Only the ECB can be a bazooka in Europe - EFSF is a tower of cards

In the latest summit, what was made evident is that European elites have agreed on three policy areas to respond to mounting market pressures primarily on Italy and Spain with France being in the horizon, who sees dark clouds gathering over its triple-A credit rating. These three areas of policy are (i) the leverage of the EFSF to expand its available funds (ii) the reaffirmation of the faith in fiscal consolidation, (iii) the impartiality of the ECB, in the sense of not allowing it to act as a lender of last resort. The rationale that permeates these decisions is that debts must not be monetized since that would (ostensibly) lead to inflation, but above all, it would be a very bad precedent regarding the responsibility each state has towards its own finances. In other words whatever deterring effect the impartiality of the ECB currently has vis a vis the fiscal responsibility of member-states, will vanish.

Though the concerns about the economic and political aspects of the matter are to a large extend spot on, the package of measures that European elites have in their mind, is logically and technically flawed. The reason is that it rules out a priori the option every currency area has to rely on its central bank, in this case the ECB, to act as a backstop to the free fall of states and the deterioration of the currency itself. In practice the drafters of the euro had erected a Maginot Line against inflation by creating a very conservative central bank, which current policy-makers do not even consider of revising (see Stricter rules are good - Stabilizing Mechanisms are much better). Our leaders are trapped in the fallacy of following the exact same dogma the drafters of the euro had, by producing measures to address inflationary pressures. This would have been very effective had the issue been one of inflation. The point here is that what we are dealing with and what our leaders fail to grasp is a series of existential pressures, not inflationary ones. Market pressures are mounting due to the lack of confidence in the euro architecture itself to overcome its own rigidities and institutional gaps. Inflation is secondary in importance when the very existence of the euro is challenged. It makes no difference at all to reinforce the Maginot Line, since the weak spot is elsewhere. That is the lack of a final backstop in Europe, a role only the ECB can effectively fulfill.

The EFSF which is supposedly the mechanism through which the fall of states will be prevented is from the outset an unstable structure as it relies on the guarantees of all member-states, including those who are in need of funds. In effect Italy, Spain and the three countries that are under bail out programmes, are providing guarantees to their selves, which are only accepted thanks to the combined gold-platted AAA credit rating of France and Germany, the eurozone's two largest economies. The fundamental flaw in this structure is that France and Germany are in their selves in an unsafe position, since not even their own finances are very stable, either because of the exposure of their banks, which will indirectly bring the need for recapitalizations that have the effect of increasing public debts, or because of the burdens they carry with every country coming to the need of the EFSF, since those are the ones who provide the bulk of the funds.

The Achilles Heel in the EFSF is exactly its dependence on the triple-A credit rating of its two biggest contributors. France in particular has a banking sector that is heavily exposed to the debts of the European South, effectively raising questions of the capacity of the country to cling on to its excellent credit rating. These doubts are further reinforced by (i) the deterioration of Italy and Spain, with Italy being forced to lend money from the markets at an exorbitant interest rate of more than 6%, implying that the area's third largest economy is making steps towards a bailout programme via the EFSF, (ii) the anemic growth in the whole euro area, which is to a large extend caused by the simultaneous fiscal austerity of all member-states, leading to a unique, euro-wide fallacy of composition, reinforced by the overall slowdown in the global economy. With respect to the latter, French President Sarkozy made reference to the need for further fiscal consolidation in his country, suggesting that the national economy will effectively enter a period of contraction. Understandably this setting, leads to a self-fulfilling path to depression, bringing down the whole system, unless some "Good Samaritan" (call me China) shows up. But a Good Samaritan will only show up, if the chances of saving the euro are also good, otherwise he will prefer to invest his capital in other ventures.

The only way to restore faith in investors that the euro will not implode, is by providing a credible backstop, a real bazooka so to speak, that will drive away whatever doubts may exist. Only the ECB acting as a real central bank, with all policy tools necessary can provide this ultimate resort. For as long as the system lacks a final backstop, markets will remain cautious and exponentially more investors will bet on the collapse of the euro, an ambitious project that was only safeguarded from inflation but was not sufficiently equiped to cope with a crisis of this kind.

The EFSF can never be the backstop in the region. It is nothing more than a tower of cards. The removal of a single card from its base, which practically is the credit rating downgrade of France, should things go for the worse - and they will - leads to the collapse of the whole edifice. Thus the EFSF will never be a bazooka, regardless of the funds it ultimately manages to have at its disposal. Only the ECB can restore faith in the markets and allow European elites to take a deep breath and search for solid and decisive ways to address all other issues, alleviated from the pressure they now have which leads them to the adoption of half-measures, and in many ways, of self-defeating policies.

European Bank recapitalizations: An imminent credit crunch

The latest summit did not produce a comprehensive solution as many expected (see The aftermath of the October 26 Euro Summit - No Solution). Apart from the consensus on certain policy areas and despite the vague figures and numbers that are not backed by any tangible plan; the decisions of the summit are full of gaps, with vital details remaining open to further negotiations. One of the few issues that is explained in some greater detail is the process of bank recapitalizations (see Annex 2 of this 14-page document that contains the official decisions of the latest summit). The positive aspect of this plan is that it finally accepts, with great delay, that European banks are quasi-bankrupt and are in desperate need for capital otherwise they will continue to destabilize the system. The negative is that the process of recapitalizations is designed in such a way that will produce adverse effects and recession in the short-to-medium term.

The reason that is true has to do with the multi-level process and with its voluntary manner. Banks will first be expected to raise capital from the market, if they fail to do so they will resort to national authorities and if those are unable to provide assistance, the EFSF will be called to carry the task. Banks are expected to meet their capital targets by June 30, 2012. In practice this suggests that bankers have a considerable time ahead to work out all necessary steps that will allow them to avoid losing control of their banks, since recapitalization implies partial or full nationalization/europeanization, depending on the amount of capital that each bank will need.

Instead of designing a plan like the one in the USA, the TARP (Troubled Assets Relief Programme), which was a nation-wide scheme that included compulsory recapitalizations; European elites came up with the self-defeating idea of allowing bankers the time to avoid nationalization, by asking from them to basically instigate a credit crunch, since if all banks are asked to raise capital from the market, they will have to draw it out of the real economy, in whatever way possible. In short the real economy will be deprived of much-needed liquidity in the midst of a recession. Without any central plan to stimulate growth only the private sector can push the European cart out of the mire of stagnant growth, yet without sufficient liquidity this is impossible. Without growth the crisis can only get worse.

The prudent choice would have been to copy the successful detoxifying exercises of TARP by transforming the EFSF into a mechanism that would be assigned the exclusive task of recapitalizing banks in a forceful way, effectively changing their boards of directors. This would allow for an immediate, coherent, Euro-wide programme that would bring Europe's banks back to healthy standards, by cleansing them from all their toxic assets, while also giving the opportunity to policy-makers to devise a simultaneous restructuring of private and sovereign debts. This is however politically undesirable for a number of reasons, hence we end up in a complex plan that favors bankers instead of Europe and its people, by allowing them precious time to do what best serves their own interests.

Compulsory and immediate recapitalizations are key. A non-compulsory recapitalization plan is going to produce adverse effects as not only it fails to address the underlying insolvency of many banks, it also allows them to continue to act like black holes to the system, effectively absorbing all the liquidity that goes their way. Banks are basically asked - and expected -  to retard growth even more, by further reducing the amount of liquidity they supply.

Moreover the idea of expecting from national authorities to recapitalize their banks can prove unpleasant, as many sovereigns will be forced to accept their inability to support their banks, which alone is not a good sign for the markets. Yet even if they are capable of doing so, the amount of capital they will have to pump in to their banks can be enough to trigger downgrades from credit agencies. This is especially true for France and Belgium. The point that needs to be made clear is that France cannot afford to lose its triple-A rating at this stage, as that would immediately lead the EFSF into jeopardy, thus effectively tearing apart the whole plan European elites have in their minds.

I already offered my first comments on the October Summit explaining how European elites failed to come up with any 'comprehensive' solution. All they did was to kick the can forward, however in their attempt to buy more time (what for?) and governed by despair they have come up with a series of proposals that effectively make the crisis worse. The plan to recapitalize banks is certainly one of them, as it will further deepen recession, effectively killing at birth the latest incomplete package European policy-makers produced.

