Nomura Securities Co Ltd, Tokyo 11 May 2010

Economic Research – Flash Report

Richard Koo: a personal view of the macroeconomy

Does culpability for the latest Greek tragedy rest solely with Athens?

* Greek fiscal crisis rocks financial markets

Last Thursday technical issues at the New York Stock Exchange triggered a steep fall in share
Date
prices, adding to the ongoing problems in Greece and at Goldman Sachs.
11 May 2010
Although the trading glitch was dealt with quickly and stocks recovered much of their losses,
(issued in Japanese on 10 May 2010)
market participants remained uneasy, and stocks fell again on Friday despite a robust US jobs
report.
R. Koo
Driving this action was a further worsening of the fiscal problems in Greece and other countries r-koo@nri.co.jp
in the eurozone periphery. That sparked concerns about counterparty risk even at Europe’s Chief economist
largest banks, and worries about the potential for crippling losses at German and French banks Nomura Research Institute, Tokyo

with heavy exposure to the eurozone periphery began to cause problems in the interbank
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* Why are financial markets still in turmoil?

The eurozone’s aid package for Greece has been largely fleshed out, and on Monday it was
announced that a large fund would be created.

The Fed also announced it would resume offering currency swaps to other central banks—a
program discontinued in February this year—in order to prevent the problems in the European Please read the important
interbank market from spreading. This was probably intended to head off the threat of a dollar disclosures and disclaimers
on pages 7–8. gl
shortage caused by dollar hoarding at European banks.

These measures will help stabilize the market in the short term, and both the euro and equities
experienced strong rallies. On the other hand, the underlying problems—(1) doubts about
Greece’s ability to trim its fiscal deficit and (2) the issue of how to address the problems in other
periphery nations—remain.

The first is a domestic political issue. Conditions in Greece continue to deteriorate, with three
persons killed during the protests and many others injured. As a practical matter, forcing an
already depressed country like Greece to carry out such heavy tax hikes and large cuts in fiscal
outlays could threaten the nation’s economy, its social fabric, and its democracy.

The fact that other nations in the eurozone periphery face similar problems is stoking unease
among market participants.

* Lenders did not perform due diligence on Greece

It is particularly difficult to convince the public of the need to reduce government spending by
saying the cutbacks are being demanded by the IMF or the global financial sector. From the
perspective of the Greek public, it appears as though these organizations of the rich are
profiting from their distress.

Nor, I suspect, would the public agree with recent portrayals in the (creditor nation-based)
media, which left the investors that lent money to Greece alone while criticizing Greece for all
sorts of deficiencies.

Although creditor-nation media are just now making a great fuss over Greece’s so-called
structural problems (eg the prevalence of corruption and labor laws that make it difficult to fire
employees), these issues have existed for decades. No wonder the Greek people are asking,
“Why now?” The overseas lenders, after all, were well aware of these problems when they lent
the money.

Typical of this strain of news coverage was an article in the 6 May issue of the Financial Times,
which contained the following passage: “Investors take fright, for example, at restrictions such

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as the one prohibiting all but the very smallest companies from firing more than 2 per cent of
their workforce at any one time.” If that is the case, we need to ask why investors ignorant of
this most basic fact of life in Greece were willing to buy the country’s bonds.

The subprime crisis in the US pitted Americans against Americans, and the banks that lent
money without properly examining borrower incomes or assets have been held to account. In
Greece’s case, however, the media have made the problems out to be entirely the fault of the
borrower.

Greece is fully responsible for releasing faulty economic data under the previous administration.
But the so-called structural problems that have recently received so much attention were all
known beforehand. In that sense, I think a major cause of the current crisis is that lenders
neglected to perform due diligence.

* Problems triggered by collusive interdependence between borrowers and lenders

German and French banks bought as much Greek debt as they did because the yields were
more attractive than those available on domestic bonds. In other words, they were effectively
pursuing a high-risk, high-return investment strategy.

In recent US congressional hearings, Goldman Sachs was criticized for selling financial
instruments containing home mortgages for which the lender had not verified the borrower’s
income. If Greece’s structural problems were as bad as they have been made out to be, the
Western European financial institutions that ignored these problems in a search for higher yields
should surely bear a similar responsibility.

