Shaky Ground: The Strange Saga of the U.S. Mortgage Giants by Bethany McLean

Bethany McLean’s new book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, is short (about 150 pages) but filled with useful information and analysis concerning the two biggest government-sponsored enterprises (“GSEs”), Fannie Mae and Freddie Mac. I recommend this book for anyone wondering about these entities and why they are still in conservatorship.

I should point out at the outset that I spent most of my career in the Domestic Finance section of Treasury, and the Treasury, no matter the political complexion of the Administration, took a dim view of Fannie and Freddie. The career Treasury official I worked for in the first half of the 1980s summed up the attitude succinctly by remarking that Fannie Mae and Freddie Mac officials paid themselves private sector salaries without taking private sector risks. While Treasury would take every opportunity to say that GSE debt was not guaranteed by the U.S. government, the market assumed, rightly as it turned out, that if the GSEs ever got into trouble, the U.S. government would make good on the debt. In other words, Treasury was correct as a legal matter in saying that the debt was not guaranteed, but most, if not all, Treasury officials knew that the Treasury would have to do something if they got into financial trouble because of the implicit government guarantee. The shock to the financial system of a Fannie or Freddie default would be too great.

In fact, it was the implicit government guarantee that effectively saved Fannie Mae in the 1980s. Fannie Mae was then faced with the same problem as the savings and loans in a rising interest rate environment. Both Fannie and the S&Ls were financing long-term assets (home mortgages) with shorter term financing. When the cost of financing became much higher than the return on their assets, this proved to be a big problem. Fannie solved this by resorting to issuing mortgage-backed securities, on which Fannie bore credit but not interest rate risk, and by changing its financing strategy so that the duration of its liabilities more nearly matched the duration of its assets, thus reducing its interest rate risk. (I am using the term “duration” in its technical sense, which is related to but not the same as maturity, but you can probably follow what I am saying even if you do not how to calculate duration.) Fannie would not have been able to do this and effectively grow out of its problem without the implicit government guarantee that afforded it continued access to the credit market. Real private companies would have faced downgrades on their debt and eventual failure.

Another reason for Treasury resentment of the GSEs is that, when it came to policy issues that affected them, the GSEs would either argue as if they were  private corporations or as if they were government entities, depending on the particular issue. Fannie Mae, in its publicity, stated that this mixture of public and private worked for the benefit of housing and the U.S. economy. From the Treasury perspective, Fannie and Freddie did just enough for low income housing in order to form a formidable political coalition including the housing finance industry, real estate brokers, and advocates for low income housing.

Further, Treasury was keenly aware that Fannie and Freddie were thinly capitalized. Officials from both companies would argue that they had a good handle on their risk, and that the only thing that could bring them down was a housing bust all over the United States, rather than in  particular regions. Treasury was resigned to appreciating that nothing really could be done about them unless they got into real trouble. In the event, there was a housing bust, and the U.S. government took them over.

Nevertheless, I do not subscribe to the view that the activities of Fannie and Freddie were major causes of the financial crisis. The person most associated with pushing this view is Peter Wallison, a former General Counsel of the Treasury Department during the Reagan Administration and currently co-director of financial policy studies at the American Enterprise Institute, a conservative think tank in Washington, D.C. He was also a member of the Financial Crisis Inquiry Commission and wrote a dissent from the Commission’s report. In his dissent, he argued that a prime cause of the crisis was the affordable housing goals of Fannie and Freddie. This was too much for his fellow Republican commissioners, and they jointly filed a different dissent, which, as I have previously commented, made reasonable arguments.

Bethany McLean easily demolishes Wallison’s argument by pointing out, among other things, that the mortgages Fannie and Freddie bought or securitized were not as risky as Wallison claimed and the two institutions were latecomers to the subprime party. As for the more sophisticated argument that Fannie and Freddie took all the good loans, leaving only bad loans for the private sector, McLean writes that “this leaves a lot of other factors unexplained. Among them: Why was there so much money, for a period of time, to be made on these fringes? Why didn’t the private sector do what it was supposed to do best, namely manage risk?” (p. 55)

It is unclear why Wallison has been obsessed with Fannie and Freddie. He may be trying to make a political case that stricter regulation of the private financial sector is unnecessary because the financial crisis, in his view, is the result of government policies. As I have indicated, I am not a fan of these companies and their activities were part of the myriad of causes for the financial crisis, but focusing on these companies and leaving out other actors, which had much more to do with the crisis, is a mistake. There is plenty of reason to question whether initially privatizing Fannie and Freddie (their respective histories, incidentally, are different) were good ideas, and, as McLean points out, the political process has not produced any consensus about what to do with these entities.

Fannie and Freddie are currently profitable, but the profits are flowing to the U.S. government, which I suppose should please deficit hawks. For example, in calendar year 2014, Fannie paid the Treasury $20.1 billion in dividends and Freddie paid $19.6 billion. However, when the government put the two GSEs into conservatorship, it left 20.1% of the common stock in private hands in order not to include the two companies’ debts on the U.S. balance sheet. Now the holders of the common stock and preferred stock have gone to court because they believe that they have a right to some of the profits the GSEs are generating. Whether or not they do has not been finally decided by the courts.

Fannie and Freddie are providing significant financial support to the housing market. Left undecided is what role the government should play in housing. The 30-year fixed rate mortgage is possible because of Fannie and Freddie, and U.S. homebuyers have become accustomed to the availability of this type of loan. On the other hand, government subsidies to housing – and Fannie and Freddie are only part of that – arguably distort markets and encourages more resources to be devoted to housing at the expense of other sectors of the economy and encourages families and individuals to buy larger houses than they really need or would otherwise buy. Since there is no consensus on what to do with the GSEs, they continue in conservatorship and, at least until the courts have finally spoken, providing their profits to the U.S. government, which also effectively bears the risks from their operations.

There is much more to the book, including discussion of Ed DeMarco, who was acting head of the regulator of  Fannie and Freddie, defying enormous pressure to have them provide relief to borrowers. There are also some errors and oversights in the book, though none are critical. I will single out two here. The author uses the term government-sponsored enterprise to refer to only Fannie and Freddie. In fact, there are other GSEs, such as the problematical Farm Credit System. (The GSE that has been successfully spun off from the government is Sallie Mae, which is active in the student loan market.)