The aftermath of the October 26 Euro Summit - No Solution

Expectations were very high prior to the latest EU summit. Mostly because of the severity of the moments and the urgent need for a solution. Expectations were also raised by the promise of French President Sarkozy and German Chancellor Merkel, to deliver a 'comprehensive' plan that would finally draw a line under the crisis. In addition the sheer length of the summit was remarkable by EU standards, as it nearly lasted a week, with countless meetings taking place prior and in-between the two-leg official summits of October 23 and 26, giving the impression that Europe was preparing to act big.

Despite the growing expectations of the markets and the mounting pressures in the economy, European elites did not deliver any 'comprehensive solution'. All they announced was that they have either agreed or are committed to agree on certain principles regarding seven issues. It is important to analyze paragraph by paragraph the official document about the Main results of the Euro Summit to realize the qualitative difference between an agreement on areas of policy that European elites consider important and an actual solution. Emphasis will be given by myself on important phrases of vague or triumphant rhetoric, which however lacks substance since nothing tangible was actually announced. The sad reality is that this summit was yet another failure to act from the side of European elites.

Starting from the first paragraph (all points are taken from the official document about the Main results of the Euro Summit - Note that another 14-page document was published, which will also be used as a reference in paragraphs/points 3 and 6):

1. An agreement that should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. Euro area Member States will contribute to the PSI package up to 30 bn euro. The nominal discount will be 50% on notional Greek debt held by private investors. A new EU-IMF multiannual programme financing up to 100 bn euro will be put in place by the end of the year. It will be accompanied by a strengthening of the mechanisms for the monitoring of implementation of the reforms.

It is important to underline that since no details accompany this debt restructuring process, it is hard to tell whether the 50% figure is actual or indicative, nor is it feasible to accurately estimate its impact. Furthermore what does "nominal discount on notional debt" really suggest? The vagueness of this phrase allows for all sorts of twists and interpretations pointing to the fact that no real haircut was agreed upon.

2. The significant optimisation of the resources of the EFSF, without extending the guarantees underpinning the facility. The options agreed will allow the EFSF resources to be leveraged. The leverage effect of both options will vary, depending on their specific features and market conditions, but could be up to 4 or 5, which is expected to yield around 1 trillion euro (around 1.4 trillion dollar). We call on the Eurogroup to finalise the terms and conditions for the implementation of these modalities in November. In addition, further cooperation with the IMF will be sought to further enhance the EFSF resources.

The use of the phrase "without extending the guarantees underpinning the facility" suggests in a clear way that financial engineering will be used to ostensibly increase the firepower of the region's bail out fund. Though details remain to be seen, since again nothing tangible was announced, it is important to realize that European elites are oriented towards officially transforming the EFSF into a mechanism that will resemble the infamous derivatives that are to a very large extend the cause of the Great Recession. This will be the greatest failure of Europeans since markets will find out that Italy and Spain, together with all the other weak parts of the chain will be practically guaranteeing their selves, effectively suggesting that the only legitimate guarantees come mainly from Germany, France and from Netherlands, Finland, Austria who are nonetheless much smaller to effectively provide guarantees. Once markets work out the math, they will see that the expanded EFSF will be nothing more than a tower of cards, a toxic financial derivative right at the heart of a plan to provide a solution to the crisis.

3. A comprehensive set of measures to raise confidence in the banking sector by (i) facilitating access to term-funding through a coordinated approach at EU level and (ii) the increase in the capital position of banks to 9% of Core Tier 1 by the end of June 2012. National supervisors must ensure that banks' recapitalisation plans do not lead to excess deleveraging.

Having already examined the Annex 2 of the 14-page document of the Euro summit, I may say that it contains certain positive elements. The best of them is the acceptance of a system-wide/euro-wide strategy to deal with the banking issues. The point though is that despite the positive elements, it is impossible to estimate whether these are sufficient or not, given that the issues of the Greek debt restructuring and the expansion of the EFSF remain unclear, thus I would remain cautious over the effectiveness of this "comprehensive set of measures". Moreover the way in which recapitalizations will take place, first with banks being required to raise money from the market, then from national authorities and ultimately from the EFSF, is problematic, since banks will reduce even more the amount of loans they issue, thus affecting the real economy in a very negative way, by considerably reducing liquidity therefore retarding much-needed growth.

4. An unequivocal commitment to ensure fiscal discipline and accelerate structural reforms for growth and employment. Particular efforts are being deployed by Spain. New strong commitments on structural reforms have been made by Italy. Portugal and Ireland will continue their reform programmes with the support of our crisis mechanisms.

5. A significant strengthening of economic and fiscal coordination and surveillance. A set of very specific measures, going beyond and above the recently adopted package on economic governance, will be put in place.

About fiscal discipline I recently published an article titled "Stricter rules are good - Stabilizing Mechanisms are much better" in which I prove - once again - that the rhetoric about fiscal discipline is non-sense and so are the arguments of unidimensional stricter rules. The problem in Europe is not one of public debt, the crisis in Europe is systemic and has to do with the feedback loops between indebted states, quasi-bankrupt banks and the institutional gaps of the euro architecture which ultimately lacks a lender of last resort, plus all those stabilizing mechanisms and shock absorbers that would never allow divergence within the single currency area. Having said that, point 4 above is completely detached from the real situation while point 5 does nothing to provide any effective solution.

6. Ten measures to improve the governance of the Euro area.

These measures are  found in Annex 1 of the 14-page document. It basically is a series of steps to improve the coordination of efforts among European offices, laying down how the president of the Eurogroup, the President of the European Council and the President of the European Central Bank will orchestrate their actions. These are indeed positive provisions to hopefully make European institutions and bodies more effective, though judging by the bodies and agencies involved I doubt that bureaucracy will be reduced.

And the final point of the official document about the Main results of the Euro Summit:

7. A mandate to the President of the European Council, in close collaboration with the President of the Commission and the President of the Eurogroup, to identify possible steps to strengthen the economic union, including exploring the possibility of limited Treaty changes. An interim report will be presented in December 2011. A report on how to implement the agreed measures will be finalised by March 2012.

This final paragraph says a lot and at the same time says nothing. Vagueness permeates every sentence while it is clearly pointed out that further action will be taken on future dates implying once again that more needs to be done. Hence expect more dithering and delay.

The Euro summit is now over. In the first days there will be some enthusiasm in the markets. Yet once the dust has set, once the echoes of triumphant rhetoric of European elites fade away, once editorials are written pointing to the inanity of the latest summit, speculation will once again strike back on an unsuspected collective of political elites who have been extending and pretending for nearly two years now.

The 'comprehensive' solution that was promised, never came. Nothing concrete exists to backstop the fall of Italy and Spain as well as the deterioration of the position of Belgium and France. The failure to act, the inability to address the systemic crisis systematically, have left us all with a bitter aftertaste. A crisis that could have already been solved if timely decisions were taken and decisive steps were made, is transforming into an existential issue and there is no guarantee whatsoever that its destructive dynamic will stop.

Every postponement makes the crisis worse, allowing contagion to the core. This should have been the lesson from our experience so far - yet somehow European elites manage to repeat the same mistake again and again. What remains to be seen is whether the markets will tolerate this shadow play any longer. I hope they will otherwise the euro is finished.

Stricter rules are good - Stabilizing Mechanisms are much better

Ever since the crisis first caught Europe the prevailing idea has been that the blame should be put on excessive public debts and the ineffectiveness of the existing rules that govern fiscal issues in the Eurozone. There have been voices calling for the need to implement the Stability and Growth Pact in a stricter way, or to enable the Commission to impose sanctions and fines on member-states that fail to comply to a given set of rules. These and other similar proposals have appeared in various guises, stressing the need for greater control over national fiscal policies, implying that the problem in Europe is one of excessive public spending.

At a first glance this idea makes perfect sense, as it suggests the obvious: rules exist to be obeyed and therefore every state must live within its means since that is the gist of those rules. However there is a problem with this particular mode of thinking. It is trapped in a twin fallacy of first seeing European states and in particular Euro-states, as separate entities, where indeed the logic would be correct and second of viewing public debt in its own capacity as if the economy is not affected by any other factor. The very nature of integration and most specifically the very essence of a monetary union is that states cannot be treated as separate entities since their fortunes are intertwined. The more powers are drawn away from the national level, the more this individual capacity is lost. Moreover the economy is much more complex than the usual binary public-private and therefore the assumption that public debt is the problem omits a considerable part of the true story.