In that sense, I think a kind of collusive denial existed between the borrower and the lenders.
Lenders thought that Greece would continue to muddle through despite its many problems, and
Greece assumed there would always be buyers for its debt even if it continued to run substantial
fiscal deficits.

This sweet tango ended suddenly last autumn when the new Greek government announced that
the previous administration had issued misleading deficit data, triggering the current crisis.

* Euro’s adoption produced two types of unwarranted optimism

From another perspective, I think the adoption of the euro produced two types of unwarranted
optimism.

Greece’s membership in the eurozone made it easy for lenders—German and French banks—
to buy Greek debt because it reduced the traditional risks of inflation and currency devaluation.
And for Greece, the denomination of its debt in euros made it easier to sell debt not only
domestically but throughout the eurozone.

In the end, this unwarranted optimism led to a breakdown of fiscal discipline.

* Maastricht requires member nations to keep fiscal deficits under 3% of GDP

The Maastricht Treaty was designed to address such risks. Specifically, it states that fiscal
deficits in member nations must not exceed 3% of GDP without special authorization from the
Economic and Financial Affairs Council (ECOFIN).

The Treaty also specifies a penalty for countries that fail to satisfy this provision, assessing a
fine of 0.2% of GDP plus 10% of the amount in excess of 3%. After all, the eurozone was not
created to allow member countries to run larger budget deficits than otherwise.

But ECOFIN did not assess a penalty when Germany and France fell into a severe balance
sheet recession following the bursting of the IT bubble and fiscal deficits exceeded 3% of GDP
in 2003. Eurozone nations have also been allowed to run deficits in excess of 3% of GDP amid
the global financial crisis triggered by the collapse of Lehman Brothers.

Finally, it makes little sense to talk about fines in the case of a country like Greece, whose

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government clearly has no money.

* Problems with Maastricht’s deficit constraints

As noted in previous reports, I think the Maastricht Treaty’s 3% ceiling on fiscal deficits is
extremely problematic. Specifically, it does not make any provision for balance sheet
recessions—in fact, it is based on the assumption that such recessions do not exist.

When a nation finds itself in a balance sheet recession, the steady application of sufficient fiscal
stimulus for a sufficient duration at the start of the slump will minimize both the size of the
ultimate fiscal deficit and the length of the downturn itself.

The Maastricht Treaty allows countries to run a deficit exceeding 3% of GDP as a short-term
measure to combat economic weakness. As soon as the economy improves, however, the 3%
rule is reinstated, even if increased government spending was responsible for the turnaround in
the economy.

During a recovery phase like the current one, which is heavily dependent on government
spending, attempts to reduce the fiscal deficit risk tipping the economy into a double-dip
recession, greatly prolonging the balance sheet recession, and ultimately increasing the size of
the national debt. This is precisely what happened in the US in 1937 and again in Japan in 1997.

* Lacking monetary or forex policy, eurozone nations need fiscal flexibility

Nor is the need for fiscal flexibility in the eurozone limited to balance sheet recessions. Member
nations are characterized by widely varying economic conditions and industrial structures.
Lacking an independent monetary or forex policy, governments’ only tool for addressing
country-specific problems is fiscal policy.

The extreme pessimism fostered in the markets by the recent problems in Greece is attributable
to concerns that tightening fiscal policy in a nation without an independent monetary or forex
policy will trigger a sharp recession that, far from reducing the deficit, could cause a collapse of
Greek society and democracy.

When Sweden experienced a similar crisis in the early 1990s, it was able to offset the pain of
severe deficit reduction efforts by sharply devaluing the local currency. That option is not
available to Greece.

Some are therefore recommending that Greece leave the eurozone. While that may be an
option in theory, in reality I think it would be extremely difficult to implement. Moving from a
weak currency to a strong one is possible, but if Greece tried to go in the opposite direction, the
result could be even greater turmoil as people held on to their (strong) euros and rejected the
(weak) drachma.

* Greece should announce an end to government bond sales to foreigners

In that case, what options does Greece have? I think the Greek government should announce
that, once the immediate crisis passes, its government bond will no longer be sold to foreign
investors. Some may question this recommendation. After all, it comes at a time when the EU
has done everything it can to persuade foreign investors to buy and hold Greek debt. In the end,
however, I think it would help resolve the discord and contradictions that currently characterize
the relationship between individual countries such as Greece and the eurozone.

