von Jan Mallien , Handelsblatt.com

Beim Hilfspaket für Griechenland gehen die Euro-Retter trotz einiger Anpassungen immer noch von extrem optimistischen Annahmen aus. Schon kleine Abweichungen können das fragile Gebilde zum Einsturz bringen.

BRUSSELS—The euro-zone economy will fall back into recession at the start of this year and is now seen contracting in 2012 as a whole, the European Commission said Thursday.

The new forecasts will add to concerns about the impact of broad-based regional austerity plans.
The 2012 forecasts for Italy, Spain and Greece were all slashed—each of them countries that are applying significant fiscal consolidation.

On an annual basis, the 17-country euro-zone group is forecast to contract by 0.3% and remain unchanged in the larger European Union. Last November, the EU forecast euro-area gross domestic product up 0.5% this year and EU GDP up 0.6%.

The Commission now expects the euro-zone economy to decline in the first quarter by 0.3% in the euro area, after dropping by the same amount in the last quarter of 2011. A recession is broadly defined as two straight quarters of economic growth.

Italy’s 2012 outlook was among the most significant changes in the forecasts. The Commission now expects Italy’s GDP to contract by 1.3% versus a 0.1% expansion forecast last autumn.

Spain’s economy is expected to shrink 1% this year compared with the 0.7% growth foreseen last November. The new forecast will make it still harder for Spain to meet its 2012 budget deficit target of 4.4% of GDP this year.

2012 GDP Forecasts

Country New forecast Old forecast*
France 0.4% 0.6%
Germany 0.6 0.8
Greece -4.4 -2.8
Italy -1.3 0.1
U.K. 0.6 0.6
Euro zone -0.3 0.5
EU 0.0 0.6
Change from previous year. *Autumn 2011 forecast.
Source: European Commission

In a news conference after the report’s release, European Commissioner Olli Rehn reiterated that Spain must ensure it meets agreed deficit targets but left the door open for a change in the budget gap goal later this year, saying “decisions”
could come once more information was available in March.

The Commission said it saw Greece’s economy contracting at an annual pace of 4.3% in 2012, versus a previous forecast for a downturn of 2.8%. The Commission said it still sees substantial downside risks to Greece’s economy mirrored by very low consumer and business confidence.

In one of the few brighter spots, the Commission said it sees Germany’s economy recovering from a temporary slowdown as 2012 continues. It projects growth of 0.6% in Germany this year with the recovery driven by stronger domestic demand and a resilient labor market.

“Available indicators for the first quarter of 2012 signal an improvement in sentiment among both firms and households. This suggests that the growth momentum has experienced a temporary interruption rather than signaling an entry into recession,” the outlook report said.

The Commission said inflation has remained more persistent than forecast due to high energy prices, as well as increases in indirect taxes.
Inflation is now seen at 2.1% in the euro area and 2.3% in the larger EU, compared with earlier forecasts of 1.7% and 2%. The EU executive says uncertainty remains high and risks are tilted to the downside.

“If an aggravation of the sovereign-debt crisis were to result ultimately in a credit crunch and a collapse in domestic demand, this would probably entail a deep and prolonged recession,” according to the report.

While sovereign-risk perceptions have abated “somewhat” in financial markets for certain countries, spreads remain at elevated levels and credit conditions for the private sector have been tightening.

“Economic sentiment is still at low levels, but stress in financial markets is easing. Many of the steps that were essential to deliver financial stability and to establish the conditions for more sustainable growth and job creation have now been taken,” said Mr. Rehn.

The Commission anticipates that after an early recession in 2012, a gradual return of business and consumer confidence will come in the second half of the year. Growth is seen highest in Latvia, Lithuania and Poland and lowest in Greece and in Portugal.

The stock market has always been fast-paced, but with the introduction of automated trading, the speed of routine transactions has increased far beyond human capacity to keep up, creating a host of new dangers. New “programs are designed to trade enormous volumes of stocks, bonds and other financial instruments at superfast speeds, taking advantage of second-to-second fractional price shifts and market trends,” reports Brandon Keim for Wired. “Flash crashes” – sharp, rapid dips and recoveries in the market happen everyday at alarming frequency, leading some experts to question whether automated trading is financially stable and whether a large-scale crash could occur as a result of constant stress on the market. Differences in cross-border trades and regulation are a particular concern. The algorithms operate in fractions of a second, so millions of trades can be made before any human could possibly respond. – YaleGlobal

New algorithms lend speed to automatic trading at the cost of human analysis, adding volatility to global stock markets

The afternoon of May 6, 2010 was among the strangest in economic history. Starting at 2:42 p.m. EDT, the Dow Jones stock index fell 600 points in just 6 minutes. Its nadir represented the deepest single-day decline in that market’s 114-year history. By 3:07 p.m., the index had rebounded. The “flash crash,” as it came to be known, was big, unexpected and scary — and a new study says flash events actually happen routinely, at speeds so fast they don’t register on regular market records, with potentially troubling consequences for market stability.

The analysis involved five years of stock market trading data gathered between 2006 and 2011 and sorted in fine-grained, millisecond-by-millisecond detail. Below the 950-millisecond level, where computerized trading occurs so quickly that human traders can’t even react, no fewer than 18,520 crashes and spikes occurred. The study’s authors call those events “financial black swans,” though they’re so common that the black swan label probably doesn’t fit anymore.

Moreover, those events fell into patterns that didn’t fit market patterns seen at other time scales. It’s as if computerized trading has created a new world, one where the usual rules don’t apply, populated by algorithms and only dimly understood by the people who made them. The extent to which that world influences our own — perhaps making events like the 2010 flash crash more likely, or causing markets to be generally more volatile — is an open question.

“There’s this whole world below 650 milliseconds. It’s like landing on another planet,” said Neil Johnson, a complex systems specialist at the University of Miami and co-author of the study, released Feb. 7 on arXiv. “It’s an enormous part of the market which is out of human reach. We have a glimpse of the kind of ecology that’s going on down there.”

Red line represents the frequency of sub-650 millisecond flash crashes, and blue the frequency of flash spikes, between January 2006 and February 2011. The black spike is the S&P 500 index. Image: Johnson et al./arXiv

Until recently, trading was the preserve of humans. Imagine a stock market and you likely envision a loud, crowded trading floor, a scene out of Wall Street. But in 1998, after the U.S. Securities and Exchange Commission authorized the first electronic exchanges, computer trading programs entered markets as equals to humans.

The programs are designed to trade enormous volumes of stocks, bonds and other financial instruments at superfast speeds, taking advantage of second-to-second fractional price shifts and market trends. It’s now estimated that high-frequency computer trading accounts for 70 percent of all equity trades. While some activity does occur at speeds with which humans can interact, much of it falls beyond the limits of human response time.

(One new computer chip built specifically for high-frequency trading can prepare trades in .000000074 seconds; a proposed $300 million transatlantic cable is being built just to shave 0.006 seconds off transaction times between New York City and London.)

In the early years of computer trading, algorithms were profitable and concerns rare. Designers and investors took their money and didn’t think much about what Johnson and co-authors call “ultrafast machine ecology.” After the 2010 flash crash, however, mainstream economists wondered if high-frequency trading systems might sometimes get weird and unpredictable.
A $4.1 billion automated sale was ultimately blamed for triggering that crash, and economists started asking questions about the new, hazy relationships between machines and markets.

“We are certainly witnessing one of the major transitions in the history of financial markets,” said automated trading researcher John Cartlidge of the University of Bristol, who was not involved in new study. “Economic theory has always lagged behind economic reality, but now the speed of technological change is widening that gap at an exponential rate. The scary result of this is that we now live in a world dominated by a global financial market of which we have virtually no sound theoretical understanding.”

