.  bread as circus same as it ever was.

RaceToTheBottom's picture

When you are talking to your friends on your bright new Obamaphone, you feel on top of the world.

Mike in GA's picture

Washington DC's present administration defines "terrifying low level of sophistication"

Obama takes NOTHING off the table when it comes to strong actions like, um, "strategic patience", ahem, cough, pffft


Reaper's picture

The debts have to be reduced or ended. Bankruptcy and debt forgiveness is a very old concept. (Jubilee in Leviticus) Economics is just another aspect of Nature. Death or severe shrinkage enables new growth. Both the debtor and creditor benefit with new growth. Both debtor and creditor choose the wrong path. When a tree falls in the forest, there's new growth.

mvsjcl's picture

Chauncey? Is that you?

Goldilocks's picture

The Scientific Method: Steps, Terms and Examples
http://www.youtube.com/watch?v=BVfI1wat2y8 (4:25)

Dr Judy Wood : Evidence of breakthrough energy technology on 9/11
http://www.youtube.com/watch?v=vadSaWyiozg (2:24:57)

RaceToTheBottom's picture

So basically, it does not matter who is right or wrong, to keep the ball rolling, we have to do this??.

That guarantees we will do exactly the same thing again....  And oh, BTW, who is most at risk if the ball stops?  Banksters....


It seems if you have inflation and bubbles, you will need a debt jubilee...

Self-enslavement's picture
Self-enslavement (not verified) RaceToTheBottom Feb 7, 2015 10:44 PM

Why don't the Greeks just do as WE do and print itself a shipload of GLD. They could lend it to Germany with interest. Germany would not be able to pay the interest and would need Greece to bail them out. End game. Check mate.

Bemused Observer's picture

Declare war on the US and rake in the post-war aid after you lose...

They might even get a reality show if they pull it off.

Don't discount the wisdom of those old movies. Network was a piece of pure prophecy...

Niall Of The Nine Hostages's picture

Again: the QE push by Draghi the other day alone was for three times the nominal value of the current Greek debt. The market cap of the Greek stock exchange is down to the $28 billion range. If NATO nuked Greece and salted the place with cobalt Greece's creditors would be out a few percent of GDP, max.

This isn't about the money.

As for Ceausescu, he wasn't overthrown for starving his people, as if anyone cared about Romania's proles. Oh no, sir. "He" and "She" might have died in bed had "He" not been so naive as to insist there be no authority in Romania above himself---not even Western banksters.

Specifically, "His" real blunders were:

1. Paying the debt off in full and years in advance (costing the banksters a small fortune in the interest they'd hoped for);

2. Not adequately insulating the army from austerity, making it easier to turn them (austerity is for civilians, remember);

3. Muttering about building up reserves that could be lent to other countries that didn't feel like borrowing from western banks at usurious rates---in other words, threatening to become the competition. "His" last visit to Iran was to explore the possibility of lending Tehran some of Romania's surplus cash.

It wasn't hard to induce the army and elements of the Romanian communist party who were out of favour and had had it in for the Conducator for years (like Ion Iliescu) to stage a palace coup. The first act of the National Salvation Front was to crush the naive liberal opposition. The second was to start racking up debt again.

Self-enslavement's picture
Self-enslavement (not verified) Feb 7, 2015 10:46 PM

I know where there's some sand I can loan him with interest. But he can't pay me back with his sand. Only my sand will be acceptable payment. Which means he will have to borrow more sand from me to pay the interest off. Let's face it, Bankers are insane.

JoJoJo's picture

Speaking of a lack of sophistication who's going to pay these Greek professionals from the old socialist government?                                            


"Over the last few decades governments throughout the western world have made extravagant spending commitments. In Ireland the welfare budget was tripled. In Greece pastry chefs, radio announcers, hairdressers, and steam bath masseurs were included among 600 professions deemed so “arduous and perilous” that workers could retire at 50 on a state pension of 95 percent of their final salary"

q99x2's picture

EU policy makers make a retarded pedophile look good.

basho's picture

many of them being one and the same.

Which is worse - bankers or terrorists's picture

Greece reminds me of what Texas Governor Sam Houston said to Southerners about the North prior to the civil war, paraphrasing: "They are determined to keep their union...they are not passionate like you because they come from colder climates but when they act with resolve they will come at you with the force of an avalanche."

basho's picture

northern EU coming at GR like an avalanche? hmmm

Jack Daniels Esq's picture

Monkee see, monkee do - TBTF Obama

Old_European's picture

The fact that it took Mr. Pettis so much time before realizing how dumb European leadership is, tells a lot about his own level of sophistication.

This old European has been saying this for ages.

basho's picture

the performances by mutti merkel and msr hollandaise along with the nitwit junker have really been great this past week.

schaüble the toothless barking dog has been shown to be quite stupid in matters financial according to his own govt. agencies.

of course porky the choc king is probably the most pitiful as he scrounges for € to pay the bills.

i hope he has his israeli passport at the ready.

as for nato it is again shown itself to be a toothless pussycat.

and j.biden back in UE fighting for his son's job.

my, my 'bring in the clowns'


falak pema's picture

I wonder if Mutti understands this analogy to Germany's financial shenanigans in 1871...which preceded the worse Franco-British shenanginans of Versailles treaty of 1919.

Nation state perverted logic.

alrightee_then's picture
alrightee_then (not verified) Feb 8, 2015 9:02 AM


Politicians make NO decisions and make NO policies........NGO's, think-tanks, and corporations make

policy/laws and they instruct politicians what to say and do.......only idiots vote!



all-priced-in's picture

So - after they write off Greece's debt - how much will Greece need to borrow to make their GDP grow 3% per year?


Is 15% - 20% of GDP a good guess?


At that rate of borrowing - how long until Greece has a level of debt so high they can't possible repay it - and will be forced to default again?





armageddon addahere's picture

They default and start over every 50 years or so. The only question is what form the default will take.

Consuelo's picture

"I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring."


Excuse me, but not being too 'sophisticated' myself, can someone explain what a statement like the above means...?   Or, did my 'sophistry alert' indicator light suffer a malfunction...?

armageddon addahere's picture

"How can you say I'm broke? I still have checks left in my check book."

Sukumvir's picture

Consuelo... don,t you bother with this guy still on a cfr fellowship... he can,t think outside keynesian lines... I have seen him kiss the ass of the likes of Zapatero and former econ minister Sebastian In his blog.. but never raised the red flag as those two were embarking on all sorts of ridiculous renewable energy projects subsidies schemes while blowing off years of accumulated fiscal surpluses in the process.

I really would like to know how Franco inflicted any scars on him and his generation while his beloved psoe party created the very dual labor market system that trapped generations of spanish youth years after Franco,s death... 

The genuine lack of dophistication lays elsewhere and certainly not in Yanis, camp.