First and foremost, refusing to sell government bonds to foreigners would serve as a strong
declaration that Greece intended to finance its fiscal deficits domestically. That should help
reassure those in Germany and France who so strongly opposed the current assistance
package because of the fear that fiscal reform effort in Greece will not be thorough enough.

External assistance is essential in the short term to prevent the problems in Greece from
developing into a Lehman-like panic. In the longer term, however, I think the Greek people need
to wean themselves off the dependence on fiscal deficits that comes from having foreigners buy

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their government debt.

Discontinuing sales of government bonds to foreign investors would also make it clear to the
Greek people that the deficit-reduction efforts are being undertaken not to enrich wealthy foreign
investors but rather to secure the nation’s future. In other words, the policy would aim to
persuade people to abandon their dependence on foreign-financed deficits and fully internalize
the nation’s fiscal problems.

That, in turn, would give the government the legitimacy to tell people demonstrating against
deficit-reduction efforts that “if you have time to demonstrate, you should go out and persuade
your friends and relatives to buy more government bonds.”

If those friends and relatives decline to do so, then it will be clear for all to see that the
government’s only remaining option is to reduce fiscal outlays. That would be far more
persuasive, in my view, than the argument that spending must be cut to satisfy the demands of
the IMF and the global financial community.

* In return, Greece should be exempted from Maastricht deficit limit

If the Greek government decided to discontinue sales of sovereign debt to foreign investors, it
should also issue a request to the EU.

Specifically, it should ask that countries electing not to sell government debt to foreigners should
be excluded from the 3% cap on fiscal deficits stipulated in the Maastricht Treaty.

By allowing only Greeks to buy Greek debt, the nation’s fiscal deficits will become a purely
domestic issue that can no longer create problems for other nations. The only ones to suffer in
the event of a government default would be the Greeks themselves. That should eliminate any
justification for outside interference in Greek fiscal affairs, including the 3% deficit cap. Freedom
from this constraint would restore the Greek government’s traditional fiscal flexibility.

Fiscal flexibility means that the government would not have to observe the 3% ceiling on fiscal
deficits in the event of a balance sheet recession. (During such recessions, in fact, financing a
large deficit is generally not a problem because there is an excess of private savings.)

* Greece could obtain maximum benefit from eurozone membership by internalizing

fiscal problems

Even if Greece declared it would no longer sell government debt to foreigners, the bonds it
issued would still be denominated in euros, so there would be little risk of inflation or capital
flight triggered by currency weakness. That would help to reassure domestic investors and
prevent sharp increases in interest rates due to such concerns.

And if the internalization of the deficit debate were to prompt a return to fiscal discipline, interest
rates might well end up lower than they are today.

Further, because the prohibition on debt purchases by foreigners would apply only to
government bonds, private companies in Greece would continue to benefit from low eurozone
interest rates. The ability to conduct all manner of business transactions without exchanging
currencies, something made possible by the adoption of the euro, would also continue.

In the short term, ending the sale of government debt to foreign investors would cause yields to
rise. In the longer term, however, it would enable the internalization of fiscal debate and ensure
greater flexibility for fiscal stimulus. All in all, I think the benefits to Greece would far outweigh
the costs.

* Pros and cons of relying on foreigners to absorb government debt issues should be
examined

While such a plan could be hard on the country in the short term, the longer-term negatives
would not be that great. After all, money borrowed from foreign investors must eventually be

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repaid.

That leads to the question of whether the temporary benefits of having foreigners buy
government debt truly exceed the costs of such a policy. For example, the reliance on
foreigners to buy bonds exposes fiscal policy to the turmoil of global financial markets and
increases the risk of contagion spread by external crises. Indeed the pros and cons of selling
government debt to foreigners should be properly examined from a wider perspective that
extends beyond the current situation in Greece.

At present, many foreign investors would like nothing more than to sell their Greek debt
portfolios, and few are interested in adding to holdings of bonds issued by a country that has
come under such heavy fire. Accordingly, I think the kind of capital controls being proposed here
would encounter relatively little opposition.

In summary, for Greece to maximize the benefits of being part of the eurozone while minimizing
the costs, I think it needs to (1) discontinue the sale of government debt to foreign investors and
(2) based on that, win an exemption from the Maastricht Treaty’s 3% cap on fiscal deficits.

