PIIGS can’t fly. Here’s why

“So how was the hen party?” I asked as she got into the bed, well past midnight. “Oh, the usual. Breakups, engagements, trouble with mothers-in-law and so on,” she replied matter-of-factly.
“Breakups?” I asked like any good voyeur would.

“Yeah. My best friend L, she dumped J again!”

“I guess she believes in Woody Allen’s philosophy: “In life, when a relationship breaks, it’s better to be the leaver than the leavee because the leaver leaves and the leavee is left and it’s terrible.””
“You and your philosophies. But what was interesting is that the women were also talking about Greece?”

“Grease? But why this sudden interest in a lubricant?” I asked with a wicked smile on my face.

“Ha ha ha. Please, no more poor jokes. But tell me na what’s this latest development in the financial crisis that seems to be unfolding now.”

“Basically it starts from Greece. The country owes $226 billion to other countries, most of it to other countries in Europe. Financially, it is not in good shape and for a while now, speculation has been on that Greece will default on its debt. To prevent that from happening, the European Union (EU) along with the European Central Bank and the International Monetary Fund (IMF) came out with a $962 billion rescue package. Loans will be given out from this pool of money to European Union countries which are having trouble with repaying all the accumulated debt. The question of course is where will the EU get the trillion dollars from?”

“Yeah. Where will they get this money from?” she asked.
“Of the rescue package, the IMF will contribute $320 billion and European governments will come up with the remaining. The point I am trying to make is, most of the European governments are heavily in debt. Take the case of what are now being called as the PIIGS economies — Portugal, Italy, Ireland, Greece and Spain. Portugal owes $286 billion to other countries, Ireland around $867 billion, Spain around $1.1 trillion and Italy a whopping $1.4 trillion.

It is highly unlikely that these countries will be able to contribute to the rescue effort, even though Spain has been making the right noises about contributing to the effort.” 

“So where is the money going to come from?”

“From countries like Germany and France to whose banks the PIIGS economies owe a lot of money. And that’s one of the main reasons why this rescue effort is being worked out. As Simon Johnson, professor of entrepreneurship at the Sloan School of Management, MIT points out “Portugal owes a great deal to Spain — and Spain, in turn, owes a great deal to France and Germany. And if you really want to scare yourself (or a European policymaker), look at how much Italy owes its neighbours.” Let me get into a little more detail. Italy owes a whopping France $511 billion or 20% of its GDP. It owes Germany $190 billion. Spain in turn owes Germany $238 billion and France $220 billion. Ireland owes $184 billion to Germany and $60 billion to France. Portugal owes $47 billion to Germany and $45 billion to France. And the smallest of them all, Greece, owes Germany $45 billion and France $75 billion. Moral of the story is that Greece is not the only country in trouble,” I explained.

“But how will this plan work?”
“The economies in trouble looking to get a loan from the $962 billion pool will have to follow structural reform and fiscal management programmes monitored by the IMF. The IMF is known not to lose its money anywhere. One of the norms required from countries using the euro is to maintain a fiscal deficit of less than or equal to 3% of GDP. The trouble is in difficult times like these, its government spending that drives the economies. Take the case of Ireland. It started implementing austerity measures back in 2008. And what’s happened since? 

The government debt as a percentage of GDP has gone up to 64% from 43.9%. Also, fiscal deficit as a percentage of GDP has doubled to 14.13% from 7.3%. In the same time, the nominal GDP of the country has fallen by 18%. Or take the case of Spain, which has an unemployment rate of 20%. In such a situation, will the country be able to cut expenditure or for that matter raise taxes to pay off all the accumulated debt?”

“So what is the way out?”
“In the past, when countries faced such crisis, they devalued their currencies. This made their goods and the services a lot of more cheaper and hence, more competitive. This in turn would mean the country could export more and earn more dollars or whatever foreign currency they had their debt in. This could then be used to pay off the accumulated debt.”

“But this formula cannot work here?” she asked.

“No it cannot. The euro is used by 16 countries, so it cannot be devalued. As economist Carmen Reinhart points out, “Many of Greece’s most important trading partners share the euro, so there is no scope for a change in an exchange rate’s value to improve competitiveness with them... Thus, the only way Greece can improve its competitiveness is through a compression in domestic prices and costs.” So products made in the PIIGS countries will become competitive only if they are able to control costs. Controlling costs may mean cutting salaries of employees, for starters, which may not be palatable for politicians.”

“So essentially it’s a situation of dammed if you do and dammed if you don’t?” she asked.

“Yeah. One possible solution for these countries in trouble is to opt out of the euro and go back to the days of having their own currency. Even so, a country like Greece may still not recover. As Marc Faber, the author of the Gloom, Boom and Doom Report recently said, “It would be a mistake to think that the bailout is actually a bailout of Greece. Greece is a write-off, you cannot have the kind of debt Greece has with olive oil income. They have no industries to speak of, they have shipping, but the shipping industry does not pay taxes in Greece.”

“Interesting. But tell me something. How do you understand all these questions I ask you?”
“I don’t.”
“Then?”
“The poet Nida Fazli has written: “kabhi kabhi yun bhi hamnein, apne ji ko behlaya hai, jin baton ko khud nahi samjhe, auron ko samjhaya hai.””
(The example is hypothetical)

References:
Everyone Says I Love You, Written and directed by Woody Allen, 1996
Europe’s Web of Debt, May 1, 2010, The New York Times
Solving a debt crisis by issuing more of the same, Karl Denninger,
May 10, 2010, www.seekingalpha.com
Initial Thoughts on the European Bailout,
The Pragmatic Capitalist, May 10, 2010, www.seekingalpha.com
Europe’s Debt Crisis: Your Questions Answered, Economix Blog, May 10, 2010, www.nytimes.com
It would be a mistake to think it is actually a bailout for Greece, May 11, 2010, www.marcfaber.blogspot.com
Nida Fazli - Gazlein, Nazmein, Sher aur Jeevni,
Rajpal and Sons, 2009