Public debt alone, is not necessarily a problem for as long as there are effective stabilizing mechanisms in place and for as long investors have faith in effectiveness of these mechanisms. For instance Japan has an exorbitant sovereign debt, however it borrows at much more favorable rates than many European countries whose debt levels are considerably lower. Similarly UK that has a quite higher debt than Spain borrows at more favorable rates. Why? because Japan and the UK are sovereign states that possess the necessary stabilizing mechanisms, whereas Spain and indeed every other member of the single European currency lack all those shock absorbers that would have never allowed the crisis to become as severe as it is. Note that the key words are not "sovereign states", the key words are "stabilizing mechanisms".

Below are the yield curves between Japan that has a public debt to GDP of approximately 220% (highest in the developed world) and Germany that has a debt ratio of around 80%, which show how Japan enjoys lower rates than Germany (by Bloomberg - data from October 25):

{Definition of yield curve according to the ECB website: "A yield curve is a representation of the relationship between market remuneration rates and the remaining time to maturity of debt securities, also known as the term structure of interest rates."  --- On the horizontal axis is the length of bonds, on the vertical axis are the interest rates}

Japan's yield curve

Germany's yield curve

Adding to the above are the graphs that compare on one hand the debt projections of UK and Spain and on the other the respective long-term interest rates, demonstrating (once again) that public debt is not the primary issue (from Paul Krugman):

Notice the second chart that in 2008 when the crisis caught the eurozone, how UK's interest rates fell while Spain's went up again despite the public debt of UK being higher at all times. Those who do not wish to abandon their dogma about public debts and strict rules will explain the above "oxymoron" as a product of "speculation" and "bias", when it would be better to just admit that other more profound issues are important.

The euro area must be treated as a single unified entity and not as an amalgamation of countries, even though it is far away from becoming a politically unified region and despite the fact that it lacks a common fiscal policy. The issue of high public debts is secondary in importance, since the primary cause of our troubles has always been the flawed architecture of the euro that lacks a series of stabilizing mechanisms that would allow the area to absorb the shocks with much less cost. This is crucial in order to understand why strict rules will never be enough. It is largely insufficient to rely on fiscal rules that do nothing to address three fundamentally important issues that can hold together a currency union:

1. a surplus recycling mechanism that will ensure the trade imbalances are restored by means of reinvesting with profit the accumulated surpluses into deficit regions in productive ventures, so as to achieve convergence and balanced growth [see A Plan for Europe – Interview with Thomas Colignatus (Part 1)], 
2. the ability to centrally finance projects, which means the need for a common treasury that will have jurisdiction over the same area the ECB has and will be granted the powers to raise money either via taxation or by means of issuing its own bonds, 
3. the ECB must be liberated from its rigid legal framework that does not allow it to monetize debts by acting as a lender of last resort.

These three do indeed require very strict rules, yet there is a qualitative distinction between the vagueness of "strict rules" and the clarity of "stabilizing mechanisms" that are accompanied by effective legislation.

The problem in the Euro area has little to do with public debts. What is really the issue here is the institutional gaps of the euro architecture, those gaps that European elites try to fill in from summit after summit. On the flip-side the euro area has an ill regulated banking sector. There would never be such pressures on the euro if banks were healthy and were able to supply the market with cheap liquidity that would reinvigorate private activity. Most European banks are in deep trouble and there ultimately cannot be any solution to the spiraling problems without a robust banking system.

The above should not be used an excuse to justify the profligacy of certain governments and the corruption wherever that existed. All this is written to point towards the direction of a correct diagnosis to our maladies. False diagnoses can potentially lead to lethal treatment. So far this is the fundamental issue we still have not addressed. Strict rules are good, but stabilizing mechanisms that go beyond the narrow understanding of perfectly separable cases and see the euro area as a largely unified entity, while also escaping from the narrow understanding of the economy, are much more favorable, effective and prudent.

The self-imposed restrictions to a solution at the EU summit

Officially we now are between two EU summits. One took place on October 23 with the aim to set the foundations for an agreement that will finally be reached at the next summit on October 26. In practice the meetings and negotiations have started from Friday and have been taking place ever since until they are concluded on Wednesday night.

European elites are called to find solutions on three main parameters with respect to the immediate issues that arise from the crisis plus a fourth that has to do mostly with institutional and governance issues:

1. Greek debt restructuring: the discussion on the so-called haircut and how big should that be and in what way should it be presented in order to avoid collateral damage such as the triggering of a 'credit event'.
2. The recapitalization of the system's quasi-bankrupt private banks first to make sure that they do not collapse to the mounting pressures and second to guarantee that they will survive the shock of a potentially big haircut on Greek debt.
3. The expansion of the firepower of the region's bail out fund, the EFSF, to allow it to effectively prevent the irreversible spread of the crisis to Italy and Spain, while also be assigned to provide in one way or another capital to banks.
4. Adding to these they are considering a fourth issue, that of closer economic governance, possibly through modifications in EU Treaties that will allow for some sort of greater control over fiscal issues from Brussels.This however does not provide any solution to current problems, it rather takes advantage of the situation to integrate further an area of policy that has remained at a national level.

So they have three issues to deal with regarding the purely short-term approach vis a vis the crisis and a fourth issue which will most probably pave the way for further economic integration, better economic governance. This will, in theory at least, provide a more credible preemptive measure to profligate public spending.

These issues are debated within a given political and legal context that is in this case very rigid. A number of self-imposed restrictions need be respected in whatever solution:

1. The ECB must at any rate remain independent in order to avoid a violation of its institutional role. In practice this implies that it must not be involved in any plan that will provide funding on countries for fiscal purposes. This is both a legal and a political matter. Legal in the sense that the ECB is by law restricted from getting involved in the fiscal issues of member-states as that violates the no-bailout clause. It is also a political one, since a possible intervention would be a bad precedent providing incentives on states not to carry on with what are seen as necessary reforms and with stricter budget control. The intervention of the ECB in the markets to buy Italian and Spanish bonds has always met stiff resistance both internally and externally and is likely to stop.
2. There must not be any eurobonds without prior fiscal integration. Here the issue is purely political, even though one might seek to attach to it an argument of legality. The introduction of eurobonds can potentially create incentives for inaction, which would suggest that Italy and Spain do not have the pressure to implement reforms. Moreover Germany and the other surplus countries will never accept such provisions without a fiscal union in place that would guarantee no irresponsible spending occurs.
3. The haircut on private investors that hold Greek debt must be done in such a way that will not trigger a credit event that would imply the payback of CDS contracts. In practical terms the process be designed in a manner which private investors will "voluntarily" accept whatever losses so as not to consider the loss as a partial default. Here the issue is technical, yet its importance is cardinal, since any miscalculations could lead to adverse effects. Greek debt must be reduced but at the same time it must be presented in a way that is acceptable by market standards.
4. Any debt reduction in Greece must be done in a way that will deter others from following a similar path in search for debt "redemption". In other words debt reduction will be accompanied by quite unpleasant measures and political conditions that will create the necessary deterring effect on others.
5. The expansion of the EFSF must be done in such a way that no more taxpayer money needs to be utilized so as to avoid any further political costs from the already unsatisfied national electorates of most countries. The growing anti-bailout sentiments force politicians to seek ways of using financial engineering to expand the EFSF.
6. The BRIC (Brazil, Russia, India, China) countries and other emerging markets, must not be allowed a bigger say in internal EU issues. Their help will be well-accepted but only if the conditions are favorable for Europeans.

Three topics to deal with the immediate effects of the crisis plus a fourth to better control fiscal policy. Discussions on these topics must not violate the above-mentioned six axioms. Can our leaders be creative enough to come up with a package that is both viable and compliant to the legal and political restrictions? Or will this rigidity and the lack of options give birth to yet another series of half-measures that will die at birth, just like the decisions of the July 21 summit? At Wednesday night answers to these and many other questions will be delivered and the world will know whether Europeans are able to stand up to the challenge of solving their problems.

Analysis of Greek debt sustainability based on the Troika report

The latest report from the Troika about the sustainability of the Greek debt has made it crystal-clear even to the most optimists that the public debt of the country is unsustainable and that haircuts of 50%-60% will be necessary. Note that this figure holds true only in the case Greece runs large primary surpluses for years - that means surpluses not including interest payments - in an already deeply depressed economy. This is however a brave assumption that might easily be proven far from true, which suggests that the haircuts will have to be increased and expanded.