Also, the author quotes former Treasury Secretary Tim Geithner saying “how little authority we had over Fannie and Freddie” without mentioning that Treasury had the authority to approve (or disapprove) their debt issuances. Treasury had used that authority mainly as a traffic cop, that is, to make sure that the Treasury and the GSEs were not all issuing debt at the same time. Treasury stopped acting as a traffic cop during the Clinton Administration. However, in the early 1980s, Treasury used the authority to stop Fannie Mae from issuing debt in a manner motivated by questionable tax strategies. In one instance, it stopped Fannie from setting up a Netherlands Antilles financial subsidiary as a way to issue bonds in Europe without imposing a 30% foreign withholding tax. (Tax law regarding the 30% foreign withholding tax was subsequently changed to exempt “portfolio interest income.”) The Treasury could likely have been more aggressive in using the debt approval authority, as Fannie and Freddie grew their mortgage portfolios, on which they bore both interest and credit risk, in the decade leading up to the financial crisis, but shied away from doing that.
 
Fannie and Freddie have long been absent from the headlines, but what ultimately to do about them is important. They should not be in conservatorship forever. Despite my quibbles, I recommend this book is for those interested in the subject, whether or not they are previously familiar with these two companies.

Treasury Auction Manipulation Investigations and Litigation – Some Comments

There have been allegations of manipulation by major dealers of the auctions for U.S. Treasury securities. Apparently, at least twenty-five lawsuits have been filed, and the U.S. Justice Department and the New York Department of Financial Services are investigating. The back story to these lawsuits and investigations is not public, and the Treasury does not seem to be commenting.

In brief the allegation is that major dealers collude in keeping the yield up (or price down) in Treasury auctions. The complaints compare the auction results to trading in the when-issued market for the same security and contend that statistical analysis shows that there must be collusion.

It is certainly possible, but, after having read two of the complaints (State-Boston Retirement System v Bank of Nova Scotia et al, U.S. District Court, Southern District of New York, No. 15-05794 and Cleveland Bakers and Teamsters Pension Fund et al v. Bank of Nova Scotia, New York Agency et al), I do not think the issue is that clear. The statistical evidence in these complaints is badly presented, and the authors, while assuming the pose of experts on the government securities market, seem to have studied up on this market fairly recently. For example, their knowledge of bond math is limited.

One problem with their argument, as “Yves Smith” on her naked capitalism blog points out, bidders in Treasury auctions may effectively demand a concession in price to act effectively as underwriters for a sizeable chunk of securities.  She thinks, though, that the plaintiffs will avoid a summary judgment against them and will proceed to discovery. If there is evidence of collusion, such as emails or chat room discussions, then there will be a case to be made.

While this is interesting, what the commentary I have read misses is that prior to changes that happened in the government securities market, by government actions, market developments, and technology, the information advantage that primary dealers enjoyed was much more significant. For example, in the 1970s and 80s, primary dealers were the only ones allowed to trade at the major interdealer brokers, with the exception of Cantor Fitzgerald, which operated a government securities trading facility. Consequently, the primary dealers had access to an inside market which was not transparent to anyone outside the club. One firm, which was not a primary dealer, Lazard Frères, complained loudly about this state of affairs, but got no support from Treasury and made no headway in its complaint.

When it came to the auctions, at the time Treasury auctions were multiple price, that is, Treasury accepted bids at the highest prices (or lowest yields) until the amount offered was sold. Competitive bidders had to pay the price that they bid, even if that was higher than the average price. This type of auction poses the problem of the “winner’s curse” for participants; in other words, they run the risk of paying too high a price for the securities. Large investors, therefore, bid through the primary dealers, because they knew that the primary dealers were better able to know the real prices in the market. The primary dealers provided this service for free, because the amounts their customers were bidding for provided them useful information about the underlying demand for the securities. This system worked for the Treasury, but it undeniably gave the primary dealers an advantage and could be criticized as unfair.

Since then, the interdealer market has changed, and prices are much more freely available (though some firms, such as Bloomberg, charge a considerable amount for the use of their terminals). Also, the primary dealer advantage in the auction has been eroded, since Treasury now auctions its securities in single-price auctions. The best bids are still the ones accepted, but all successful bidders pay the lowest price accepted, thus doing away with the winner’s curse problem. (The argument from a cost perspective for Treasury is that the amount of money that Treasury “leaves on the table” is made up for or more than made up for by the higher prices bidders offer in this type of auction. In other word, bidders are not tempted to shade their bids but are more willing to bid based on their true demand curve in this type of auction, since they know that they will not overpay for the securities.)

In single-price auctions, there is less reason for investors to go through a primary dealer, and the amount of direct bids by investors has increased. This seems to be a fairer system for Treasury auctions. However, one can easily see that single-price auctions do leave room for collusion, and perhaps game theorists should study whether the opportunities and temptations to collude are greater in single-price or multiple-price auctions.

In any case, it will be interesting to see if the government investigations or the private class action lawsuits develop any hard evidence beyond the statistical analysis. One interesting point is that the statistical evidence for collusion apparently end after the Libor manipulation investigations become public.

Update on VW Diesel Emission Investigation

After I posted my last entry on this blog, “Volkswagen, Diesel Emissions, and Regulatory Failure,” Bloomberg published an article on its website, “VW's Emissions Cheating Found by Curious Clean-Air Group,” which explains how the VW diesel emission issue was discovered.

Briefly, according to the article, the International Council on Clean Transportation (“ICCT”), a non-governmental organization headquartered in Washington, DC with other offices in San Francisco and Berlin, decided to test certain American versions of diesel cars in order to demonstrate that U.S. stricter emission standards could be met. In Europe, there were questions about the lab test for emissions of the European versions of these cars. In other words, the researchers were not initially suspicious of Volkswagen.

The researchers asked for help from West Virginia University’s Center for Alternative Fuels, Engines and Emissions since it had the right equipment to measure emissions while a car is being driven. The testing demonstrated the excess emission of nitrogen oxides from the VW cars. This was not the case with a BMW, which was also tested.

ICCT’s press release on this matter can be found here.      