In the new study, researchers led by Johnson and simulation engineer Brian Tivnan of the University of Vermont analyzed millisecond-scale price logs from 600 markets. The numbers were gathered by Nanex, a Chicago-based company that sells live market data.

‘We now live in a world dominated by a global financial market of which we have virtually no sound theoretical understanding.’

From this analysis emerged records of 18,520 sub-950-millisecond crashes and spikes — far more than they, and perhaps almost anyone, expected. Equally as striking as these events’ frequency was their arrangement: While market behavior tends to rise and fall in patterns that repeat themselves, fractal-style, in periods of days, weeks, months and years, “that only holds down to the time scale at which human stop being able to respond,” said Johnson. “The fractal gets broken.”

Why this should happen isn’t exactly clear, but the researchers think it reflects differences between human and computer trading strategies. Whereas people have many different strategies, high-frequency programs “sacrifice diversity for speed,” said Tivnan. “You see a lot more homogeneity at the sub-second scale than we see above 1,500 ms.” In the researchers’ models of high-frequency trading markets, a variety of algorithms eventually evolved into a few stripped-down, optimized forms.

With many algorithms converging on just a few different strategies, the high-frequency trading market could become vulnerable to systemwide herd behaviors. Fortunately for us, the market seems to rebound from spikes almost as immediately as they occur — Johnson and Tivnan likened the effect to a “coiled spring” returning to form — but as seen in May 2010, this might not always happen.

Johnson and Tivnan also used another metaphor to describe the flash crashes and spikes: fractures. The events could be imagined as microfractures in the wing of an aircraft, accumulating unnoticeably until some critical, breakage-causing mass is reached. To that end, they found a correlation between rising frequencies of sub-950-ms flash events, market volatility after 2008, and the May 2010 flash crash. The 10 stocks most prone to crash-and-spiking were all financial companies, with Morgan Stanley, Goldman Sachs and Wells Fargo topping the list.

“Lay the occurrences of spikes and crashes against each other on the same timeline, and then look at the movement of a major index like the Standard & Poor’s 500. What’s particularly interesting is that dramatic increases of spikes and crashes coincided with major movements in the S&P index itself,” said Tivnan.

However, it’s uncertain whether this correlation reflects a cause-and-effect relationship. It could conceivably be just a coincidence. “The results are provocative, but need more statistical testing to be something you can reliably interpret,” said complex systems theorist Doyne Farmer of the Santa Fe Institute, who was not involved in the new study.

Blue bars represent the distribution of different high-frequency trading strategies; red bars represent strategies that could be added at critical points to reduce flash behaviors. Image: Johnson et al./arXiv

Uncertainties notwithstanding, the paper is still “an extremely important contribution to solve the puzzle of financial complexity,” said econophysicist Tobias Preis of the Swiss Federal Institute of Technology, who studies patterns that precede market bubbles. Cartlidge called the paper “timely and important,” and said the findings are “likely to have a significant impact on market participants and regulators alike.”

The question of regulation is a tricky one. In the aftermath of May 2010, federal U.S. regulators introduced so-called “circuit breakers” that automatically halt trading if a stock price falls too much, too fast. But whether this actually works isn’t yet known. “Currently, we’re having trouble even observing at that level of resolution, let alone regulating it,” said Tivnan.

Tivnan also works for the MITRE Corporation, a nonprofit engineering and technology consultancy that provides research support to U.S. regulatory agencies. Both the U.S. and European Union are actively investigating further intervention in the machine trading world.

Johnson and Tivnan propose a subtler approach than circuit-breakers, one that would “steer” automated markets by introducing rogue algorithms when herd behaviors appear imminent. Farmer wants markets altered to become slower, with trades occurring intermittently — once per second or once even per minute, rather than constantly — and speed de-emphasized. That would allow algorithm designers “to focus on the quality of decision-making, rather than the time it takes,” said Farmer, who preaches caution in designing new regulation.

“There’s a danger of Europeans doing some changes they haven’t thought through, and there’s danger of the United States not changing things they need to change,” Farmer said. “It’s hard to think these things through, because nobody understands them.”

Citation: “Financial black swans driven by ultrafast machine ecology.” By Neil Johnson, Guannan Zhao, Eric Hunsader, Jing Meng, Amith Ravindar, Spencer Carran and Brian Tivnan. arXiv, 7 February 2012.

Greece is now officially a ward of the international community. It has no real independence when it comes to fiscal policy any more, and if everything goes according to plan, it’s not going to have any independence for many, many years to come. Here, for instance, is a little of the official Eurogroup statement:

We therefore invite the Commission to significantly strengthen its Task Force for Greece, in particular through an enhanced and permanent presence on the ground in Greece… The Eurogroup also welcomes the stronger on site-monitoring capacity by the Commission to work in close and continuous cooperation with the Greek government in order to assist the Troika in assessing the conformity of measures that will be taken by the Greek government, thereby ensuring the timely and full implementation of the programme. The Eurogroup also welcomes Greece’s intention to put in place a mechanism that allows better tracing and monitoring of the official borrowing and internally-generated funds destined to service Greece’s debt by, under monitoring of the troika, paying an amount corresponding to the coming quarter’s debt service directly to a segregated account of Greece’s paying agent.

The problem, of course, is that all the observers and “segregated accounts” in the world can’t turn Greece’s economy around when it’s burdened with an overvalued currency and has no ability to implement any kind of stimulus. Quite the opposite: in order to get this deal done, Greece had to find yet another €325 million in “structural expenditure reductions”, and promise a huge amount of front-loaded austerity to boot.

The effect of all this fiscal tightening? Magic growth! A huge amount of heavy lifting, in terms of making the numbers work, is done by the debt sustainability analysis, and specifically the assumptions it makes. Greece is five years into a gruesome recession with the worst effects of austerity yet to hit. But somehow the Eurozone expects that Greece will bounce back to zero real GDP growth in 2013, and positive real GDP growth from 2014 onwards. Here’s the chart:

Note that the downside, here, still looks astonishingly optimistic: where’s all this economic growth meant to be coming from, in a country suffering from massive wage deflation? And under this pretty upbeat downside scenario, Greece gets nowhere near the required 120% debt-to-GDP level by 2020: instead, it only gets to 159%. And to make things worse for the Eurozone, the report explicitly says that under the terms of this deal, “any new debt will be junior to all existing debt” — in other words, there’s no way at all that Greece is going to be able to borrow on the private markets for the foreseeable future, so long as this plan is in place.

As in all bankruptcies, the person providing new money gets to call the shots. And it’s pretty clear that the Troika is going to have to continue providing new money long through 2020 and beyond. Under the optimistic scenario, Greece’s financing need doesn’t drop below 7% of GDP through 2020. Under the more pessimistic scenario, it’s 8.8%. And here’s the kicker: all of that money is being lent to Greece at very low interest rates of just 210bp over the risk-free rate. Much higher, and Greece’s debt dynamics get even worse. But of course even with well-below-market interest rates, Greece is still never going to pay that money back.

The cost of this plan is €130 billion right now, and €170 billion over three years, through the end of 2014; it just continues going up from there, with no end in sight. Remember that total Greek GDP, right now, is only about €220 billion and falling.

Oh, and in case you forgot, this whole plan is also contingent on a bunch of things which are outside the Troika’s control, including a successful bond exchange. The terms of the deal, for Greek bondholders, are tough: there’s a nominal haircut of 53.5%, which means that you get 46.5 cents of new debt for every dollar of existing bonds that you hold. The new debt will be a mixture of EFSF obligations and new Greek bonds; the new Greek debt will pay just 3% interest through 2020, and 3.75% until maturity in 2042.