At any rate an analysis of the troika's "strictly confidential" report will allow us to better understand what European leaders will be called to agree upon in today's (October 23) and Wednesday's (October 26) EU summits. I need to say that I hold some reservations regarding the authenticity of this report, however it was republished in the Financial Times and referenced by important analysts such as Paul Krugman and many other esteemed news sources, which at least provides some cover.

The report (taken from Credit Writedowns) starts with the following:

Since the fourth review, the situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform driven increases in productivity. The authorities have also struggled to meet their policy commitments against these headwinds. For the purpose of the debt sustainability assessment, a revised baseline has been specified, which takes into account the implications of these developments for future growth and for likely policy outcomes. It has been extended through 2030 to fully capture long term growth dynamics, and possible financing implications.

The assessment shows that debt will remain high for the entire forecast horizon. While it would decline at a slow rate given heavy official support at low interest rates (through the EFSF as agreed at the July 21 Summit), this trajectory is not robust to a range of shocks. Making debt sustainable will require an ambitious combination of official support and private sector involvement (PSI). Even with much stronger PSI, large official sector support would be needed for an extended period. In this sense, ultimately sustainability depends on the strength of the official sector commitment to Greece.

From the outset the report puts everything into context making a clear statement towards the need for bigger haircuts on private investors. In addition to that it underlines the importance of continuous official support even if PSI becomes much stronger. Even with the revised baseline public debt will remain at very high levels, well above 100% to GDP up until 2030.

About the revised baseline, the report includes:

Recent developments call for a reassessment of the assumptions used for the debt sustainability analysis. Since the fourth review, the situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity. The authorities have also struggled to meet their policy commitments against these headwinds, and due to administrative capacity limitations in the Greek government. The growth and fiscal policy adjustments assumed under the program individually have precedent in other countries’ experience, but experience to date under the program suggests that Greece will not be able to set a new precedent by realizing at the same time and from very weak initial conditions a large internal devaluation, fiscal adjustment, and privatization program.

And follows with a number of more likely policy and macroeconomic outcomes than need be included in order to give debt sustainability a firmer founding. Namely slower recovery, lower privatization proceeds, reduced fiscal adjustment needs,  delayed access to market financing. With all these parameters taken into account the drafters of the report note the following:

Under these assumptions, Greece’s debt peaks at very high levels and would decline at a very slow rate pointing to the need for further debt relief to ensure sustainability. Debt (net of collateral required for PSI) would peak at 186 percent of GDP in 2013 and decline only to 152 percent of GDP by end-2020 and to 130 percent of GDP by end-2030. The financing package agreed on July 21(especially lower rates on EFSF loans) does help the debt trajectory, but its impact is more than offset by the revised macro and policy framework. Greece would not return to the market until 2021 under the market access assumptions used, and cumulatively official additional financing needs (beyond what remains in the present program, and including the eventual rollover of existing official loans) could amount to some €252 billion from the present through to 2020.

Graph 1

The troika makes the following comment regarding the above graph:

Stress tests to this revised baseline illuminate further the problem with sustainability, revealing that the downward debt trajectory would not be robust to shocks

And the final kick is given with the following graph which shows how unsustainable Greek debt can become if privatization is lower than anticipated.

Graph 2

According to graph 2 and after considering what is seen as the best case scenario, Greek sovereign debt will peak roughly above 180% to GDP between 2012~2013 and will gradually fall to around 120% to GDP by 2030. If however privatizations do not yield the expected results then the debt levels will be significantly higher throughout the whole time horizon, with an estimated public debt of close to 160% to GDP by 2030. The gist of this graph is that even with the revised baseline Greece will practically not be able to access markets until at least the 2020 decade. As for the worst case scenario, Greece will practically start counting lost decades. All this holds true given the assumption of stable growth.

However the troika's officials made clear the case that debt dynamics can easily go for the worse if permanent growth and interest rates experience shocks:

Permanent growth and interest rates shocks can lead to unsustainable debt dynamics:

Growth. Results can be very sensitive to growth outcomes. Fixing the primary balance, permanently lower growth (-1 percentage point each year) would render debt clearly unsustainable, while higher growth (+1 percentage point each year) would lead debt to fall to just under 130 percent of GDP by 2020. Allowing fiscal feedbacks—with higher growth making it easier to sustain a higher fiscal adjustment and lower growth making it easier to fall permanently short of targeted adjustment levels—would reinforce these outcomes. There is also a second endogeneity at play, whereby strong growth will be very hard to achieve unless Greece’s high debt overhang is decisively tackled. Overall, the scenario emphasizes the crucial importance of frontloading growth-enhancing structural reforms for debt sustainability.

Spreads and Bund rates. If new market access would take place at slightly different levels, this would not have a large impact on the debt level. For example, if return to markets is at 150 bps higher than the baseline but primary balances are unchanged, debt-to-GDP levels would be only slightly different by 2030. Essentially, Greece is not in the market in this scenario until late the second decade, limiting the need for new market financing, and thus the impact of interest rates. However, higher Bund rates, which would affect the rates for the heavy volume of official borrowing, would limit the debt decline in the second decade once potential growth starts to slow down and result in debt stabilizing at a very high level (about 150 percent of GDP).

Finally the report sends a clear message to policy-makers ahead of of the two EU summits of October 23 and 26 regarding the case of Greece. It stresses the need for "large, long term, and sufficiently generous official support" and the importance of "deeper PSI":

Making Greek debt sustainable requires an appropriate combination of new official support on generous terms and additional debt relief from private creditors

As mentioned in the introduction the latest report from the troika tells policy-makers what the markets and the independent analysts already knew: that Greek debt is unsustainable and the so-called "haircut" of 21% deriving from the PSI that was agreed on July 21 was nothing compared to the actual debt reduction that is necessary. I am afraid to point though, that the report is still optimistic, given that a 50% or even 60% haircut will still be insufficient for Greece alone and of course to properly appreciate the impact of the haircut one needs to take into account the broader crisis in the Euro area and the effect a debt reduction will have on Europe's private banks.

Given that the private investors that will be called to take a considerably bigger haircut mainly are European banks, who are in one way or another intertwined with European states, it seems that the debt relief of Greece is basically a reallocation of the problems rather than a solution to them, since what will be lost in private investments will have to be covered by bank recapitalizations, which will in their turn affect public finances of other states. It becomes evident that if we were to focus on Greece alone we would reach the conclusion that debt relief is the solution to the sustainability of Greece's public debt, yet once we have a look at the broader picture of the systemic crisis of the euro we see that all we have is a broader ad hoc quasi-mutualization of the problems, which will in practice only succeed in buying time for politicians until they finally agree on how to address the crisis in its totality by implementing system-wide measures, effectively abandoning their current approach of perfectly separable local/national crises. More shall be said once the summits are over and we have the final decisions in our hands.

An argument on whether we need Referenda on EU Membership

I was asked to submit my views on Debating Europe regarding the question "Do we need Referenda on EU Membership?". Here is what I wrote:

There are a few problems with referenda that need be clarified before answering the principal question of whether EU membership should be decided through such a decision-taking process.

First a referendum though it has always been seen as the ultimate expression of democracy, isn't in fact democratic, since people do not really put forward their desires and their ideas, but are rather called to decide on two predetermined alternatives they had no impact on. A referendum would have been democratic if the options included, where themselves the outcomes of localized direct decision making, using the power of the Internet and/or other media to collect the views of the everyday citizen at the lowest possible level. For as long as the options and the content of a referendum are decided by a selected minority that in many cases is comprised of unelected bodies completely detached from the individual voter, then such processes are democratic only in name not substance. But for argument's sake let us assume that a referendum is indeed democratic and since we want to call our societies democracies we should use this method of decision-taking on a regular basis or at least on important issues. The second problem that immediately emerges exists in asymmetric information and the over-simplification of things that cannot be over-simplified.

Asymmetric information and technical difficulties: How can citizens decide on EU membership when they do not know every aspect of it? I am not saying that people are incapable of making the right decisions, I am only raising an issue of technicality since let us not forget that the EU Treaties comprise of a vast legal corpus which is hard even for law experts to grasp in full. Now let us assume that these documents are presented in a way that is understandable to everyone, to reach the next aspect of the technical issue: How can one evaluate the implications of these rules without having full or good knowledge of the issues these rules affect? How can one decide on CAP or Schengen or the Euro or any of EU realm of policies without knowing the direct and indirect effects and implications. This of course does not only apply to citizens but in many cases holds true for politicians and political parties.