Meanwhile, press reports (here and here) indicate that VW has told its U.S. dealers to halt sales of 2015 model year diesel cars and the 2016 diesel cars have not yet been certified by the EPA for sale. VW dealers must be fuming.                                                                                                                                    

Volkswagen, Diesel Emissions, and Regulatory Failure

Yesterday came the news out of the blue that the Environmental Protection Agency and the California Air Resources Board are charging Volkswagen with incorporating software in 2009-2015 diesel cars that enabled cheating on emission tests, particularly the emission of nitrogen oxides. According to the EPA, VW has admitted the use of a so-called “defeat device” in these cars. The EPA letter to VW states: “It became clear that CARB and the EPA would not approve certificates of conformity for VW's 2016 model year diesel vehicles until VW could adequately explain the anomalous emissions and ensure the agencies that the 2016 model year vehicles would not have similar issues. Only then did VW admit it had designed and installed a defeat device in these vehicles in the form of a sophisticated software algorithm that detected when a vehicle was undergoing emissions testing.”

The defeat device software was designed to sense when a car was being tested for emissions and would reduce emissions in order to pass the test. However, the degree of emission control used during the test is not applied when the car is being driven, and emissions are then significantly higher for nitrogen oxides and not in conformity with EPA or California requirements.

Though this is not spelled out by the agencies, presumably turning off some of the emission controls enables better performance and better fuel mileage. Approximately half-a-million cars may have this defeat device and will have to be recalled for a fix yet to be devised. (Disclosure: I own one of these cars.) There may be some reluctance among some owners to bring their car into a dealer for the fix, if the fix for the emission issue results in less power and worse fuel mileage. How the cars will be affected is not clear at this point. VW is under orders to devise a fix, but has not yet done so.

The EPA has the power to fine VW; press reports indicate that VW’s potential fine could be up to $18 billion, but most observers think it will be substantially less than that. Meanwhile, while the EPA and the CARB continue to investigate, the Justice Department is also investigating. Justice is presumably investigating whether any criminal charges should be brought.

West Virginia University and International Council on Clean Transportation (“ICCT”) researchers initially discovered the discrepancy between emissions in real-world driving and test results. (Update: More information has since appeared about this, which I summarize in the next post. The ICCT was not initially suspicious of VW, but was looking at the differences in the emissions between European and U.S. versions of the same cars because of questions that had arisen about the emissions of these cars in Europe.)

The West Virginia researchers may not have looked at the responsible software code. An interesting article by Alex Davies on the Wired website, “The EPA Opposes Rules That Could’ve Exposed VW’s Cheating,” explains that this likely would have violated the 1998 Digital Millennium Copyright Act, which is administered by the Copyright Office of the Library of Congress. According to the article, in December 2014, the Copyright Office was asked to grant exemptions from certain provisions of the Act for software used in cars, trucks, and agricultural machinery. The article states: “Having access to car controls would allow for ‘good-faith testing, identifying, disclosing, and fixing of malfunctions, security flaws, or vulnerabilities,’ [the exemption proponents] argued, according to comments they submitted to the Federal Register.”

The Alliance of Automobile Manufacturers opposed granting the exemptions, and the EPA opposed all the requested exemptions, but one, on which it did not take a position. The EPA was concerned that granting exemptions from prohibitions from examining the computer code would enable consumers to change the code in order to boost performance of their vehicles at the expense of higher emissions. The Copyright Office has not yet made a decision. The Wired article concludes:

The irony of the EPA’s concern over owners altering their vehicle code in a way that would violate the Clean Air Act is that VW was allegedly using its surreptitious algorithm to do exactly this—that is, to favor performance over fuel economy in a way that violated the Clean Air Act. And legalizing public access to the software used in the 482,000 VW cars now being recalled could possibly have revealed the alleged “defeat device” code earlier. As noted on Twitter by Thomas Dullien, a prominent security researcher and reverse engineer who goes by the handle Halvar Flake: “The VW case is an example why we need more liberal reverse engineering regulation. In a world controlled by code, RE creates transparency.”

Meanwhile, in Europe, where about half the cars are diesel, there has been concern that lab testing of automobile emissions is not providing accurate results. The European Commission plans to impose real-world emission testing requirements in 2017. There is some skepticism about whether the new testing regime will close the gap enough between test results and emissions produced by cars on the road.  

EU requirements for nitrogen oxides emissions are not as stringent as those in the U.S. Nevertheless, according to a February article in The Guardian, there are suspicions that auto manufacturers may be using “tricks” to pass the emission tests. The article does not address whether any of these suspected “tricks” are violations of law. At least some of them may be permitted loopholes. Regarding the current emission tests, the article states:

But the current ‘New European Drive Cycle’ laboratory test for measuring these emissions is a quarter of a century old, and has been outpaced by technological developments in the car industry. Studies have shown that lab techniques to measure car emissions can easily be gamed with techniques such as taping up doors and windows to minimise air resistance, driving on unrealistically smooth roads, and testing at improbably high temperatures.

Campaigners say that car makers also use tricks such as programming vehicles to go into a low emissions mode when their front wheels are spinning and their back wheels are stationary, as happens in such lab experiments.

Note that the programing trick the article refers to is similar to what VW has been accused of and admitted to doing in the U.S.  

The concern in Europe has recently been increased by a recent report claiming that only ten percent of new diesel cars meet current requirements. The concern in Europe about the health hazards of diesel cars has been building for some time. There are proposals to ban diesel cars in Paris in 2020, and the French government wants to phase out diesel cars. London is also considering restricting diesel cars, and Mayor Boris Johnson plans to impose a surcharge in addition to the congestion charge on diesel cars in 2020.

Clearly, there have been policy and regulatory failures with respect to diesel cars on both sides of the Atlantic. Europeans are reconsidering their move to diesel cars, and, in the U.S., I would think that the tax credits for diesel cars that were in place for a while to encourage diesel as an alternative automotive fuel will be viewed as a mistake. (I benefitted from that tax credit.)

Opponents of government regulation will no doubt jump at this experience to demonstrate how the government, with even the best of intentions, manages to do the wrong thing. That government policy was not well thought out in this area is clear. (I posted a comment in 2012 about how volume illusion was exaggerating the greater efficiency of diesel engines. A given volume of diesel weighs more than an equal volume of gasoline.) The inadequacy of testing and VW and perhaps other car companies apparently manipulation of test results are real failures of both the public and private sector. However, I don’t think that one can make an argument that without government regulation, automobile emissions would be less than they are now. They almost certainly would have been worse.