The plan assumes that 95% of bondholders will accept this deal, which seems optimistic to me. Bondholders are by their nature a fractious and contrarian bunch, and Greece is not saying that it’s going to default on holdouts. As a result, bondholders have to guess what might happen if they fail to tender into the exchange: they might get defaulted on and receive nothing; they might get paid out in full; or they might get defaulted on while being offered, for the second time, the same exchange they’re being offered right now. Some of them, especially the ones holding English-law bonds, might well be tempted to hold on to at least some of their bonds, just to see what happens.

More to the point, the plan assumes that Greece’s politicians will stick to what they’ve agreed, and start selling off huge chunks of their country’s patrimony while at the same time imposing enormous budget cuts. Needless to say, there is no indication that Greece’s politicians are willing or able to do this, nor that Greece’s population will put up with such a thing. It could easily all fall apart within months; the chances of it gliding to success and a 120% debt-to-GDP ratio in 2020 have got to be de minimis.

Europe’s politicians know this, of course. But at the very least they’re buying time: this deal might well delay catastrophic capital flight from Greece, and give the Europeans more time to work out how to shore up Portugal if and when that happens. Will they make good use of the time that they’re buying? I hope so. Because once the Greek domino falls, it’s going to take a huge amount of money, statesmanship, and luck to prevent further dominoes from toppling.

Nothing is sacred to Pedro Passos Coelho, not even Carnival. Portugal’s prime minister expects government employees at their desks and working on Entrudo, the traditional high point of the country’s Carnival celebrations, which falls on this Tuesday.

This is “not the time to talk about tradition,” the conservative head of state has commanded those of his citizens who see the move as an attack on their culture. Rather, he says, they should stop “whining” about austerity measures. It’s time, the prime minister adds, to break free of old structures and to change “lazy and sometimes self-involved patterns of behavior.”
Fans of Carnival celebrations are not the only ones affected — churchgoers and nationalists will have to make bitter sacrifices as well. In response to this national state of emergency, the Portuguese government plans to do away with four public holidays. Corpus Christi and Assumption are to be crossed off the calendar without a replacement, and public holidays celebrating Portugal’s first republic and the 1640 end to its union with Spain can no longer be commemorated, as is customary, with family celebrations and an extended siesta.

Fears of Default

This readiness to make sacrifices comes as welcome news to the so-called troika, made up of the European Commission, the International Monetary Fund (IMF) and the European Central Bank (ECB), whose officials are currently in Lisbon to evaluate the country’s reform program. The troika hadn’t even asked for such drastic measures, and their austerity watchdogs’ findings are sure to be positive. In recent months, the Portuguese government has also implemented brutal tax hikes and cut pensions and unemployment benefits.

All this makes Portugal a poster child for austerity measures in the eyes of Brussels and Berlin. German Finance Minister Wolfgang Schäuble went so far last week as to promise his Portuguese counterpart Vítor Gaspar additional aid, even though the international community has already provided the country with €78 billion ($101 billion) worth of support. “If there would be a necessity for an adjustment of the Portugal (program), we would be ready to do that,” Schäuble told Gaspar, who dutifully expressed his thanks. The exchange, caught by a camera crew, quickly became a popular video clip on YouTube.

But does Portugal really have a better chance of avoiding bankruptcy than Greece does? Or is the country simply the next domino destined to fall in the course of the euro crisis?

Financial markets take a far more critical view of Portugal than does the troika. They are assuming there is a 71 percent probability that the country will default within the next five years, as reflected in insurance premiums on Portuguese government bonds — so-called credit default swaps — in early February. Deutsche Bank writes that market participants expect that “leading European politicians’ assurances notwithstanding, the private sector will become involved in the case of Lisbon as well, or a debt default may even occur.”

Collapsing Demand

The €78 billion in aid is enough to last until September 2013, since Portugal has also managed, thanks to the European bailout, to place some short-term bonds on the market. Still, the moment of truth won’t be long in coming. “Emergency plans, in case Portugal is not able to return to the capital market, need to be specified soon and in a credible fashion,” major Swiss bank Credit Suisse says.

For now, Portugal finds itself in a deep recession. As a result of the government’s drastic austerity measures, most people have considerably less money at their disposal than they had before. With domestic demand collapsing, unemployment has risen to record levels. Last year, 30 percent fewer cars were sold in Portugal.

At least 200,000 people marched through the streets of Lisbon on Feb. 11, starting in three different areas of the city and converging on the centrally located Praça do Comércio on the Tagus River. “No to inequality, no to impoverishment,” they shouted.

Just as in demonstrations that have taken place in Greece, German Chancellor Angela Merkel was a favorite subject of their signs. One showed the chancellor as a dominatrix, forcing a naked Prime Minister Coelho to his knees.

Competitive on the Global Market

Rogério Hortelão is one person who hasn’t lost his optimism despite all the problems. “We’re good at improvising,” says the president of auto parts supplier Incompol. Hortelão, a former mechanic with the Portuguese Air Force, started his business 25 years ago with a lathe and three men. Now, 350 employees at his factory in Samora Correia use heavy equipment to stamp out metal components for BMW and other customers. In 2009, the last time that demand within the automotive industry collapsed, Hortelão took the same approach to fighting the crisis as many mid-sized German companies did. He didn’t fire a single employee, but instead gave them further training. It enabled him to fulfill a personal dream. Incompol now uses high-tech equipment to weld together individual components for aircraft manufacturers such as Embraer in Brazil and Pilatus in Switzerland.

Most of Hortelão’s products go to buyers in other countries, and even his domestic customers are subsidiaries of international corporations. This allows the company to remain independent of the government’s austerity programs.

Unlike Greece, Portugal certainly has competitive companies capable of succeeding on the global market. Europe’s largest and most modern paper factory, for example, is located near the Portuguese port city of Setúbal.

Portugal has gradually overtaken Scandinavia when it comes to producing high quality copy paper. “Each year we sell each person in Germany at least 500 sheets of paper for photocopying,” Hermano Mendonça, marketing director for Portucel, says in fluent English. Portucel, a publicly traded company that is majority owned by a single Portuguese family, exported nearly €1.5 billion worth of paper in 2011.

The reason behind this success is the large eucalyptus forests that now grow in Portugal. Conservationists take a critical view of these monocultures, but the trees’ long fibers provide good raw material for paper. Portucel owns 120,000 hectares (300,000 acres) of woodland and also buys timber from thousands of private landowners. The hunger for raw material is so great that the company has plans for additional timber plantations in the former Portuguese colonies Mozambique and Brazil.

Too High Costs

Export-oriented industries are the ones still doing good business here in this country at the far southwestern corner of Europe. When Portugal joined the EU in 1986, several German corporations became heavily involved here, before the advent of strong competition from locations in Eastern Europe and Asia. Portugal is still benefiting from investments made during that period.

Volkswagen, for example, has 3,600 employees producing its Sharan minivan, as well as its Eos and Scirocco models, at its facility near Setúbal. Production increased by a third last year, with almost 100 percent of vehicles destined for export. German engineering and electronics company Bosch also has several thousand employees in Portugal and runs Europe’s largest manufacturing facility for car radios in Braga in northern Portugal. The company’s thermotechnology subsidiary is even based in Portugal.
In more recent years, though, German companies have stopped making major investments in Portugal. The country is certainly a competitive location, because salaries haven’t risen nearly as much as in Greece, but transportation costs for the 2,000-kilometer (1,200-mile) trip to the periphery of Europe are so high, and local markets so small, that in recent years most companies have preferred to relocate to Asia.

Subsidies from Brussels, meanwhile, meant that many Portuguese citizens felt little incentive to pursue their own ventures. German Chancellor Merkel had sharp criticism for costly bridges and tunnels constructed on the Portuguese island of Madeira, whose governor managed to rack up €6 billion in public debt. The highways around Lisbon are also among the best in Europe.