Over-simplification: Albert Einstein famously said that "things should be made as simple as possible but not any simpler". A mere "yes" or "no" on EU membership violates Einstein dictum in three ways: (a) It over-simplifies the EU itself. EU is not a monolithic organization. It rather consists of numerous institutions dealing with a variety of issues in a number of dimensions. In short the EU is a very complex nexus that involves diverse power groups of all sorts. So which EU will citizens be called to decide upon which again brings us to the question of asymmetric information, (b) It does not clarify in any way what are the costs and benefits of membership and of non-membership. A work which again requires a deep understanding and analysis of the EU and the state's policies and objectives, (c) it over-simplifies the answers. The options the citizen is given in a referendum do not state his/her intentions or preferences. This is true not only in the case of a mere yes-no binary but also in more expanded answers. The point is that the options available will always be vague, allowing anyone to interpret them at will, effectively distorting the possible message citizens wanted to send, assuming they all had the same thing in mind when choosing a particular option which frankly speaking is never the case.

Let us consider for instance that all of the above are somehow dealt with so we can proceed to the fundamental question "Do we need Referenda on EU Membership?". This question is in itself problematic for it fails to shed light on a series of interrelated issues. How will a referendum solve let's say the crisis in Greece? Or how will it make the Common Agricultural Policy a rational plan of allocating resources, instead of the wasteful anachronism it now is? Or then again is a referendum a prudent option in times of social unrest where extreme sentiments often prevail over reason? Driving this train of thought towards its logical conclusion will only lead us to a mere "No".

What we need in Europe is not referenda that ask vague things and provide dubious options; we need an organized civil society, critical and demanding citizens that will demand a bigger say at the lowest possible level, which will effectively cover a considerable part of the current democratic deficit of the EU. Democracy is not exercised every four-fives years or whenever there is a referendum. Democracy is an everyday struggle where every individual has the duty to decide on what the common good is, while at the same time effectively working for his/her own well-being.

A collective of bureaucrats sending dictates from a "command center" in Brussels is certainly not a good thing. However referenda are for sure not the answer to it. The illusion of choice a referendum gives does nothing to address the fundamental democratic problem of our times: that unscrupulous big interests have the capacity to influence in the any way they want our cumbersome, big governments/bureaucracies.

Issues are so subtle and complex that cannot be brought down to a mere binary of "yes or no". This does not mean that citizens are incapable of making the right decisions for themselves. It is only a reminder that citizens need to become active in political life, so as to improve their states and eventually the EU as a whole.

The Shadow Play of uncontrolled European disintegration

The upcoming EU summits on October 23 and 26 will eventually produce a Faustian bargain. A plan that will be too little-too late, oriented towards the wrong direction. European leaders have been in denial of the systemic nature of the crisis and have been dithering for long now. Their ad hoc, self-defeating half-measures and policies muddled through kick the can forward, pray and delay; have only succeeded in transmogrifying a controllable crisis into an existential issue for the Euro and consequently the ideal of a common Europe.

The inanity of never-ending, front-loaded austerity, the continuing denial of private European bank's near-insolvency together with the inability to solve the issues of under-investment and investment flows, have all led to a process of disintegration and deterioration. This process starts from the very design of the euro architecture that was never meant to withstand a shock-wave of such proportions and extends to the ill regulated European banking system which produced mountains of debt that everyday citizens have time and again been called to pay by means of draconian austerity, bank bailouts/recapitalizations and bailouts to individual states who in their turn use the lion's share of the funding to pay back their creditors, Europe's banks.

The vicious cycle between insolvent states, quasi-bankrupt banks is reinforced and its destructive power accelerated by means of insisting on the perfect separation of the local/indiviual crises that have given birth to a toxic bail out fund, the EFSF, that has the unique "ability" of putting further pressure on the collapsing euro edifice by increasing the debt ratios of its contributing member-states.

The sort of treatment to the crisis European leaders are suggesting is equivalent to the treatment physicians offered their patients during the Middle Ages in Europe, when fever was "cured" by opening a wound to release blood, ostensibly to lower the body's temperature. In most cases the patient died from bleeding yet physicians continued their failing practices, putting the blame of the death on the severity of the fever.

A false diagnosis leads to a potentially lethal cure. This is exactly what policy-makers are now planning to do with the leverage of the EFSF. They are thinking of utilizing methods of financial engineering to treat a problem of financial engineering and over-leverage. In addition they have been supplying insolvent states with expensive bailouts accompanied by a poisonous austerity drug, with the groundless hope they will recover, when in fact their position worsens and their eventual bankruptcy becomes worse and tougher to bear.

Summit after summit, press conference after press conference and statement after statement by various EU officials and state leaders set up a shadow play of cynical hypocrisy, in which the human costs of lost generations are already seen in the mountains of debt that are constantly being accumulated with every step Europe makes in its downward path to hell and by years of under-investment and crippled growth.

There is no future in the way policy-makers are currently treating the crisis. There will certainly be no solution to the spiraling problems of the Euro Crisis in the upcoming summit(s) that continues on the same path of previous meaningless summits. European leaders have not found the courage and the will to treat the systemic problem systematically. Their shadow plays, the theaters of absurdity that are usually being concealed by pompous rhetoric are contributing to the process of disintegration in which we all find our selves in.

Sixty years of European integration can be brought to an abrupt end, thanks to a few years of inability to act. Europe can solve its problems but for now and for the near future it continues to deny its duty. The worsening of the crisis in Europe will plunge the whole world in another Great Depression; a despicable mire that will see partners putting the blame on each other effectively shattering what was constructed over the last decades. The sooner European elites come to realize their responsibility to act, the fewer the costs will be.

Greece must change bottoms-up and so must its people

Greece was ill administered ever since democracy was restored in 1974 after the fall of the military dictatorship. The people who once demanded progress and change in their struggles to overthrow the oppressive military junta, became traitors to their own principles and effectively caused more harm than good once they gained power, by abandoning the values they had espoused and allowing for corruption, maladministration and bureaucracy to create a state that was 'devouring its children' just like Kronos did in the Greek mythology.

The Greek state became the fief of the country's two major parties New Democracy and PASOK (Pan-Hellenic Socialist Party). The infinite capacity in corruption of these two parties, made public finances the vehicle through which every ignorant charlatan would be granted riches and benefits at the expense of broader society. Public money were wasted in cumbersome bureaucratic procedures, malinvestments and partitocratic practices that bought votes.

Every single Greek was well aware of what was going on in the country. Everyone has contributed in bringing Greece to today's misery. Certain individuals have greater responsibility than others and certain politicians played a catalytic role in the process, yet this should not be an excuse of not judging the people. The people are those who voted for the politicians they now blame, the people are those who never protested against corruption and partitocracy.

The state is the people. This should be made clear to every Greek who now searches for the malevolent politicians that created this situation. Corrupted politicians are the reflection of a malignant society. Every single citizen has the duty to care about who he/she elects to power and should constantly scrutinize political actions to provide the necessary checks and balances a truly democratic society needs. It is essential to realize that only people have responsibility and if they do not care then things will eventually go for the worse. So far Greeks were caring about their own self even if that implied working against the state and effectively the public good, by endorsing corruption.

Greece must change bottoms-up if it is to survive in the modern era as a member of the EU and as a respected state that provides a decent living to its citizens. In that sense the troika's demands are well-justified and welcome, since the internal system would never make the tough choice to change itself. Note that the need for drastic changes is fundamentally different from the madness and inanity of front-loaded austerity. To put it otherwise, I absolutely agree with the ends of the troika but I strongly disagree with their means (see The fiscal discipline delusion and Full analysis of the Euro Crisis).

Those who do not want to see the truth. Those who still demand from the state to provide them with all sorts of objectionable benefits; those who are putting all the blame on individual politicians or on the party they oppose, can continue to live in oblivion as they have done for ages. The rest of society needs to move forward and this can only be done through much-needed reforms and by realizing that each one of the citizens is the state.

The tragedy of the Greek Crisis: Economic paralysis and social unrest amid fears of implosion

Greece is practically bankrupt since May 2010 when it lost market access and came to the need of a bailout co-financed by the EU and the IMF, that has technically postponed the inevitable default ever since. For months now the Greek government which no longer serves as a sovereign authority that represents the Greek people, but as a mere group of filling clerks completely subjugated to the dictates coming from the troika's officials (EU-IMF-ECB), has been implementing draconian austerity measures that have put the Greek people on the edge, have raised unemployment close to 20% (around a million people) and have led to a very deep recession in the economy. The so-called fiscal consolidation policies have only succeeded in obliterating the Greek middle and lower classes. The continuing injection of the same poisonous austerity drug in conjunction with rising inflation and falling aggregate demand has slashed into pieces the productive forces of the Greek economy and has effectively guaranteed that not even supply-led growth will be possible in the short-to-medium term.