What VW has apparently done is appalling and that it took U.S. regulators this long – the cars in question date back to the 2009 model year – is not encouraging. VW of course will pay a price. Its dreams of becoming a major player in the U.S. market would seem to be shattered, and its bet on diesel cars is in question. It is not clear, though, whether other technologies than that used in the VW cars that are likely to be recalled and that are in use in some diesel cars in the U.S. are adequately reducing emissions. It is also possible that new cheaper and effective technologies can be developed without too much sacrifice.

Note: This post was updated in light of new information about the ICCT and West Virginia University research into this issue, which is discussed in the next post.

The Fed and Interest Rates

As of this writing, the Federal Reserve Open Market Committee has not announced its decision on interest rates. However, Binyamin Applebaum wrote an interesting New York Times article, dated September 12, about how the Fed might go about implementing an increase in interest rates – “The Fed’s Policy Mechanics Retool for a Rise in Interest Rates.” Because of the amount of excess reserves held by banks at the Fed, raising short-term rates is not as simple as in the past. Moreover, market reactions to any announcement and to subsequent Fed actions to implement a decision to raise rates, which will happen at some point, if not today, could prove to be complicating factors.  

A Few Comments on the Interagency Report on the U.S. Treasury Market on October 15, 2014

On July 13, 2015, five agencies – the U.S Treasury, the Federal Reserve Board, the Federal Reserve Bank of New York, the SEC, and the CFTC – issued a report prepared by their staffs   entitled The U.S. Treasury Market on October 15, 2014. It attempts to analyze the sharp increase in the price of the 10-year note and the quick reversal of this increase between 9:33 a.m. and 9:45 a.m. on October 15. The report reaches no conclusion as to why this happened.

Antonio Weiss, Counselor to Treasury Secretary Jack Lew, was apparently heavily involved in preparing this report. He gave a speech about the report at a Brookings event on August 3 – “Are there structural issues in the U.S. bond market?” Antonio Weiss, you may recall, is the former Lazard investment banker whose confirmation as Treasury Under Secretary for Domestic Finance was blocked by Senator Elizabeth Warren.

The report clearly entailed a lot of work and usefully highlights changes in the Treasury market and the development of technology, most particularly the growth of electronic platforms and automated trading. The report, though, is unsatisfying, and not just because the authors were unable to develop a clear explanation about what happened on October 15.

First, there is no clear explanation as to why anyone but market participants should care about this unusual event. In this connection, Jerome (“Jay”) Powell, currently a Federal Reserve Governor and a former Treasury Domestic Finance Under Secretary in the George H.W. Bush Administration (I worked for him when he was a Treasury official), remarked at the Brookings event:

“So I think it's important to take a step back and put it in context. So technology is evolving from risk appetite and risk management is evolving, the supply and demand of liquidity is evolving, and regulation is evolving, and they're all evolving at the same time. Markets are adapting to that at the same time. So you have to look at these events and ask whether they matter or not, which is kind of a sense of your question. Does it matter that the 12 minutes -- things that we couldn't really explain? So if it only happens once, maybe it doesn't matter so much, but the real question is, is there a pattern? And I just don't think we know, I think it's frustrating but we don't really know. I think rates will be increasing over time, presumably volatility as we get over the zero lower bound, volatility will return to normal levels just as an arithmetic matter we'll be able to do that. And I think we'll be learning. I think that's what we have to do is learn as this process goes on.” (Transcript, p. 62.)

Second, there is no discussion of developments that day in other financial markets, including the U.S. stock market and stock and fixed-income markets abroad, which may or may not have had something to do with what happened in the Treasury market on the morning of October 15.

Third, the report intriguingly discusses a “heightened level of self-trading” – “defined as transaction in which the same entity takes both sides of the trade so that no change in beneficial ownership results” (p. 32 of report). The report though does not analyze whether this had any effect on market prices and studiously avoids any judgment of whether any of this activity might have been illegal or an attempt at market manipulation. Given that the one group for which what happened on October 15 really mattered, the active traders that made or lost money that morning, this is a hole in the report. The enforcement staffs of the agencies which participated in this report presumably did not participate in its preparation, and it is understandable that in interviewing market participants the researchers did not want to be making what might appear as an enforcement investigation. Nevertheless, more attention to who made and lost money in this event might have shed light on what happened.

Finally, it is interesting to note that in response to a question Antonio Weiss emphasized the need for “better access to data” and Jay Powell said he “was very surprised at how difficult it was to the data.” It is worth noting that in this respect that in the 1992 Joint Report on the Government Securities Market, the Treasury and the Federal Reserve opposed imposing audit trail requirements on the government securities market. In the 1993 amendments to the Government Securities Act of 1986, the SEC did receive the authority to request transaction reports form government securities brokers and dealers in order “to reconstruct trading in the course of a particular inquiry or investigation being conducted by the Commission for enforcement or surveillance purposes.” The Treasury also received large position reporting authority in when-issued and recently issued Treasury securities. (Government Securities Act Amendments of 1993, Sec. 103 and 104.) There seems to be a hint that the Treasury and the Fed may be thinking of supporting legislation granting enhanced authority to impose record-keeping rules and information reporting on significant market participants and lowering the hurdles of sharing this information among interested government agencies. It is unlikely that this will happen, if at all, before the next President and the next Congress are in power.   

Varoufakis and Plan B; Schäuble and the European Nightmare

Former Greek finance minister Yanis Varoufakis outlined his preparations for a parallel payment system and a possible exit from the euro and made other observations, especially about German finance minister Wolfgang Schäuble, in a conference call on July 16. It was hosted by the London-based Official Monetary and Financial Institutions Forum (“OMFIF”), which appears to have institutional and individual memberships from both the public and private sector from various countries. This includes both public and private fund managers. Though this has not been mentioned in any press accounts, I think it is fair to assume that Varoufakis was paid, and probably paid well, to participate. (Varoufakis is not setting any precedents here. Ben Bernanke for example has appeared before investor groups for pay, now that he no longer works for the U.S. government.) In any case, Varoufakis delivered for his hosts. I am not sure that what he had to say would have led to any good trades, but it was uncommonly interesting.