Part 2: The Oranges that Are Too Expensive to Pick

The troika’s inspectors have also discovered that agrarian Portugal imports €2.5 billion more agricultural products than it exports. The inspectors plan to address this issue in meetings with the Portuguese government this week. Those familiar with agriculture don’t find the situation surprising. Many fields lie fallow because it was easier to collect subsidies for olive trees than to actually harvest the olives. The Algarve region has a bafflingly high number of orange trees bursting with fruit. Farmers lament that harvesting the oranges is no longer profitable, now that hiring the Romanians who used to pick the fruit has grown so expensive.

Even the tourism industry has collapsed in the wake of the financial crisis. With the British pound so weak, many of the English tourists who usually blanket the Algarve’s beaches have elected to stay at home. German tourists, meanwhile, have been scared off by 12-story concrete blocks in Algarve cities such as Portimão. Built in the days of easy money a few years ago, these buildings now wait in vain for buyers.

Seemingly socially beneficial policies on the part of the government have actually contributed to the country’s plight, for example by preventing rents from rising in line with inflation decades ago. The result is that many Lisbon residents still pay €50 a month in rent, but live in buildings that are falling into disrepair. In many Portuguese cities, property owners have started simply nailing their windows shut, rather than renting out the apartments.

With new rental contracts almost impossible to obtain, young people looking to move out of their parents’ homes were forced to put themselves deeply into debt buying their own homes. That wasn’t a problem in the days of the economic boom, when Portuguese banks were happy to make loans that even covered more than the purchase price of a house. “They asked me if wanted to go on vacation as well,” remembers single mother Paula Dias.

Exporting the Educated

Now, the banks themselves are struggling to survive, and they’re increasing pressure on those borrowers who are still able to pay. Dias, who is German-Portuguese and works at auto parts supplier Incompol, teaches German at various language institutes to help make ends meet.

There’s no shortage of demand for language courses, and many of Dias’ students have in fact left Portugal for Germany. Ever since the crisis began, well-educated university graduates have become the country’s new export.

Alexandre de Sousa Carvalho, a gentle and good-looking revolutionary with dark hair, was prompted to think about the issue after more and more of his friends moved away. Last year, Carvalho and a few others used Facebook to mobilize nearly 500,000 demonstrators under the slogan “geração à rasca,” or “desperate generation.”

Young people are the ones most affected by Portuguese laws that are meant to benefit society but in reality do anything but. Job protection laws covering normal employment contracts are extensive, with employers required to pay their employees a severance package even when a temporary contract expires. The result is the widespread use of so-called “recibos verdes,” or “green receipts.” Meant as a method of contracting freelancers, this system has become a way to deny full-time employees their rights. Young people are required to pay social security contributions, but without themselves benefiting from the system. They can’t claim Christmas bonuses or vacation pay, and of course can be fired without notice.

Carvalho says he believes nine out of 10 university graduates are scraping by this way. He cites a Portuguese saying: “The mustard has reached the nose.” In other words, they’ve had enough.

But clearly the mustard has not yet risen far enough. Lisbon hasn’t had any of Athens’ burning barricades, and Carvalho himself doesn’t believe in the “tabula rasa of the revolution.” Instead, he wants to get his Ph.D. in political science first.

Grasp on Reality

This forbearance and solid grasp on reality have proved Portugal’s greatest strengths in the crisis. In the country’s last elections, 85 percent of voters chose parties that support Coelho’s reform policies. Most people in Portugal are aware that they were living well beyond their means and are willing to cut back, even if that’s not easy in a country where the average annual salary, before taxes, is €17,000.

Disposable income is expected to drop by a further 6 percent this year, thanks to tax increases and pay cuts for civil servants. This is not exactly the ideal environment in which to achieve a growth rate of at least 2 percent, the figure that will be necessary for Portugal to overcome the crisis.

Because of these conditions, the troika’s inspectors, who plan to present their latest progress report next week, won’t demand any new austerity measures. The inspectors, led by Jürgen Kröger from Germany, will instead call for structural reforms aimed at making Portugal competitive. The country still imports far more goods than it produces, just as Greece does.

In addition, extensive deregulation of the job market is meant to give young people a chance. Reforms are also planned for the justice system — with 1.5 million cases pending, judges have simply given up. Rental laws need to be changed in such a way that landlords no longer board up their properties. The commission also wants to know why dockworkers in Portugal, a country that has always depended on its sea routes, earn considerably more than their counterparts in other European port cities such as Hamburg or Rotterdam.

Still, it will be a while before these structural reforms have an effect. One internal European Commission estimate suggests Portugal won’t be able to regain the confidence of the capital markets until 2015 or 2016. That would mean the EU and IMF would still need to cough up an additional €25 billion, by the most conservative estimate.

But Portugal can be stubborn too. Lisbon, Porto and a number of other cities have decided their employees are allowed to celebrate Carnival this year — despite the crisis.

LONDON—Top European banks, responding to new regulations and wary of lending, are stashing increasingly large sums of money at central banks around the world in a collective flight to safety.

The eight giant European banks that have disclosed their annual results in recent weeks reported holding a total of about $816 billion in cash and deposits at central banks as of Dec. 31, according to calculations by The Wall Street Journal. That is up 50% from a year earlier, when the same banks were holding roughly $543 billion.

The stockpiling, which occurred over the course of last year, represented a collective response to the growing pressures on the European financial system. By storing funds at central banks in Europe, the U.S. and elsewhere, banks ensure that their money is safe. And they appease nervous regulators who want to guarantee that banks will have easy access to funds in a pinch.

But the strategy has a downside. Banks are depositing money at central banks instead of lending it to individuals, businesses or governments, which has the potential to exacerbate a Europewide lending drought. In addition, central banks pay paltry interest rates on the deposits, squeezing bank profits.

Hard-hit French banks were at the vanguard of the trend.Last year, Société Générale SA more than tripled the amount of money it was placing at central banks world-wide, to €44 billion ($57.8 billion). BNP Paribas SA’s central-bank deposits soared 74% to €58 billion. More than half of BNP’s deposits are parked at the Federal Reserve, with the remainder at the European Central Bank, the Bank of Japan and other central banks.

“We have faced a huge crisis in the second half of last year. And so we reacted as fast as possible in order to be on the safe side,” BNP Chief Executive Jean-Laurent Bonnafe said last week.

In addition to BNP and Société Générale, the six other banks included in the tally are Spain’s Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA; Switzerland’s UBS AG and Credit Suisse Group AG; Germany’s Deutsche Bank AG; and the U.K.’s Barclays PLC. Each reported holding more cash and central-bank deposits at the end of 2011 than a year earlier.

It is hard to gauge the scale of the buildup in historical terms. Until recently, most banks haven’t regularly reported the amounts they are depositing at central banks. That has started to change over the past year, in a nod to increasing investor attention to banks’ liquidity positions.

The amount of cash that European banks have deposited at various central banks is likely the largest in at least 15 years, said Andrea Filtri, a banking analyst with Mediobanca SpA in London. “Regulators want to make sure they don’t have another liquidity crisis,” he said.

Regulators require banks to maintain “liquidity buffers” comprised of cash and assets that banks can easily convert into cash, to make sure that they are insulated against sudden crises. Countries such as the U.K. have strict definitions of what counts toward those buffers: primarily cash deposited at central banks and bonds issued by top-rated governments.

In recent months, the volatility of European government bonds, as well as the market stigma attached to holding them, has prompted some big banks to dump those bonds and instead satisfy liquidity requirements by depositing more cash at central banks, according to executives at several top lenders.