* National fiscal policy and euro administration should have been uncoupled from the
beginning

In retrospect, it appears that eurozone member nations should have agreed from the beginning
to sell government bonds only to domestic entities. By doing so, they could have avoided a
situation in which a fiscal crisis in one nation has the potential to unleash turmoil throughout the
eurozone.

The eurozone is unique as a currency bloc in that it is a collection of regional governments with
no central government. To make it work, economists deemed it necessary to cap fiscal deficits
in member nations at 3% of GDP.

But this left member nations with no policy tools—monetary, forex, or fiscal—of their own. That
may be acceptable when the economy is healthy, but when it is not we run into the kinds of
problems seen today. And once those problems surface, the EU must do the opposite of what it
originally intended to do — ie, it must provide aid to deficit nations instead of collecting fines
from them.

If the eurozone nations agreed from the start that fiscal deficits must be financed with domestic
savings, governments would find it much easier to maintain fiscal discipline, and it would be
possible to completely de-couple the administration of the euro from fiscal trends in member
nations.

For the ECB, the steward of the euro, this would be a far better world than the current one, in
which fiscal problems in one country can have repercussions throughout the eurozone.

* The lessons of this crisis were costly

A look at the numbers underlines the absurdity of this ability of fiscal problems in one nation to
cast the entire eurozone—and global markets—into turmoil. The Greek government’s fiscal
consolidation plan, the effectiveness of which continues to be questioned by the market, calls
for the nation to trim its fiscal deficit by €25.4bn over the four-year period from 2000 and 2013,
for an average of €6.4bn a year.

But the damage to the eurozone as a whole from the crisis greatly exceeds €25.4bn if we take
into account the loss in stock market capitalization and the decline in terms of trade resulting
from euro weakness. The damage is even greater if we consider the declines in global equity
markets.

All this is the result of mechanically tying the eurozone’s continued existence to fiscal deficits in
member nations. As the recent experience demonstrates, this system comes at an extremely
high price.

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* Eurozone should allow member nations to select their own approach to fiscal policy

In light of the above, I think the eurozone should provide member nations with at least two
choices. One is to continue operating under the current system, with fiscal policy constrained by
the deficit ceiling stipulated in the Maastricht Treaty. The other is to gain exemption from
Maastricht’s 3% cap on fiscal deficits by opting to stop selling government debt to foreign
investors.

I think this would be a valuable option not only for Greece but also for Spain, Portugal, and
Eastern European nations that expect to join the eurozone in the near future.

Ideally, all members of the eurozone would eventually opt for the second alternative. That would
create a far more streamlined and robust currency bloc than we have today, in my view. For the
eurozone to function with all its idiosyncrasies, I think it requires the idiosyncratic condition of a
ban on government bond sales to foreigners.

* How will ECB assess Greek government debt?

“Foreign investors” here refers to the private sector and does not include monetary authorities
like the ECB. The ECB will naturally buy and sell Greek government debt as part of its monetary
policy operations. Under my proposal, however, its counterparties in those operations would be
Greece-based financial institutions only.

This brings up the technical question of how the ECB should assess the value of Greek
government debt. For example, what discount should it apply to Greek debt submitted by Greek
banks as collateral against ECB loans? There are a variety of possible methods, but one would
be to set the discount in line with Greek government bond yields. Government debt earning high
yields in the domestic market (and thus trading cheaply) would be discounted more heavily
under this proposal.

Last week the ECB announced it would accept Greek government bonds as collateral
regardless of ratings assigned by external agencies. If the ECB is willing to ignore credit ratings,
I see no reason why it could not use Greek investors’ own assessment of their government’s
bonds—in the form of bond yields—to assess these securities.

Some continue to call for Greece’s exit from the eurozone. As noted above, however, moving
from a weak currency to a strong currency is easy enough, but the converse is extremely
difficult and could trigger turmoil far more intense than what we have experienced over the past
few weeks.

I think my proposal is worth considering because it would enable Greece and many other
countries to obtain maximum benefit from its eurozone membership at minimal cost.

Richard Koo’s next article is scheduled for release on 8 June 2010.

Nomura Research 6
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