The Greek economy remains stagnant for many months now. One tax is incremented on top of the other every few weeks. The rising costs of taxation combined with continuous work strikes in important sectors of the economy, the reluctance of private banks to supply liquidity (if and wherever possible), plus the increasing fears of the state defaulting on its debt obligations have all played their part in bringing down whatever barriers to bankruptcy might have existed before. Meanwhile the society is forced to endure the excruciating pain of the shock therapy treatment that is being implemented by the troika and its assignees. The people's reaction to the harsh austerity has been decisive and incessant. Currently there is an ongoing general 48-hour strike that started on October 19. The continuing demands for tightening the belts have only been producing adverse effects since neither the economy can readjust to the ongoing reforms and "reforms", nor the society can survive the transition. The market is totally paralyzed and the society is falling into chaos and anarchy. An implosion with unpredictably destructive consequences is quite possible.

It is true that Greece was badly regulated, highly corrupted and very ineffective. The politicians, the citizens can - and must - be blamed for all the malignancies of their economy-society-state that have made the internalization of the systemic crisis of the euro so severe. However the mere acceptance of the truth is fundamentally different from accepting and resorting to the sort of self-defeating front-loaded austerity that does not take into account human costs. The sort of measures that are being implemented in Greece go far beyond the scope of making reforms and addressing structural rigidities. They are a cruel form of punishment rather than a treatment that would above all guarantee the survival of the Greek 'patient'.

Greece must change and the Greek people must understand that ongoing strikes that ask for money, as if the state is a big cornucopia, a big source of wealth that remains to be exploited, only lead to a dead-end. All that continuous strikes achieve is to worsen the position of the country, both because the economy loses a considerable amount of income and because European partners see no reason to keep supporting Greece, since they witness their money being wasted. As a sentimental agent I fully understand the Greek people, I myself am experiencing the effects of this economic agony, yet as a rational agent I know that default and exit from the euro and the EU will literally destroy the country and will bring its people in front of a far greater nightmare. This should not imply however that the troika should ask for just about anything by exploiting the ghost of bankruptcy. They too must understand that many of their demands go against any economic reasoning. The troika or any other should not abuse its power to make an example of Greece, of how it is to disobey the rules. Now the troika is going too far and thus is partially responsible for the situation in the Greek interior.

What I wish to say to my fellow Greeks and to my fellow Europeans is that there is no point to search for scapegoats now. These hours require unity and solidarity. It will be disastrous for the Greeks to put all the blame of their misfortunes on the "cruel" Germans and ignore their own responsibilities, just as it is foolish for the Germans to blame the "lazy" Greeks for causing the crisis as if the euro architecture was stable and Europe's private banks were healthy. Moreover it is objectionable to use Greece as a means to achieve political ends. In Europe we are facing a crisis of the euro, a systemic crisis that will only be solved with system-wide measures (see Full Analysis of the Euro Crisis). If the upcoming EU summit on October 23 does not provide such measures and if those who hold the fates of Europe do not realize the severity of the moments and the weight of their decisions then I am afraid of the worst...

Questions and Answers on the October 23 summit for the Euro Crisis

Lately I have been receiving many questions from my readers regarding various issues related to the next steps European leaders are about to make in the upcoming summit on October 23. I have found many of these questions worth answering in public. Below is a list of the questions I will be answering:

1. What are the main parameters of the new plan for Europe?
2. Greece will have its debt restructured. What does that imply?
3. What does it mean for the ordinary taxpayer to recapitalize banks?
4. The region's bailout fund, the EFSF, will be 'leveraged' to expand its funding capacity. What about it?
5. Will Greece exit the euro?
6. Can Europe solve its problems?

1. What are the main parameters of the new plan for Europe?
The details remain to be announced after the summit. From the available information the new plan will be established on three pillars. First there will be a restructuring of the Greek debt. The so-called haircuts on private investors might reach as high as 50%. If this is a real debt reduction and not a rollover of the debt in the future it means that the debt of Greece will be cut in half.  This is fundamentally different from what was the case of the July 21 summit's decision for Greece. In that case the Private Sector Involvement (PSI) would ostensibly result in a 21% "haircut" for private creditors, when in fact it was an exchange of current bonds for bonds with longer maturities and the 21% was the discount in present value - in practice part of the debt would pass on to the future effectively not reducing the amount of the Greek sovereign debt. Now they are not talking about a rollover of current debt to the future, they are talking about reducing the total amount of debt by accepting that part of it will never be paid back.

The second pillar is a plan to recapitalize private banks. The exact form that plan will take remains to be seen. From what information is currently available it seems that it will be quite technical in the sense that it will first expect from national authorities to carry the task and if those are unable to do so, then the EFSF would step in to provide the necessary funds. Banks need to be recapitalized for two reasons. Namely to consolidated at least temporarily their troubled finances, second because a Greek debt restructuring will lead to considerable loses for many banks and will create a shock wave that needs to be contained to avoid unpleasant consequences.

Third is the expansion of the funding capacity of the EFSF, the region's bail out fund. This will be done through a very technical process called 'leverage' that need not be explained here. The gist is that the EFSF will guarantee a portion of the debts of troubled countries (for now its main focus is Italy and Spain).

2. Greece will have its debt restructured. What does that imply? 
There are two dimensions to the matter. The first is the purely national and has to do with what are the implications for Greece, while the second is the European and relates to the impact this will have on the rest of the eurozone. To a large extend those two overlap, yet for the sake of explanation will be treated separately.

The dimension of Greece first. If the restructuring is about reducing the total amount of Greece's debt, then this means that the burdens will be reduced and future generations of Greeks will not have to bear the current immense costs. Of course this must not be seen as a gift to the Greek people, since it will be accompanied by draconian austerity and radical reforms in the economy that will aim to dismantle what is seen as a nexus of internal market rigidities. The debt reduction will come with immense pain for the people of the country so those local political powers who are deluded that the debt restructuring is only good news should think twice.

Now the European dimension. A restructuring of the Greek debt implies that private creditors, who are in their vast majority European banks, will have to accept loses which in many cases are unable to endure. In practical terms this suggests that many banks will run short of capital and will face the threat of closing operations. The case of Dexia is just the tip of the iceberg since the whole European banking system is deep in the hole, with many banks being in a zombie-like condition for years. That is partially why the plan will be accompanied by bank recapitalizations.

3. What does it mean for the ordinary taxpayer to recapitalize banks?
It means that governments will use taxpayer money to prevent banks from collapsing. For most people this is outrageous yet even though I also hate to say so, it is more than necessary since if banks are allowed to collapse then all the savings of everyday people who have been working hard for all their lives will be lost - and if savings are lost the resulting misery and the agony will be many times greater and much harder to bear.

Apart from the economic aspect of the matter which relates to prevent the entire system from collapsing, with catastrophic ramifications for everyone, there is a moral issue as well, that is summed up in the following question: Why should everyday people pay for the loses and the gambling of a small minority of bankers? I agree that this is morally wrong and that states should not indirectly support reckless spending by bailing out banks. But I am afraid to say that at the point we currently find our selves in we have no alternative. To satisfy this moral argument bank recapitalizations should be done in exchange for shares which practically means partial (or total in some cases) nationalization of private banks. For me this is the most realistic approach, that prevents the system from falling apart and that partially satisfies the popular demand for justice since buying shares means that the current governing boards will be replaced by people appointed by governments, to at least gain some control.

4. The region's bailout fund, the EFSF, will be 'leveraged' to expand its funding capacity. What about it?
This is a very technical issue. To put it simply the EFSF will be modeled like a financial derivative, like an insurance that will guarantee a portion of the debts of Italy and Spain (those two countries are the main focus now). This will allow its funding capacity to be increased up to five times. In theory the EFSF will be able to provide funding to Italy and Spain for approximately two years during which policy-makers will have to come up with something else to deal with the underlining malignancies of the system. In other words this can only buy some extra time but cannot possibly solve the crisis.

As a sentimental agent I say that it will work since I do not even want to imagine what will happen if it fails, but as a rational agent I am afraid to admit that an issue of over-leverage cannot be dealt with a leveraged mechanism and hence the whole plan will eventually fall into jeopardy, since markets will know how to attack it.