“It’s a symptom of where the markets are right now and how people feel safer putting their money at central banks,” said an official at a top Spanish bank.

Officials at some banks say the big increase in central-bank deposits partly reflected the ECB’s move in late December to provide €489 billion in three-year loans to more than 500 banks. The infusion was an effort to ward off a potential cash crisis as lenders struggled to pay off and renew their maturing debts in early 2012.

Several bank executives have said they simply deposited large chunks of their borrowings back at an ECB deposit facility.

But that explains a small portion of the industrywide spike in central-bank deposits. Banks were depositing increasing amounts over the course of 2011, with a pronounced leap in the third quarter of the year, before the ECB announced its loan program.

Deutsche Bank, which said it didn’t borrow money from the ECB, had stashed €136 billion at central banks at the end of December, up from €94 billion three months earlier. Germany’s largest bank only recently started disclosing its central-bank deposits, but it appears to have had roughly €70 billion deposited at central banks in late 2010 and early 2011.

Deutsche Bank’s liquidity reserves “are the highest ever in the history of the bank,” CEO Josef Ackermann said earlier this month.

Some European banks acted at the behest of individual regulators. Spain’s Santander—which increased the amount it deposited at central banks to €97 billion at the end of December, up 58% from June 2010—said the rise was partly due to tougher liquidity rules in the U.K. and Brazil, where it has major operations.

The big holdings of cash and deposits at central banks are taking a bite out of bank profits. BBVA, Spain’s second-largest bank after Santander, said it was holding nearly €31 billion of those funds at the end of last year, up 55% from a year earlier and 45% from last summer. The bulk of the funds were in Europe, but they were also in central banks in Latin America and at the Fed.

BBVA said those assets earned an average yield of 0.99% in the fourth quarter. That compares with the average yield on the bank’s overall assets of 4.41%.

It is unclear whether the deposit levels will remain elevated for the foreseeable future. Some bank executives say it is likely a long-term phenomenon as banks adapt to new regulations. Others say banks might find better uses for the funds once market conditions improve.

“There is no need to keep such a huge buffer once things would stabilize and calm down,” said BNP’s Mr. Bonnafe. “So this is something we are going to manage in order to try and optimize between security and cost.”

New Bailout Set as Debt Deadline Looms; Private Creditors Take Deeper Losses

BRUSSELS—Greece ended months of uncertainty by finally securing a new bailout and debt-restructuring agreement with euro-zone finance ministers, but doubts remain over whether Greece will be able to meet the ambitious terms of the accord.

The finance ministers agreed on the long-awaited €130 billion ($171.9 billion) deal after haggling into the early hours of Tuesday morning to settle the final details.

Officials said the meeting, which lasted nearly 13 hours, produced a plan that would reduce Greece’s debt to 120.5% of gross domestic product by 2020. International Monetary Fund Managing Director Christine Lagarde said that target was lowered from 129% at the start of the meeting.

Private-sector creditors agreed to take a write-down on their bonds of 53.5%—more than the 50% write-down that had been conceded before the meeting. The private-debt exchange is expected to cut Greece’s debt by €107 billion, according to the Institute of International Finance, which negotiated on behalf of bondholders.

According to a statement from the finance ministers, Greece would also benefit from an arrangement in which the European Central Bank would distribute profits on its estimated €45 billion to €50 billion in holdings of bonds it bought in the secondary market in 2010-11 to euro-zone governments, which may then use them to help Greece.

Profits on an estimated €12 billion of bonds held by national central banks in the euro zone will be passed on to Greece, reducing its debt by €1.8 billion before 2020. The meeting decided against the central banks participating in the private-sector debt exchange.

The ministers also agreed to a further reduction in interest rates on the €53 billion in loans from the euro-zone made as part of the first bailout agreed upon in May 2010, saving some €1.4 billion.

“The deal is a good result for Greece, for the euro zone and for the markets, we hope,” said Italian Prime Minister Mario Monti after the meeting.

Even with the agreement, economists expect the deal will leave longer-term questions about Greece’s ability to pay off even its reduced debt burden. “There are downside risks. This is clear,” said the IMF’s Ms. Lagarde. “It’s not an easy program. It’s a very ambitious program.”

The problem: The Greek economy must become more competitive through across-the-board wage cuts, allowing the country to export its way back to economic health. But that hoped-for export boom could take years to materialize.

Meanwhile, falling wages will only deepen Greece’s recession, making the government’s debt burden—still large even after the restructuring—harder to bear.

The ministers agreed that the European Commission, the European Union’s executive arm, would have “an enhanced and permanent presence on the ground” in Greece to better monitor Greece’s economic performance.

Greece also agreed to put money corresponding to the following quarter’s debt servicing bill into a special segregated account, and would agree to introduce a change in the Greek constitution to ensure priority is granted to debt repayments.

The second bailout would offer Greece €130 billion in loans on top of the €110 billion it received from the euro zone and the IMF in May 2010. The IMF, concerned about its large exposure to the euro zone, is expected to offer just a minimal contribution this time around, leaving euro-zone governments to shoulder the vast majority of the second loan package.

The IMF agreed to provide €30 billion of the first bailout, but officials last week expected its contribution to be just €13 billion this time around.

The agreement will set in motion an exchange of an estimated €200 billion of Greek government bonds in private hands for new bonds with roughly half of their face value, which must be completed by the middle of next month. That exchange could set off legal disputes with disgruntled bondholders.

Analysts said the accord would have to be approved by some national parliaments in the euro zone, potentially causing uncertainty. A further test of the program will come in the months ahead, when the tough austerity measures Greece passed to secure the aid package are supposed to come into force.

These include yet another round of spending and pension cuts for an economy in its fifth year of recession, coupled with a 22% cut in the minimum wage.

With elections tentatively scheduled in April to replace the coalition government of Prime Minister Lucas Papademos, Greek politicians may become increasingly wary of standing behind the measures that just passed Parliament over popular outcry, analysts said

Their worries were heightened by comments from Antonis Samaras, the leader of the New Democracy party who is likely to be prime minister after the elections, who told Parliament last week: “I want to avoid the jump over the cliff today, to buy time, to restore normality and to go to elections tomorrow…. This is why I ask you to vote in favor of the new loan agreement today and to have the ability tomorrow to negotiate and to change the current policy which has been forced on us.”

Marie Diron, an economist at Oxford Economics, said, “They have to satisfy the euro-zone governments while at the same time making very tough measures acceptable to their population. That is something a technocratic government can perhaps manage, but after the election it might become much more difficult for an elected government to satisfy these two goals.”

Some euro-zone governments have taken a harder line with Greece. German, Dutch and Finnish officials have become increasingly skeptical that Greece will implement the painful economic policies its Parliament backed.

Dutch Finance Minister Jan Kees de Jager, speaking before the finance ministers’ meeting, called for “permanent” oversight of the Greek government by officials of the so-called troika—the European Commission, the ECB and the IMF.

“When you look at the derailments in Greece, which have occurred several times now, it’s probably necessary that there’s some kind of permanent presence of the troika in Athens,” Mr. de Jager told reporters upon arriving at the finance ministers’ meeting. “Not every three months, but more permanent.”

If Greece dutifully adheres to policies prescribed by the troika, the economic impact could be harsh, Ms. Diron said.

“Cuts in the minimum wage will bite very hard,” she said.

Lowering the minimum wage is supposed to address some of the failures of the previous austerity packages, which focused on reducing the government’s borrowing needs.

Capital flight, soaring borrowing costs, tanking currency and stocks and a central bank forced to pump vast amounts of cash into local banks — that is what Japan may have to contend with if it fails to tackle its snowballing debt.

