‘The PIIGS should exit the euro’

She is a Wall Street veteran, having worked for Goldman Sachs, McKinsey & Co and Sumitomo Bank. Since 2006, she has run the top ranked economics and finance blog www.nakedcapitalism.com. Meet Yves Smith, who most
recently authored Econned.
“You now hear the expression, ‘IBG-YBG’ which is ‘I’ll be gone, you’ll be gone’, which means if a deal or a trade blows up later, it will be someone else’s problem. That attitude, that the health of the firm was someone else’s responsibility, and all you cared about was your own bottom line, was unheard of in my day in the 1980s,” she says, reminiscing the old days. In this interview she speaks to DNA. Excerpts:

What is your view on the recent crisis in the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain)?
There are two big factors in the PIIGS crisis that are not getting enough attention. First, the Eurobanks were badly undercapitalised prior to the crisis, and heavily exposed to risky assets, often as a result of bonus gaming. Eurobanks, in particular the German banks, are even further behind the US ones in cleaning up their balance sheets and so, are vulnerable to shock. They hold PIIGS sovereign debt, hence restructuring losses are a threat to their solvency. Second, the bailouts fail to address the core problem facing the Eurozone, which is an internal imbalance, much like the so-called global imbalance, which is mainly an imbalance between the US and China as a result of China running a currency peg against the dollar. There is no mechanism in our current currency arrangements to discourage mercantilism, in particularly, one country running sustained trade surpluses. Currency depreciation of the trade deficit countries is the usual remedy, but in the case of the US versus China, and the periphery states versus Germany, that is blocked. The other route is to greatly increase consumption in the trade surplus countries, but neither China nor Germany is interested in that.

Typically in case of debt crises (as was the case in the East Asian Crisis) countries devalue their currency, and try and export their way out of trouble. That cannot happen in the current case; given that euro is not the currency of just one country.

Do you think it makes sense for PIIGS economies to opt out of the euro?
It would be much better for the PIIGS to exit the euro possibly as a block, restructure their debts, and depreciate their currencies. The alternative is going to be worse for them and the world. The euro will have to drop far to provide enough of an export boost to the PIIGS given that Germany runs a big surplus within the EU; a mere fall of the euro will not solve the internal imbalance. And a big enough of a fall in the euro is a huge deflationary shock to the rest of the world.

You state in your book Econned that the case for trade liberalisation is overstated. How is that linked to the current crisis in Europe?
It may seem heretical to question the benefits or more open trade, but the US example show how a naive posture towards trade may not help its citizens. Before the early 1980s, consistent trade deficits would have been seen as a sign the US was shipping demand (and hence jobs) overseas. And the US has had stagnant average worker wages since 1980s, with the standard of living increasing primarily due to rising household debt. That is not a healthy or sustainable model and in fact, was the key driver of the crisis. Borrowing was in large measure supporting unproductive consumption, rather than borrowing to fund business expansion, training, or infrastructure investments that can increase future incomes are another matter.

An off shoot of this has been the savings glut theory, which says that Americans and Europeans only borrowed because Japan and China had very high savings and very few domestic investment options. Thus they ended up lending money there. Do you buy into that story?
Never before in history have developing economies lent to advanced economies on a large scale. That should tell you something is amiss here. The savings imbalance is a symptom of the trade imbalance, but trade is a sacred cow, so we talk about only the financial part of the equation. While the US clearly would have ceded some manufacturing to emerging economies, it went far further than was optimal The dirty secret here is  that outsourcing and offshoring lowers labour costs (which is not that large a constituent element in many finished goods) while increasing shipping, inventory carrying, and most important, managerial costs. And it also introduces rigidity and risk into your business system. This is true even in areas like software development, most of the labour cost savings are offset by an increase in managerial costs (the coordination time of much more highly paid people). But it would take a very long time for the US to partially reverse this trend. We’ve not only ceded manufacturing capacity, but skills, both at the manager and worker levels.

One of the side effects of this belief in markets was deregulation. How did that happen? 
When you look at the history, there was no proof for the argument made by the proponents who were lobbying the Carter Administration (in fact, if anything, the evidence contradicted their arguments), but the economy was so bad, the officialdom was desperate to try anything that might help. Ironically, the most important move taken was by the industry itself in 1970. Prior to then, all New York Stock Exchange members had to be partnerships. Partnerships are unlimited liability organisations. If you suffer big losses, say through trading or as a result of litigation, the creditors can go after the personal assets of the partners. That focuses the mind.

And how did that help?
The investment banking and brokerage industries always encouraged a certain amount of aggressive behaviour. After all, the firms for the most part only make money as a result of executing transactions, so they push their staffs through a compensation structure that has low salaries and high bonuses. But that was offset by managerial checks in the partnership era. The firms were smaller, nearly all the partners were active in the business and closely supervising the people underneath them. They would also make people partner only if they trusted them not to take undue risk. And there was much less mobility in the industry, the big reward was making partner and if you changed firms mid career, it would be much less likely that the partners in the firm you joined would have the same level of trust in you as they had in someone who had worked for them his entire career.

Then things changed?
Yes. The aggressive impulses of the industry over time had fewer and fewer checks as the industry moved to an ‘other people’s money’ model. And product complexity, particularly customised derivatives, allowed the industry to take fees and move risks onto customers that most of them did not understand.  A lot of products are misrepresented, yet competitive pressures virtually force fund managers to dabble in riskier products to deliver returns in line with their peer group. The incentives throughout the industry are very bad.

What did I-banks do to loot their investors and the global economy?
You now hear the expression, “IBG-YBG” which is “I’ll be gone, you’ll be gone”, which means if a deal or a trade blows up later, it will be someone else’s problem. That attitude, that the health of the firm was someone else’s responsibility, and all you cared about was your own bottom line, was unheard of in my day (the 1980s).

What do you think are the three things that should be done, and are not being done to handle the current crisis?
We need pay reform in the financial services industry. One way would be to impose more liability and much higher capital requirements at the big dealer firms if they do not adopt pay structures that emulate the results of the partnership era. Failure to address it just sows the seeds for another big crisis.