For a quite technical analysis on the matter you may visit this article on Zero hedge.

5. Will Greece exit the euro?
The answer is "no". There is absolutely no chance that Greece will exit the euro for economic and political reasons. The economic part relates to the fact that this would be disastrous for the Greek economy and for the rest of the euro area, while the political part has to do with the fact that such a decision will become a very bad precedent that will have serious implications on everyday political life in Europe, by hindering the sense of integrity that now exists. Greece will only exit the euro if the single currency collapses. There is no other way. The analysis as to why is this true has been provided in previous articles of mine and I highly recommend you have a look at 1) Currency union and Greek Euro Exit and 2) Exit of Greece from the euro is nonsense.

6. Can Europe solve its problems? 
Yes of course, since the crisis in Europe is above all political. The complexity of European politics is what has made the crisis so severe. In my latest article titled The current economic and political situation in the Euro Area I documented the following parameters of the current political situation in the Euro Area:

The political situation:

• Regardless of how cynical this might sound, the crisis is seen as a unique opportunity to push for the most radical reforms in countries that have been unwilling to implement the necessary changes over the last years/decades (the shock therapy approach). In practical terms, the immense pressures that arise from the prospect of default in Greece first and then in Portugal, Ireland, Italy and Spain give the power to the rest of the eurozone countries to use their economic support as an incentive to demand much needed reforms.
• Germany, Netherlands, Austria and Finland possess immense bargaining power over the rest of the countries, because of their much more favorable economic position. On the other hand countries like Italy and Spain, despite the fact that they are the 3rd and 4th largest economies of the euro do not even dare to think of speaking their mind as that could easily produce adverse effects in the markets, leading interest rates to new heights, making their position even worse.
• Because of their inability to make propositions, these two countries are trapped in a position where they cannot have any practical impact on political decisions and on the other hand must implement austerity measures that further worsen their economic situation by contracting their economy. Austerity needs to be implemented for the sake of showing compliance to the hard line of the surplus countries and for appeasing the markets, since inaction would be conceived as a sign of inability to deal with fiscal issues, again leading to uncertainty and unrest which would affect interest rates on sovereign bonds (see The ECB captivity and the Italian, Spanish and Belgian prisoners).
• Greece is treated in a way that causes excruciating pain to its society. The harsh treatment is used as a detterant to any other country, sending a clear message that reforms must take place to avoid the suffering Greece is forced to endure. It is crystal clear that the demands of the 'troika' from Athens go against any economic reasoning and even though most can agree that reforms are more than necessary no sensible person would offer her consent to the sort of austerity policies the troika's officials put forward. The malignancies of the Greek economy-society-state are deep seated and need to be addressed in their totality. Yet this must be done in a way that does not kill the patient.

Europe can solve its problems but must finally choose to do so. I hope the above have provided sufficient answers to the questions of many people out there and have offered food for further thought as to what we should expect from now on.

The current economic and political situation in the Euro Area

European leaders are expected to agree on a 'comprehensive plan' to deal with the spiraling crisis of the euro. The final document will derive from the upcoming summit on October 23 and for the time being many technical details and other parameters remain unknown. From the information available it seems that it will include provisions to restructure the Greek sovereign debt, recapitalize private banks, expand the funding capaicty of the EFSF.

In the midst of all the bargaining that is taking place on the backscenes of European politics as every one prepares for the summit, it would be useful to have a look at the current environment in the eurozone to understand how difficult, yet absolutely essential, it is to agree upon a comprehensive package that will stem the crisis.

The environment in which the summit will be held is quite bleak and the issues that need to be addressed are multifaceted. A depiction of the economic and political situation in the euro area will allow us to appreciate where the eurozone currently stands and what challenges policy-makers face.

The economic situation:

• Many European banks have been in a zombie condition for long now, retarding growth by absorbing all the liquidity that is thrown their way. Their underlining insolvency was never addressed and thus they have been acting like black holes to the system (see Dexia zombie bank: The tip of the iceberg and the derisory stress tests)
• Greece is insolvent and will sooner or later have to restructure its debt, with haircuts on private creditors reaching 50% or more. An exit of the country from the euro is economically self-destructive and politically impossible. Any plan about the fate of Greece must be within the context of the single currecy (see Currency union and Greek Euro Exit and also Exit of Greece from the euro is nonsense).
• Portugal and Ireland, have qualitative differences between with the former being in a more difficult position than the latter. Yet both remain vulnurable to any volatility in the rest of the eurozone and therefore can easily fall back into serious trouble should the situation deteriorate.
• Italy and Spain are solvent but lack liquidity, which raises fears about their capacity to finance their short-term needs. This effectively leads to a self-fulfilling cycle where the expectations of default lead towards that direction. The two countries have practically lost market access however this is not visible at the moment thanks to the contast intervention of the ECB, which can only buy time until a stable solution is found.
• Belgium and France are both solvent and have no liquidity problems (for now), but their private banks are seriously exposed to the debts of the European South, which suggests that the amount of capital that needs to be pumped into these banks is considerably higher than that of other countries. Should such a task be left to be dealt with at a national level both Belgium and France will have a hard time recapitalizing their banks, as they will effectively further worsen their already unstable public finances. This will most probably result in downgrades from the major credit rating agencies. It is fundamentally important to realize that if France loses its AAA credit rating then the EFSF, which largelly depends on France's credit rating, will fall into jeopardy, taking down with it the programmes in Ireland and Portugal and whatever other task might be assigned to the region's bail out fund.
• The surplus countries of the area, Germany, the Netherlands, Austria and Finland are in a much better position and in fact are the only countries that still have an option that others do not: they can bail themselves out of the euro should things go for the far worse (even though this is not what they wish to do and this is not an optimal choice). However the overall slowdown in the global economy and the recession in the European periphery has reduced aggregate demand for their exports.
• Inflation in the euro area has remained high and has now reached 3% according to the latest eurostat report. The ECB needs to maintain a hawkish approach by keeping main interest rates at least stable, however this will further worsen the liquidity issues of Spain and Italy (see Evaluation of inflation and unemployment amid the Euro Crisis).

The political situation:

• Regardless of how cynical this might sound, the crisis is seen as a unique opportunity to push for the most radical reforms in countries that have been unwilling to implement the necessary changes over the last years/decades (the shock therapy approach). In practical terms, the immense pressures that arise from the prospect of default in Greece first and then in Portugal, Ireland, Italy and Spain give the power to the rest of the eurozone countries to use their economic support as an incentive to demand much needed reforms.
• Germany, Netherlands, Austria and Finland possess immense bargaining power over the rest of the countries, because of their much more favorable economic position. On the other hand countries like Italy and Spain, despite the fact that they are the 3rd and 4th largest economies of the euro do not even dare to think of speaking their mind as that could easily produce adverse effects in the markets, leading interest rates to new heights, making their position even worse.
• Because of their inability to make propositions, these two countries are trapped in a position where they cannot have any practical impact on political decisions and on the other hand must implement austerity measures that further worsen their economic situation by contracting their economy. Austerity needs to be implemented for the sake of showing compliance to the hard line of the surplus countries and for appeasing the markets, since inaction would be conceived as a sign of inability to deal with fiscal issues, again leading to uncertainty and unrest which would affect interest rates on sovereign bonds (see The ECB captivity and the Italian, Spanish and Belgian prisoners).
• Greece is treated in a way that causes excruciating pain to its society. The harsh treatment is used as a detterant to any other country, sending a clear message that reforms must take place to avoid the suffering Greece is forced to endure. It is crystal clear that the demands of the 'troika' from Athens go against any economic reasoning and even though most can agree that reforms are more than necessary no sensible person would offer her consent to the sort of austerity policies the troika's officials put forward. The malignancies of the Greek economy-society-state are deep seated and need to be addressed in their totality. Yet this must be done in a way that does not kill the patient.

The above form the environment in which European leaders are called to agree on a plan to deal with the crisis. An objective observer might be led to the conclusion that Europe is unable to solve all of its problems since what might pose as a solution to one is in fact a problem for the other. Indeed the multi-dimensional issues and the overall complexity of the matter give the impression of clashes of interest in more than one occassion. However such a conclusion would have been logically flawed and a serious misunderstanding of the fundamentals of the crisis of the euro.