Not long ago such doomsday scenarios would be dismissed in Tokyo as fantasies of ill-informed foreigners sitting on loss-making bets “shorting Japan.”

Today this is what is on bureaucrats’ minds in Japan’s centre of political and economic power.

“It’s scary when you think what could happen if there’s triple-selling of bonds, stocks and the yen. The chance of this happening is bigger than markets think,” says a senior official.

Leaning back in a leather sofa in his office, the official appears relaxed, but the way he wastes no time answering questions about a debt meltdown, suggests it is an all too familiar topic.

The official, like many others interviewed by Reuters, declined to be named because of the sensitivity of the subject and his alarm over Japan’s $10 trillion-plus debt overhang has yet to be reflected in public debate or action. But these officials would be the ones pulling the levers in the command center if Japan were to be hit by a debt crisis.

The government borrows more than it raises in taxes, and its debt pile amounts to two years’ worth of Japan’s economic output, the highest debt-to-GDP ratio in the world.

It costs Japan half of the country’s tax income just to service its debt. Each year, Japan’s debt level increases by more than the combined gross domestic product of Greece and Portugal.

Yet Prime Minister Yoshihiko Noda’s plan to double the 5 percent sales tax to 10 percent over the next three years is seen as far too timid to stop debts from piling up.

Furthermore, he has yet to win over many in his own party and half of the public while the opposition threatens to scupper the plan, which it supports in principle, to force snap elections.

Technocrats who might have once dismissed worst-case scenarios are now beginning to take them seriously as doubts grow over whether Japan is ready to act and as Greece’s budget meltdown stokes the euro zone’s debt crisis.

Conventional wisdom is that Japan is safe as long as it keeps covering about 95 percent of its borrowing needs at home. What emerges from a dozen or so interviews with fund managers and officials versed in monetary and fiscal policy is that a risk of domestic investors going on a strike is what makes them particularly nervous.

ARMAGEDDON SCENARIOS

The fact that bureaucrats openly discuss such disaster scenarios shows their concern that the public, politicians and even some people in financial markets do not take the situation seriously enough, and that the debt blowout will become a self-fulfilling prophecy if necessary steps, such as raising taxes, keep getting pushed back.

But to some economists who have followed Japan for years, the frustration is that the country has yet to solve its underlying problems of slow economic growth and stubborn deflation. As long as those conditions persist, it will be difficult to crawl out from under the debt burden.

“If you wind the clock back five or 10 years, they’d have been saying all the same things and probably with a very similar time horizon of three to five years,” said Richard Jerram, chief economist at Bank of Singapore.

“If you’re worried about it, and you think you’re three to five years away (from a potential crisis), why not do something about it now by trying to boost growth in the economy? Awareness of the problem never seems to translate into a response.”

While officials stress it is too early for a definite contingency plan, there seems to be an agreement that financial institutions will be the hardest hit because of their big government bond holdings, and that the Bank of Japan will play a key role in shoring up the sector.

“The most important thing, in the event of a crisis, is perhaps not trying to affect fund flows by buying government bonds in huge amounts, but to make sure Japanese banks aren’t forced to sell en masse to meet day-to-day funding,” one of the officials familiar with BOJ thinking said. “Once it becomes a banking sector problem, it’s very hard to contain the damage.”

In an event of a surge in yields, the Bank of Japan could flood money markets with cash the way it did after the March 11 earthquake and act as a market-maker for the bond market, matching bids and offers if they fail to meet, officials say.

The finance ministry could also be forced to redeem bonds ahead of maturity to calm investors, says Yoichi Miyazawa, former vice finance minister and upper house lawmaker for the opposition Liberal Democratic Party.

Miyazawa, who led work on the party’s crisis plan, says the worst case scenario could involve bank bailouts and Greek-style austerity if debt servicing costs soared, threatening to eat up a big portions of revenues.

“The government should show a concrete roadmap for rebuilding public finances, including the kind of reforms adopted by Greece, which involve painful belt-tightening, slashing welfare spending and boosting sales and other tax rates,” he said.

Finance Ministry data confirms that banks, rather than the budget, would take the hardest, most direct hit. First, the 2012/13 budget plan is based on 10-year yields of 2 percent, giving the government some cushion considering those bonds are currently yielding less than half of that.

Secondly, its simulations show adding 1 percentage point to borrowing costs would add 1 trillion yen to about 22 trillion in borrowing costs over the course of one year, rather than double them as some commentators warn, because the spike would only affect newly issued and rolled over debt.

TIPPING POINT

What sets Japan apart from Europe’s crisis-hit nations is that it borrows almost exclusively at home and with domestic savings of some 1,500 trillion yen ($19 trillion) it can do it paying less than 1 percent for 10-year bonds.

Deflation and the yen’s long bull run foster a “patriotic” home bias among households and institutions, turning private savings into quasi public money, always there and easily accessible.

In addition, the central bank acts as a buyer of last resort for the market, taking up large amounts of government bonds both as part of its annual quota of more than 20 trillion yen and an asset-buying plan launched in 2010.

That explains how a nation with one of the lowest tax burdens in the OECD and a stagnant economy never seemed to have trouble rolling out hefty stimulus packages or subsidizing social security. In fact, the system got so entrenched that bond sales are often reported as budget “revenue,” not borrowing.

The $10 trillion question is when that money or local investors’ patience will run out.

Budget arithmetic and demographics suggest that it will take another decade before Japan’s swelling ranks of retirees will begin to run down their vast savings to the point where Tokyo will need to start borrowing more from overseas lenders.

The optimistic view is that until then the government can keep rolling over the snowballing debt with ease.

“There’s a very strong system in place where all the stakeholders benefit from how things operate now,” says one official.

“Japanese banks don’t have anywhere else to invest, so park their funds in the JGB market. The BOJ supports this by accepting JGBs as collateral. The only thing that could trigger a bond sell-off would be a huge pull-out of deposits from banks, which is hard to imagine.”

The government’s current medium-term fiscal plan seems based on this optimistic view, assuming a leisurely pace of adjustment and aiming to get close to primary balance, where revenues match spending excluding debt costs, no sooner than in 2021.

Pessimists — and there seems to be a growing number of those among the bureaucrats — think there is much less time.

These bureaucrats play a major role in managing Japan. Over decades of virtually single-party rule, Japan developed a system where expertise and formulation of policies would be the domain of elite bureaucrats rather than elected politicians.

The ruling Democratic Party of Japan promised to challenge that system when it swept to power in 2009 alienating many ministry officials. Since Noda took over last September though, he has been repairing relations with bureaucrats and has particularly good, close relations with officials at the finance ministry, which he headed before.

POLITICAL TEST

Officials and fund managers say the first test of nerves could come as soon as next month when the parliament is due to debate the government’s proposed sales tax hikes.

Noda calls it a tax and social security reform, but critics say it is a misnomer given that the plan does not prescribe any substantial cuts in pension and health care spending.

Rating agencies, the International Monetary Fund, and many economists also agree that what is on the table will at best slowdown the piling up of the debt.

“It is much too little, much too slow,” says Koji Sakuma, chief economist at the Institute for International Monetary Affairs think-tank headed by a former top currency official.

Sakuma estimates the sales tax would need to go to 25 percent or more to close the financing gap built up over the past 20 years when Japan failed to respond to rising costs associated with rapid ageing by adjusting taxes and social security premiums.

Even tax hikes on such a scale will fail to reduce the debt burden if Japan remains stuck in deflation and anemic growth, he warns. “If we stay in this situation, this amount is never repayable. It’s just impossible.”

But even a modest rise is seen as a watershed for Japan where raising the sales tax has been a political taboo for years.

Noda’s chances look dim because the opposition, which controls the parliament’s upper house, wants to leverage that and block the tax plan to force Noda to call an early election.