The July 16 OMFIF conference call was held under the “Chatham House Rule,” which allows for the information to be used but prohibits identifying the source or the other participants present. At the end of the call, one of the hosts, OMFIF managing director David Marsh, aware of the “slightly sensitive” information Varoufakis conveyed, admonished the participants in the call with a somewhat stronger version of this rule:

“…I do have to say also that you did say one or two things which were slightly sensitive regarding various episodes when you were a minister, so I would just like to say to everybody that none of this information that you have been hearing here should be used to make any trades of any sort in any way. But also please do not pass those on to other people, this is a private conversation under the famous Chatham House rule. And the idea is that you hear first-hand from Yanis Varoufakis, and also Lord Lamont, about their experiences –but this is not a public broadcast, this is not the BBC.” (Transcript of the call here; audio here.)

Mr. Marsh also reported that there were “84 people on the line from all over the world.” I suspect there were more than that, since multiple people could be listening to the call on a single speakerphone. Given that, it is surprising that it took 10 days for the information about Varoufakis’ preparations to set up a parallel banking system in Greece in the event the banks to leak. It was first reported on July 26 in the conservative Greek newspaper Kathimerini, which has been critical of the current Greek government. It seems likely that the leak was meant to embarrass Mr. Varoufakis and the current government. Indeed, some claim that Mr. Varoufakis has committed treason or other crimes. (I know nothing about Greek law, but I suspect that these allegations will not go anywhere.)

Since this story broke, Varoufakis and his two questioners Norman Lamont and Marsh agreed that the recording of the call be made available online. Subsequently, a transcript has also been released at the OMFIF website.

Why Varoufakis decided to make the secret preparations for an alternate payment system, including the hacking of the website for tax payments which he says was controlled by the troika, is not entirely clear. He had to have known, Chatham House Rule notwithstanding, that the information was too explosive to stay secret, given the number of listeners.

After listening to the call, I suspect that Varoufakis has bristled at the charge that the Greek government failed badly in its negotiations with the other Eurozone countries because they had no plan, and no credible way to threaten, pulling out of the euro. He implies that Prime Minister Tsipras did not have the courage to escalate the fight with the Eurozone countries by implementing the plan when the European Central Bank (“ECB”) forced the closure of the Greek banks. Varoufakis is prompted to tell this story after Marsh asks:

“You obviously didn’t have a Plan B and did rather weaken your negotiating argument, because the others were absolutely scared of you leaving and yet you said ‘Don’t worry we’re not going to leave.’ I think though just in the last couple of weeks you yourself did start to think about a Plan B, and I think you even gave some inkling about it in your interview with the New Statesman where there was a vote in the inner-cabinet in Athens after the referendum and you were in favour of trying to prosecute a Plan B and you were out-voted. Do you think there was still a chance, if everything goes badly, that there may well be a Plan B and that the Grexit - which nobody wants in Greece, I understand that - may come about even though it is something for which you are unprepared?”

Whatever the reasons Varoufakis made this public, the story he tells shows how dangerous the brinksmanship played by both sides were to European unity. What Varoufakis had in mind, using the Greek tax website as an alternative payment site, would not have been as provocative as another scheme to take over the Bank of Greece and use the euro notes in its vaults. This has been reported to have been an idea of former energy minister Panagiotis Lafazanis and Varoufakis. If Greece had done that, the fury of the ECB would have come down on Greece, and the notes would have been declared counterfeit. Varoufakis does not mention this in the call, and it is not clear whether he really supported this. In any case, the press has dropped this story.

However, setting up an alternative payment system which could be switched to a new currency would have been provocative enough. Whether it would have worked at all is not clear, but it could only have bought Greece a bit of time and all hell would have been let loose in Europe. If there is a decision for Greece to leave the euro, the mechanisms to do this should be negotiated with substantial input from technical experts. It is a complicated undertaking to accomplish smoothly, and disputes over who owes what to whom are inevitable.

Also, in the conference call, Varoufakis indicates that Greece may have been set up. While the Greek parliament is passing legislation required by the preliminary agreement as preconditions to negotiating a final loan agreement, the IMF may very well decide that it cannot participate because the level of Greek debt is unsustainable. That could cause the whole agreement to fall apart, which may lead to a Greek exit from the euro, which is what Schäuble wants, though it is not the preferred outcome for Chancellor Angela Merkel.

According to Varoufakis, Schäuble wants to use Greece to terrorize France:

“[Schäuble] believes that the Eurozone is not sustainable as it is. He believes that there has to be some fiscal transfers, some degree of political union. He believes that, for that political union to work without federation, without the legitimacy that the properly elected federal parliament can render can bestow upon an executive, it will have to be done in a very disciplinarian way. And he said explicitly to me that the Grexit, a Greek exit, is going to equip him with sufficient bargaining power, with sufficient terrorising power, in order to impose upon the French that which Paris is resisting. And what is that? It is a degree of transfer of budget-making powers from Paris to Brussels.”

Schäuble is wrong both about economics and politics. Austerity has clearly not worked, and having Germany dictate to other EU countries how they should manage their affairs will also not work. In a perceptive column in The New York Times, Shahin Vallée writes that a euro leading to Germany being able to dictate will not be acceptable for other major European countries:

“…The choice will soon be whether Germany can build the euro it wants with France or whether the common currency falls apart.

“Germany could undoubtedly build a very successful monetary union with the Baltic countries, the Netherlands and a few other nations, but it must understand that it will never build an economically successful and politically stable monetary union with France and the rest of Europe on these terms.

“Over the long run, France, Italy and Spain, to name just a few, would not take part in such a union, not because they can’t, but because they wouldn’t want to. The collective G.D.P. and population of these countries is twice that of Germany; eventually, a confrontation is inevitable.”

While the France of François Hollande is not the France of Charles de Gaulle, France is still a proud country and will not stand for Germany dictating its fiscal affairs. France may be able to be “terrorized” (probably too strong a word) in the short-term, but that will not last long.

The basic problem is that a monetary union implies a fiscal union, and for that to work in Europe, it must have legitimacy and be subject to democratic control. There is no clear path for that to happen. Jean Monnet’s European dream is in danger of turning into a nightmare.

Greece and the Future of the Euro: Whither Europe?