What we are facing in Europe in not a series of perfectly separable issues. All of the above are interconnected and all trace their roots in the systemic nature of the euro crisis (see Full analysis of the Euro Crisis). The only way to deal with the challenges ahead is to abandon the current understanding that treats the crisis as an amalgamation of otherwise individual cases that can be dealt with on a case-by-case basis. We need a system-wide approach instead that will take into account all of the above. Such an approach is feasible and there are a series of steps that can be taken towards that direction. What is required first and foremost is political willingness and hopefully this will exist on the following summit, given the severity of the moments.

About the plan for Greek debt, bank recapitalizations, bigger EFSF

The next EU summit on October 23 is fast approaching and European elites are working on a multi-faceted plan to contain the crisis. The new plan for the Euro crisis has three facets: 1) Greek debt restructuring, 2) bank recapitalizations, 3) increase of the funding capacity and scope of the EFSF. Though the plan is not yet finalized as its exact form will be determined on the next summit, it still is possible to make some early assessments by taking into account the systemic nature of the crisis.

By systemic crisis, I mean a malady of the system, which in this case is the euro architecture itself that lacked the necessary stabilizing mechanisms to prevent the crisis from becoming so severe; and also the lack of a unified and well-regulated banking sector (see Full Analysis of the Euro Crisis). The fact that the crisis is systemic implies that it will only be solved with system-wide measures. This suggests that the upcoming plan must abandon the self-defeating dogma of perfectly separable national crises that has so far treated the matter on a country-by-country basis, with all the unpleasant negative effects such a false diagnosis could have. Europe's elites are now called to solve the consequences of their own mistakes and they should have the courage do it. They must accept that their policies have so far been part of the problem and not a solution to it.

What we have been facing in the Euro area is a crisis that simultaneously evolves in three separate realms: (a) debt crisis, (b) banking crisis, (c) under-investment crisis. So far our leaders have only been looking at point a while completely neglecting (and denying) the other two. Fortunately the new plan seems to have incorporated point b, as there is a discussion on how to best recapitalize banks. In that sense we are witnessing some progress and we are seeing steps towards a partial system-wide strategy. What remains to be seen is if  there will be any provisions to address the under-investment crisis, however I am not aware of anything substantial towards that direction, so it seems to me that point c will be omitted once again.

Within the above-mentioned context a coordinated effort to restructure Greek public debt in conjunction with a system-wide bank recapitalization is a very positive step forward, yet it is largely insufficient to arrest the crisis for one very simple reason: it fundamentally depends on contributions from already indebted and already endangered member-states, which suggests that market pressures will again intensify a few days/weeks after the natural optimism the next summit will initially bring.

Here is where the tricky part comes into play and it has a name: EFSF. It is of cardinal importance to understand that nothing can be done at no cost. An expansion of the EFSF to allow it to undertake the task of recapitalizing private banks while also being expected to buy sovereign debt is a venture that will increase the burdens of all states and the bigger the EFSF gets, the bigger the burden. This extra cost can fundamentally put into risk the credit rating of France which implies that the credit rating of the EFSF will fall into jeopardy, bringing down with it, the programmes in Ireland and Portugal and whatever other task it might be assigned to.

With many parameters still unknown it would be unwise to expand further on the subject. From what we have so far it seems that European leaders are finally realizing that the crisis is systemic and must be addressed systematically. Greek debt restructuring in concurrence with bank recapitalizations is definitely a sound option. However what remains to be solved is the cost of all this process that for now will fall on the public finances of member-states either via the EFSF or some other route. This is certainly not good as it will be the Achilles Heel of any effort to contain the crisis. If that thorny part of the ongoing bargaining is not solved then I am afraid the next summit can be led to a failure just like the previous one on July 21 that was not even worth the paper and ink needed to print the final decision.

Let us hope that our leaders will finally grasp the severity of the moments and stop kicking the can down the road.

The four sources of contagion in the Euro Area

By the word "contagion" we mean the transmission of the economic crisis from one part of the Euro area, to another. As I am currently writing this, contagion in the euro area has already reached the core and has seriously contaminated Italy, Spain, Belgium and major European banks that have for long now been verging on insolvency. The crisis in the euro area is systemic as I have always said, yet if a system-wide approach was devised from the very beginning then there would be no contagion and the crisis would have been tackled in its early stages with much less cost both in terms of human suffering and in terms of money and time (see Full Analysis of the Euro Crisis). The crisis has now spread from the weakest parts of the euro area to the strongest due to four main reasons: (1) the interconnection of the economies of euro member-states, (2) the systemic flaws of the euro architecture that lacks the necessary stabilizing tools and a unified banking sector, (3) the underlining insolvency of European banks that was never addressed, (4) the toxic structure of the mechanism that intended to solve the crisis, the EFSF.

The interconnected of Euro member states is realized in three ways: First, there is intense trade between the states, thus a loss of one will also imply a loss of the other (see Evaluation of inflation and unemployment amid the Euro Crisis). Second, private banks have heavily invested in sovereign bonds of Euro states and would be seriously affected in case a single state is unable to pay them back (see Can a 50% haircut save Greece? Can it save the euro?). Third, because the euro is above all a project with political ends, which implies that all members are partners that will come to the need of those in trouble. Hence an inability to provide assistance to any partner state can be seen as a political failure (see The crisis of the Euro is deeply Political). Euro member-states are like a group of climbers that are tied together, where if one falls, all fall down together (see Currency union and Greek Euro Exit).

Coming to the structural flaws of the euro I have already covered the issue in depth in a previous analysis of the Euro Crisis (see Full Analysis of the Euro Crisis). For the sake of reminding you about the general aspects of the matter here is what I wrote (for details see the analysis):

The euro as it was designed was nothing more than the first stage towards a genuine monetary union that presupposes apart from the free movement of goods, persons, services and capital (the Four Freedoms), the political willingness and the common vision; two other fundamentally important elements: Namely a fiscal union and a unified banking sector.

For as long as politicians do not have the necessary tools/mechanisms to combat the crisis, then there can be no end to the cost. As such the architectural flaws of the single currency need to covered either by using in a creative way existing institutions or by devising new ones (though the latter can be time-consuming and thus might not be ideal).

Moving on to the third source of contagion, about the underlining insolvency of European banks, I have been stressing for months now, that private banks were deep in the hole despite what the stress tests showed and regardless of what politicians said. Dexia passed the test in July with flying colors, but was recently proven practically bankrupt, thus proving me correct and showing how derisory the tests were. European banks had over-borrowed prior to the 2007+ crash and leverage ratios where as high as 50/1 or even 60/1 (Deutsche Bank for instance had a debt that was as high as 80% of Germany's GDP!!!). All this toxic waste stayed in their books and was never cleansed by a central plan, as was the case in the United States through TARP (Troubled Asset Relief Programme). Hence today we have the discussion of (again) recapitalizing private banks to prevent a financial meltdown that will bring the whole world into another deep recession.

Finally the fourth source of contagion is the EFSF itself. It is a terrible mechanism despite the fact that it has been created with the most sincere intentions. As it is currently structured, it resembles a huge CDO (Collateralized Debt Obligations - the sort of financial derivatives that caused the Great Recession in the first place) right at the heart of Europe. It comprises slices of debt each with a different credit rating that all together constitute a AAA rated body. The problem with that is that such a structure is toxic for it depends on the guarantees of its member-states, in other words it increases their debts so as to have funds. For as long as the triple-A rated countries cling to their excellent credit rating the EFSF will remain triple-A rated itself. But if France loses its current credit rating, which is quite possible if it has to recapitalize its gravely exposed private banks, then the burdens will all fall on Germany, which suggests that the mechanism can easily fall into jeopardy, taking down with it the programmes in Ireland and Portugal. The problem now with the EFSF is the following: at its current funding capacity and with the new powers it was granted in the July 21 Summit, it has been overstretched and is practically unable to either contain the shock wave of a Greek default/restructuring or provide a backstop to the fall of Italy, Spain and possibly Belgium (see The ECB captivity and the Italian, Spanish and Belgian prisoners). If it stays in its current form, it is useless, if it is provided with further funding it becomes even more toxic, thus even more volatile.

With all these in mind, it becomes clear that contagion can no longer be contained and even if it could, that would not come from the sort of "firewalls" that some politicians promise, as if those would derive at no cost. To build firewalls you need to address all of the above, and this cannot be done with the kind of half-measures that many are putting forward. The crisis can only be killed off with a coherent system-wide strategy that will take into account all of the sources of contagion.