Yuuki Sakurai, head of Fukoku Capital Management, asset management arm of Fukoku Life Insurance, says the proposal’s failure could jolt both foreign and domestic investors. But like many other market players, Sakurai stresses that many big institutions have no choice but to stay invested in Japanese bonds.

“A failure to make a decision would greatly ruin sentiment in the JGB market, but investors such as life insurers and pension funds have the obligation to pay in yen, so increasing foreign assets would be a risk for them too.”

Dan Farley, chief investment officer at State Street Advisors, a U.S. firm that manages institutional investors’ assets, sounds less concerned. His point is that, ironically, Europe’s crisis helps Japanese bonds.

“Our view is that Japan, much like U.S. Treasuries, continues to be viewed as a safety holding for investors, so given that fact we ultimately always expect that there will be a certain level of demand for those bonds that ultimately helps mitigate any drastic move in interest rates or a sell-off of these bonds.”

Farley, speaking in a Tokyo office on the 39th floor of a swanky Tokyo midtown office and shopping complex in the Roppongi district, exudes confidence that contrasts with apocalyptic scenarios spun by some bureaucrats.

“If the sales tax hike plan falls apart, that would give foreign investors a chance to start speculative JGB selling,” says a government official. “Such foreign players got burned in the past but whether they would succeed this time depends largely on how Japanese traders and investors would react. If the Japanese lose faith in JGBs, they would follow suit and trigger a sell-off.”

FUKUSHIMA LEGACY

Most officials are not as bearish and believe that while the market may see volatility and some spike in yields from today’s record lows, the cards for now remain stacked in JGBs favor.

But they sound genuinely worried that a failure to act on taxes now will make Japan more vulnerable when it reaches the next critical point. That may come if the nation’s current account — the broad measure of its dealings with the world — swings into deficit.

Hefty surpluses have allowed Japan to accumulate foreign assets exceeding 300 trillion yen, making a nation with the most indebted government also the world’s biggest international creditor.

But soaring fuel imports since the Fukushima nuclear crisis drove the trade balance into deficit in 2011 for the first time in three decades and probably brought closer the moment when the current account will also fall into the red.

JPMorgan Securities sees it happening in early 2015, but notes it would take several more years to run down the asset cushion.

Its analysts give only a 5 percent chance that over the next three-to-five years Japan’s debt will plunge into crisis, which they define as a surge in 10-year bond yields towards 4 percent. In such a case, domestic financial institutions would dump foreign holdings to cover losses on Japanese government bonds, letting the crisis spill into other countries.

Under a slightly more benign scenario, which the Asahi newspaper reported this month as part of Mitsubishi UFJ Financial banking group’s contingency plan, a deficit would come in 2016 and drive 10-year yields to 3.5 percent. The report, which Reuters has been unable to verify, said the bank would respond by selling longer-term bonds and switching to short-term bills.

Fund managers say such scenarios remain hypothetical as long as global investors shun risks and the Japanese lack attractive alternatives to big-scale holdings of yen-denominated government debt.

A resolution of Europe’s debt crisis and return of risk appetite combined with a lasting reversal of the yen’s upward trend and a return of carry trade using the yen to fund investments in higher-yielding assets could change that.

Farley says the emergence of government debt of new economic powers such as China or Brazil as safe high-grade investment could also allow Japanese investors to diversify away from JGBs, though he expects such a change would be gradual.

Tokyo technocrats worry that the psychological impact of Japan losing its long-cherished status as a top capital exporter could produce an explosive mix if combined with a sense of policy paralysis and better alternatives elsewhere.

“The worst-case scenario, or capital flight, would become reality if the Japanese start feeling that Japan will go into steady decline and they will find no reason to keep their assets at home.”

($1=78.42 yen)

Date: 20-02-2012
Source: SPIEGEL

“It was a grave mistake to bring all the south European states into the euro zone.”

In an interview with SPIEGEL, Harvard economist Kenneth Rogoff, 58, says it was a mistake to bring all the southern European countries into the common currency. He also argues that Greece should be granted a “sabbatical” from the euro and that a United States of Europe may take shape far sooner than many believe.

SPIEGEL: Mr. Rogoff, the eurozone finance ministers are likely to soon provide Greece with new loans totalling €130 billion ($171 billion), with the aim of stabilizing the country for the next few years. Will that save the euro?

Rogoff: It is hardly the final word, even for Greece. The mountain of debt in Greece is simply too big and the country is not competitive. Indeed, it’s going to be very difficult to keep Greece in the euro zone.
SPIEGEL: But the government has announced tough austerity measures. Pensions are being cut, wages frozen. Those kinds of measures are almost unheard of in Europe.

Rogoff: But they’re still not enough. To make Greece competitive, wages would have to be halved. That is impossible to implement politically, but without a steep wage cut, the economy will continue to stagnate. Greece urgently needs the prospect of growth. It is currently experiencing its fifth consecutive year of recession. This is a failure of historic dimensions.

SPIEGEL: But surely it can’t get any worse? Many economists are saying that the crisis in Greece has bottomed out and the worst is over.

Rogoff: I would be more cautious. The problem in Greece is not an ordinary recession but a full-blown financial crisis, something which countries usually take a lot longer to recover from. This kind of economic collapse goes much deeper than a normal slowdown. The longer the economy continues to shrink, the more restless the trade unions get, and the more pressure builds up on politicians to put an end to the misery.

SPIEGEL: What cure would you prescribe?

Rogoff: The government in Athens should be granted a kind of sabbatical from the euro, while otherwise remaining a full member of the European Union. The country would leave the monetary union and reintroduce the drachma, for example. The drachma would immediately trade at deep discount to the euro, making Greece’s export and tourism sectors competitive again. Once the country had achieved a higher level of social, political and economic development, it could return to the euro zone.

SPIEGEL: Most European politicians seem to dismiss that as unviable. They see a Greek exit as the beginning of the end for the euro zone.

Rogoff: I don’t see it that way. Of course, Europe would have to assure Greece that it would not be punished in any way for taking such a step. And there would have to be a credible road map for Greece’s eventual return.

SPIEGEL: If Greece were to leave the euro zone, a wave of panic might engulf other countries struggling with debt, such as Portugal. How can we prevent the contagion from spreading?

Rogoff: If Greece leaves the euro, the markets will demand sensible answers to two questions. First, which countries should definitely keep the euro? And second, what price is Europe prepared to pay for that? The problem is that the Europeans don’t have convincing answers to those questions.

SPIEGEL: What advice would you give Merkel and her counterparts? Should they tear the euro zone apart?

Rogoff: No, certainly not. We are talking about bending not breaking, with one or more periphery countries allowed to leave temporarily in order to enjoy greater flexibility. There is currently no simple solution for this unparalleled crisis. The big mistakes were made in the 1990s.

SPIEGEL: Does that mean the whole idea of the euro was a mistake?

Rogoff: No, a common currency for countries like Germany and France was a reasonable risk, given the political dividends. But it was a grave mistake to bring all the south European states into the euro zone purely for reasons of political union. Most of them were not ready for it economically.

SPIEGEL: That may well be, but the fact is that now they are part of the monetary union, and that can’t simply be unravelled.

Rogoff: Which is why there is only one alternative: Either the euro completely collapses — with all the catastrophic consequences that would entail – or the core members of the currency union manage to turn the euro zone into a genuine political union.

SPIEGEL: Europe has recently agreed on a fiscal compact committing all members to better budgetary discipline. Is that a step in the right direction?

Rogoff: Yes, but it will by no means suffice. All this treaty does is give the markets the temporary illusion that the problems have been solved for now. It has achieved nothing more than that.

SPIEGEL: What is needed instead?