For now the Greek saga that was commanding front-page headlines has receded to judge by the news coverage. In its place have come more up-to-the-minute stories, such as the Iranian nuclear deal, the opening of embassies in Washington and Havana, and the latest outrageous statements of Donald Trump. The reduction in news prominence of Greece’s travails in the Eurozone is understandable. After all, the Eurozone countries and Greece have reached a tentative deal and an agreement to finalize that deal. (Of course, all this will be followed by more talks when current deals become clearly impossible for the Greeks to fulfill.) The banks have now reopened, albeit with strict limits on cash withdrawals and economy-crippling capital controls still in place. During this time as the new deal is finalized, the Europeans have extended a €7.16 billion bridge loan to the Greek government, which they have used to pay their creditors, including the IMF and the ECB.

Nevertheless, for those of us who have followed the progress the Europeans have made in forming “an ever closer union” over the decades, the recent Greek saga provides both fascination and horror. Fascination, because it is inherently interesting. The experiment of a monetary union of nineteen sovereign countries is unprecedented, and a crisis, however predictable, provides a storyline that proves irresistible for those of us interested in this sort of thing. The horror comes from the suffering of the Greeks, the seemingly mistaken negotiating tactics of the new Greek government, the stupidity of their European counterparties who fail to act in their own interests, as correctly understood (to borrow a Realpolitik concept), and the very real danger that the European project will shift into reverse. This all is consequential and the implications for Europe and the world are much greater than the fate of a small country (albeit beautiful and with charming and friendly inhabitants) in the European “periphery.”

I always thought that the adoption of the euro was premature. The countries involved were too different, and adopting a uniform monetary policy for countries with different economic and social policies and different cultures and languages seemed as asking for problems. Those spearheading the drive for greater European unification of course knew this; they hoped that problems as they arose with the euro would serve for greater harmonization of policies in other spheres.

What was surprising was that the euro did as well as it did for as long as it did. It was even conceivable that it could be a competitor to the U.S. dollar as the reserve currency of choice. The economic crisis beginning in 2008 changed all that, and the euro flaws became easy to see. While various countries in what is called the periphery had and have problems which have been made more difficult to manage because devaluation of one’s home currency is not an option, the Greek situation has become the most difficult for the Eurozone countries. It poses starkly the question of whether the strategy of achieving a closer union through engrenage is now failing and whether the movement toward an ever closer union will now shift into reverse.

The Greek crisis has not only put the conceptual problems with the euro in bold relief; it also has shown the inadequacy of the economic theories, such as they are, of the leadership of the dominant country in EU, Germany, and that of some of the other northern and former Soviet bloc countries following Germany’s lead. Clearly, the policy of using austerity to solve debt problems has not worked. In Greece’s case, it has made the debt problem worse. The denominator of the ratio everyone looks at, debt to GDP, has been falling, meaning that the ratio has been increasing. The austerity of the past five years has prolonged and worsened Greece’s recession, turning it into a depression. Greece also does not have the option of trying to offset the decreased demand from austerity with a looser monetary policy than its main trading partners, given the euro. Judging from a presentation German finance minister Wolfgang Schäuble made earlier this year at Brookings, he apparently believes that austerity will generate confidence that a country is getting its fiscal house in order. This confidence will lead to greater investment and hence growth. Neither conventional macro nor experience provides justification or evidence that in the face of double-digit unemployment that this is correct. Moreover, the worsening debts to GDP ratios due to slower economic growth most likely have the opposite effect on confidence.

But beliefs die hard. The Eurogroup insisted on continued austerity for Greece, along with reforms to certain laws which arguably will give Greece a more efficient and competitive economy. While these may help the Greek economy once the current depression is over, it is hard to see how reforms to certain uncompetitive laws will help Greece get out of its current slump.

Also, the Eurogroup played rough with Greece during the negotiations. For example, it has been reported that Dutch finance minister and Eurogroup president Jeroen Dijsselbloem told Greek finance minister Yanis Varoufakis that, if he did not agree to the Eurogroup demands, “your economy is going to collapse...We are going to collapse your banks.” 

As it turned out, this was no idle threat. On Sunday, June 28, the European Central Bank (“ECB”) announced that it would not raise the amount of Emergency Liquidity Assistance (“ELA”) that the Bank of Greece could extend as collateralized loans to Greek banks. This was the day after Prime Minister Tsipras announced that he would submit the terms of the latest offer from the Eurogroup in a referendum on July 5. The restriction on ELA loans led to the closure of Greek banks on the following Monday, withdrawal limits of €60 a day, and capital controls. After Greek voters overwhelmingly rejected the latest (and by then defunct) offer of the Eurogroup imposing austerity on the Greek economy in a much watched referendum vote on July 5, the ECB again said on the next day that it would not raise the ELA amount and would “adjust” (i.e., raise) the haircuts on Greek government debt serving as collateral. This essentially brought the Greek economy to its knees, and a probably panicked Alex Tsipras agreed to even harsher terms than the Greek voters had rejected on July 13.

While the Eurogroup led by Schäuble and Dijsselbloem played very rough with Greece, it is fair to criticize the Greek government for its negotiating tactics. The economic arguments that the Greek officials were making made more sense than that of their more strident interlocutors, but the abrasiveness with which they conducted themselves and the call for a referendum look in retrospect to have been mistakes. It did not get them anything, except perhaps a worse deal than was originally obtainable.

On this point, though, John Cassidy of The New Yorker argues that “Syriza’s surrender wasn’t necessarily an ignominious one.” The reason is that this episode points out the necessity for change in Europe, thus, perhaps, paving the way for that change:

In the Marxist intellectual tradition, from which many senior members of Syriza hail, progress comes about gradually. To overthrow the existing order, you have to first mobilize the masses by stripping back the democratic veil and showing the real workings of the system: only then will the “objective conditions” be ripe for revolutionary change. Tsipras and Syriza didn’t create the conditions for change. But in bringing Greece to the brink, and demonstrating that its creditors were willing to see it collapse if it didn’t buckle to their demands, they did, arguably, succeed in showing up the eurozone as a deflationary straightjacket dominated by creditors. And they did this with all of the world watching. “One must know who the enemy is, in order to fight the enemy,” Alex Andreou, a Greek blogger who is sympathetic to Tsipras, wrote last week. “Syriza has achieved that. Now, it is over to you, Spain. Take what we’ve learned and apply it wisely.”

Having followed the developments, I do not think that Tsipras had such a devious negotiating strategy in mind. Cassidy is correct, though, that the outcome of the negotiations, with more still to come, has highlighted problems with the euro and EU governance. This growing realization may bring change, but what kind of change is uncertain. Cassidy concludes his article by quoting Tsipras’s comment to the Greek parliament that “this fight will bear fruit,” but goes on to write: “Only time will tell if that was wishful thinking.”

Another interesting disagreement that the Greek crisis revealed is the irrevocability of a country’s decision to use the euro. Interestingly, Schäuble has made no secret of his desire for Greece to give up the euro, at least temporarily. For him, this is not an immediate cost issue, since he argues that Greece leaving the euro would make it possible to forgive some of Greece’s debt and he says that the EU would provide Greece humanitarian aid during the monetary transition.

Schäuble’s preference for Greece to leave the euro is not new. For example, Andrew Ross Sorkin of The New York Times wrote an article at the end of June discussing a conversation in July 2012 between Schäuble and then Secretary of the Treasury Tim Geithner on this subject. Geithner reported in this conversation in his book, Stress Tests: Reflections on Financial Crises. Geithner was visiting Schäuble at his vacation home on an island in the North Sea. They had been discussing how to keep Greece in the Eurozone, but then, according to the article:        

To Mr. Geithner’s dismay, however, Mr. Schäuble took the conversation in a different direction.

 

“He told me there were many in Europe who still thought kicking the Greeks out of the eurozone was a plausible — even desirable — strategy,” Mr. Geithner later recounted in his memoir, “Stress Test: Reflections on Financial Crises.” “The idea was that with Greece out, Germany would be more likely to provide the financial support the eurozone needed because the German people would no longer perceive aid to Europe as a bailout for the Greeks,” he says in the memoir.

“At the same time, a Grexit would be traumatic enough that it would help scare the rest of Europe into giving up more sovereignty to a stronger banking and fiscal union,” Mr. Geithner wrote. “The argument was that letting Greece burn would make it easier to build a stronger Europe with a more credible firewall.”

Fast-forward three years. What Mr. Schäuble articulated that summer afternoon to Mr. Geithner is finally taking shape.

 

This is interesting, since many economists, most prominently Paul Krugman, have argued that Greece would be better off leaving the euro. Krugman is no fan of the austerity Schäuble has prescribed for Greece and other countries with debt problems, but there seems to be some common ground between him and Schäuble on the question of Greece and the euro.

From an economic perspective, the argument that Greece should leave the euro is strong. That, though, has to be at least somewhat tempered by politics, because the motivation for creating the euro was politics, not economics. The determination of many leaders in Europe to keep the Eurozone intact should not be underestimated, though it will be severely tested in the coming months and years. German Chancellor Angela Merkel disagrees with her finance minister on the desirability of keeping Greece in the Eurozone. Also, disagreeing is ECB Mario Draghi (“whatever it takes”). At a press conference on July 16 (after the Greek parliament vote on the deal) in which Draghi announced that the ECB would increase the amount of ELA lending the Bank of Greece can make to Greek banks by €900 million, he said (according to Bloomberg): “We always acted on the assumption that Greece will remain a member of the euro area. There was never a question.”

The crisis also brought about a noticeable rift between the two key countries of the EU, France and Germany. France, along with Italy, is more sympathetic to the problems Greece faces and is more willing than Germany to offer concessions in order to preserve the Eurozone and not set the precedent of a country giving up the common currency.

The vision of an ever closer union seems more distant, and, as for Schäuble, it is not clear what his vision is. A Europe in which Germany is viewed as being able to dictate policy is not sustainable. There will be a reaction against that; in fact, there already is. The uncertainty of Britain’s continued membership in the EU is more open to question, with some leftist voices, seeing the Greek debacle, having doubts about the benefit of membership, along with politicians on the right who have long held that position.

Most observers believe that the targets for primary surpluses will be impossible for Greece to meet. A new Greek crisis is likely. Whether the EU will end up putting off difficult decisions (“kicking the can down the road”) when that crisis arrives is uncertain. What can be said, though, is that the intransigence of Germany and some other Eurozone countries has put the European project in doubt.  

The Bank of Greece, the ECB, and the Euro

One of the little remarked on issues if Greece either decides or is forced to leave the Eurozone is how the Bank of Greece and the European Central Bank (“ECB”) would accomplish the divorce. It is difficult to get a handle on this for two reasons. First, there is no provision for a country to leave the euro in any of the legal documents that created the common currency, since the adoption of the euro by an EU member state was deemed to be irreversible. Second, the information provided by the ECB on its website is sparse concerning technical details. (The websites of the Federal Reserve System provide more information and provide it more clearly.) Because of this, what I have written here is my understanding of the situation, but there may be errors given the opaqueness of the publicly available information about Eurozone monetary policy and the operations of the ECB and the national central banks.

Much of what is done with respect to monetary policy, except for all-important decisions, is handled by the national central banks, not the ECB. The ECB, unlike the Board of Governors of the Federal Reserve System, is an actual bank, with assets and liabilities. However, much of the assets and liabilities of the Eurosystem are carried on the books of the national central banks.

The May 2015 balance sheet of the Bank of Greece shows on the liability side €27.4 billion of euro banknotes and €17.8 billion of euro banknotes allocated to it in the Eurosystem. It also shows €100.3 billion of liabilities related to the Target2 cross-border payment system of the European System of Central Banks. On the asset side, the balance sheet shows €38.8 billion of lending denominated in euros and related to monetary policy to euro area credit institutions (presumably mainly Greek banks) and €77.6 billion of other claims denominated in euro to euro area credit institutions. How these liabilities and assets (and others) would be handled or taken off the Bank of Greece’s balance sheet and transferred to the ECB and other national central banks is unclear.

It seems likely that the current Greek government had not thought about this during the painful negotiations with the other Eurozone countries. The majority of Greeks want to stay in the euro, though they hate the austerity that has been imposed. Since the Greek government could not credibly threaten to leave the euro and tell the Eurozone countries that they would lose additional amounts in addition to the debt they hold due to the monetary divorce, this gave the hard-line countries a negotiating advantage. The Germans and other essentially told Greece, leave the euro, we don’t care. At the same time, of course, the ECB was strangling the Greek economy by not allowing the Bank of Greece to provide additional credit to Greek banks. The Eurozone countries play rough.