Rogoff: What the monetary union needs more than anything is a central government, including a a finance minister, with significant tax and spending authority. The individual countries should also stop insisting on national control of banking regulation. That is a matter that should be dealt with exclusively at European level.

SPIEGEL: Do you honestly believe that the countries in the euro zone can bring themselves to hand over that much more power to Brussels?

Rogoff: The terrible thing is that few countries in Europe seem genuinely prepared for that. Those politicians who know what is needed keep quiet, fearing opposition from the voters. But the pressure of this crisis will create a momentum whose scope and impact we cannot yet imagine. At the end of the day, the United States of Europe may well come about a lot quicker than many would have thought.

SPIEGEL: With all respect to your optimism, the Europeans are unlikely to play along with that. The popular opinion in most member states is that Europe has far too much power, not too little.

Rogoff: Europe is in an interim stage, quite similar to that in late 18th century America. The ratification of the United States constitution in 1788 was preceded by 12 years of a loose confederation, which sometimes worked but usually didn’t. Europe is in a similar situation today. States are like people, it is difficult to sustain a stable half-marriage; either you go for it or you forget it.

SPIEGEL: Many politicians in Europe think that the introduction of euro bonds would pave the way for a marriage later. Do you share that opinion?

Rogoff: No. In the current situation euro bonds would be absolutely the wrong solution. How could Germany protect itself if the French minister of finance makes a few bad decisions? The subject of euro bonds will only become relevant once the political union has been established.

SPIEGEL: Economic imbalances within the euro zone are regarded as one of the main reasons behind the current mess. The southern European states accuse the Germans of exporting too much. Do they have a point?

Rogoff: That is absurd. Portugal’s and Spain’s problem isn’t Germany, it’s China. The south Europeans have to understand that they cannot maintain their current standard of living in the context of globalization without significant economic reform. There are great opportunities for those who can adapt to the new realities.

SPIEGEL: That’s not really music to Spanish or Italian ears.

Rogoff: Perhaps, but I think most Italians and Spaniards well understand the challenges.

SPIEGEL: What reforms do the governments need to implement?

Rogoff: Wages in southern Europe have risen sharply over the past few years, but these countries traditionally produce relatively simple goods like textiles. They are no longer competitive in a global context, which is why production has shifted to Asia. The Federal Republic of Germany, by contrast, has an innovative industrial sector whose high-quality products are very much in demand in emerging economies. That is why Germany has been the winner in the globalization process, while Portugal, Spain, Italy and others are among the losers.

SPIEGEL: That is why some economists have suggested that Germany should increase wages to strengthen demand in Europe. Would you agree with that?

Rogoff: No, because Germany faces many competitors outside Europe, who would jump at the chance of seeing a less competitive Germany. There are only two options. First, the south European states have to invest a lot more money in education and aim to produce better-quality goods. At the same time, they also have to lower wages in some industries to keep up with the competition from emerging economies like China, India or Brazil.

SPIEGEL: Do you think the euro zone will have the same members in 2015 as it does now?

Rogoff: It may well be the case that all current members remain in the euro zone, and that Germany keeps on shouldering the ever-increasing debts of other countries. But the price of such a scenario is very high for all involved: southern Europe would become embroiled in permanent stagnation and the German economy would eventually be dragged down to a slower growth trajectory. 

Hour-glass grafitti in Athens: “After a short thunderstorm, the sun will shine again.”

Europe’s finance ministers plan to approve a second bailout for Greece on Monday but Hans-Werner Sinn, the head of Ifo, a top German economic think tank, warns that the money will only help international banks — not the Greeks. He argues that Greece can only solve its crisis if it quits the euro.

SPIEGEL ONLINE: The finance ministers of the euro zone want to approve a new bailout for Greece this Monday. Can the additional €130 billion ($172 billion) save Greece?

Sinn: No, and the politicians know it can’t. They want to gain time until the next election. I think we’re wasting time by doing this.

SPIEGEL ONLINE: Why?

Sinn: Because Greece’s external debt is rising with every year that passes until it leaves the currency union. We’re getting ever further away from solving the problem. The basic problem is that Greece isn’t competitive. The cheap loans that the euro brought the country artificially raised prices and wages — and the country has to come back down from this high level.

SPIEGEL ONLINE: So the euro countries shouldn’t approve the aid?

Sinn: They should give them the money to ease their exit from the currency union. The Greek government could use the money to nationalize the country’s banks and prevent the state from collapsing. The state and the banks must continue to function through all the turmoil that an exit will entail.

SPIEGEL ONLINE: This turmoil would hit the population hard.

Sinn: Yes, undeniably. But the turmoil would only be temporary, it would last one to two years perhaps. This time would have to be bridged with the financial aid from the international community. But the drachma will immediately depreciate and the situation will stabilize very quickly. After a short thunderstorm, the sun will shine again.

SPIEGEL ONLINE: How would a euro exit help Greece in concrete terms?

Sinn: It would become competitive again. Because Greek products would rapidly become cheaper, demand would be redirected from imports towards domestically produced goods. The Greeks would no longer buy their tomatoes and olive oil from Holland or Italy but from their own farmers. And tourists for whom Greece has been too expensive in recent years would return. In addition, new capital would flow into the country. The rich Greeks who deposited so many billions, possibly hundreds of billions of euros, in Switzerland would see the falling property prices and wages and would have an incentive to start investing in their own country again.

SPIEGEL ONLINE: Does the exit from the euro zone entail Greece going bankrupt?

Sinn: No, quite the reverse. The bankruptcy forces the exit. The Greeks will immediately leave if they don’t get any more international aid because the bankruptcy couldn’t be managed within the euro system. The state would be insolvent and the banking system too. The entire payments system would fall apart. The chaos can only be avoided if Greece leaves and the currency depreciates immediately.

SPIEGEL ONLINE: Does that mean Greece should be forced to leave?

Sinn: No, no one should force anyone. But at the same time Greece doesn’t have the right to receive permanent assistance from the other euro countries, and Greece’s creditors aren’t entitled to have the debt repaid by the international community. Everyone has to earn their standard of living themselves, and those who choose to earn money from risk must bear that risk.

SPIEGEL ONLINE: If Greece were to exit the euro zone, would the tough austerity measures still be necessary?

Sinn: In this case, savings really only refer to a reduction in debt growth. The economist only refers to savings if debt is actually repaid. Greece is nowhere near doing that. But it’s true that Greece has gotten used to the flow of cheap credit from abroad, and that it’s politically impossible to cut wages to the extent needed to make the country competitive.

SPIEGEL ONLINE: By how much would wages have to be cut?

Sinn: Greek products must become 30 percent cheaper in order to be on a par with Turkey. You can only achieve that through a euro exit and depreciation. Without depreciation, millions of price lists and wage contracts would have to be rewritten. That would radicalize the trade unions and push the country to the brink of civil war. In addition, companies would go bankrupt because their assets would shrink while their bank debts would remain unchanged. You can only reduce the bank debt through depreciation. The plan to radically restructure Greece within the euro is illusory.

SPIEGEL ONLINE: Why are the euro-zone countries so adamant that Greece must remain in the currency?

Sinn: This isn’t really about the country. The Greeks are being held hostage by the banks and financial institutions on Wall Street, in London and Paris who want to make sure that money keeps on flowing from government bailout packages — not to Greece, but into their coffers.

SPIEGEL ONLINE: What about the contagion that a bankruptcy or a Greek exit would involve? Financial markets may speculate that other countries will suffer a similar fate as Greece.

Sinn: There may be contagion effects. But I think this argument is being instrumentalized by people who are worried about losing money. People keep on saying “the world will end if you Germans stop paying.” In truth only the asset portfolios of some investors will suffer.