Given all the current problems with the deal that was arrived at earlier this week, there should be some study of how to extricate the Bank of Greece from the euro. Greece’s departure from the euro is certainly a possibility at some point, and the taboo of considering it has been broken.

After all, the current deal may fall apart. The IMF may not extend more credit to Greece unless it is given relief on its current debt, which the Germans say they do not want to do. There seems little likelihood that the Greeks will be able to privatize enough assets in short order to put €50 billion in an escrow fund. Moreover, the economic policies imposed on Greece, assuming the Greeks carry them out, will likely hurt economic growth, making its debt problem even worse.  

A Note on Emergency Liquidity Assistance, the ECB, the Bank of Greece, and Greek Banks

The capping of Emergency Liquidity Assistance (“ELA”) at €88.6 billion to Greek banks is what gave rise to the current Greek bank holiday, capital controls, long lines at ATMs, and great costs to the Greek economy. It also gave the hardliners among the Eurozone group of nations the leverage to get the Greek government to agree to very harsh terms in order to keep the euro and stave off immediate economic collapse.

To read the press articles on this, one would have the impression that the ELA are loans made by the European Central Bank (“ECB”). This is not true. It is national central banks that make the loans, but the Governing Council of the ECB can restrict what the national central banks can do. The ECB’s two-page description of ELA procedures can be found here. The beginning part of the document states:

Euro area credit institutions can receive central bank credit not only through monetary policy operations but exceptionally also through emergency liquidity assistance (ELA). ELA means the provision by a Eurosystem national central bank (NCB) of:

(a) central bank money and/or     

(b) any other assistance that may lead to an increase in central bank money to a solvent financial institution, or group of solvent financial institutions, that is facing temporary liquidity problems, without such operation being part of the single monetary policy. Responsibility for the provision of ELA lies with the NCB(s) concerned. This means that any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB.

However, Article 14.4 of the Statute of the European System of Central Banks and of the European Central Bank (Statute of the ESCB) assigns the Governing Council of the ECB responsibility for restricting ELA operations if it considers that these operations interfere with the objectives and tasks of the Eurosystem. Such decisions are taken by the Governing Council with a majority of two-thirds of the votes cast…

Note that the document states that the NCB, in the current case, the Bank of Greece, bears the risk arising from ELA loans. Therefore, what the Governing Council of the ECB has done ostensibly to protect the Bank of Greece is to raise the haircuts on Greek government debt presented as collateral to the Bank of Greece (“The financial situation of the Hellenic Republic has an impact on Greek banks since the collateral they use in ELA relies to a significant extent on government-linked assets”) and to cap the amount of the loans. Of course, this very action served to damage the Greek economy and make it more likely that Greece would default on its bonds.

The ECB is supposed to be an independent central bank, but this decision has all the marks of having been done for political reasons. It would be interesting to know what the President of the ECB, Mario Draghi, thought about this and why at least two-thirds of the voting members of the Governing Council voted the way they did. It may be some time before we know the answers to these questions, though, given the number of people involved, I suspect we will eventually learn something about what transpired.

Make no mistake. It was not the missed payment to the IMF that caused the current, acute economic crisis in Greece. It was the decision of the ECB Governing Council restricting the Bank of Greece to use ELA. This caused a run on the Greek banks, with the Bank of Greece not being able to provide more physical euros to the banks. Removing the current restrictions on account withdrawals and the capital controls will be difficult and will take time, because of the fear that this would engender more withdrawals and transfers of funds to foreign banks.

How Much Does Greece Owe? The Omission of Tier2 Liabilities

Statistics about Greek debt are hard to interpret, and different news outlets give different figures which are hard to reproduce. For what it’s worth, here are some statistics I have found.

According to a Greek news source (To BHMA), the Greek public debt was 312.7 billion euros at the end of March. Bloomberg reported in February that the Greek government owed 315.5 billion euros. Reuters reported at the end of June that Greece owed its official creditors 242.8 billion euros. This figure excludes what is owed to private sector creditors. It is also difficult to reconcile the other statistics in the article with this total amount.

However, what all these figures exclude are the liabilities of the Bank of Greece, which would likely not be paid if Greece were to exit the euro. Intra-European system liabilities reported on the May 2015 Bank of Greece balance sheet total 118.1 billion euros. Of this, 17.8 billion is related to physical euro currency and 100.3 billion has to do with cross-border payment transactions through the Tier2 system which connect national central banks of the Eurozone with each other. If Greece were to leave the euro, the European Central Bank would likely have to eat these losses. The Tier2 amounts owed by central banks to the ECB are not secured by collateral. The losses would be shared among the national central banks of the Eurozone.

While it is unclear how much the Bundesbank would be hit, Reuters reports that the head of the Bundesbank has told the German government about potential losses greater than the 14.4 billion euros the bank has set aside to cover losses due to the Greek crisis. These losses would flow through to the government’s budget. The German government, as other governments in the Eurozone, receives government earnings from its central banks. The profits would be less in the event of a Greek exit from the euro. The losses due to Tier2 liabilities would likely be an addition to losses due to bond defaults.

I first became aware of this issue when I read a Wall Street Journal blog item. As the blog indicates, we will likely be hearing more about this if Greece and the troika do not come to an agreement soon. While the Eurozone countries can bear the losses of a Greek exit, the messy and potentially costly central bank issues have to be a consideration.

A Note on Scalia's Dissent in King v. Burwell

Many conservatives find Justice Antonin Scalia's dissent in King v. Burwell more persuasive than Chief Justice John Robert's opinion for the Court. This is even true of at least one conservative writer who argues that the Court's decision was good for the Republicans, because a ruling for the plaintiffs would have meant that Republicans' divisions and inability to agree on an alternative would have become all too plain.

I disagree that Scalia's dissent is convincing or persuasive. I have read both the Court's opinion and Scalia's dissent. For all its bombast, one reason that Scalia's dissent fails to convince is that it makes an assumption that is not supported by any evidence he cites, namely that Congress probably wanted to withhold subsidies to qualifying residents of states that did not set up their own exchange as a way to incentivize them to do so. Never mind that no one was aware of this incentive until some enterprising lawyers who want to see the Affordable Care Act repealed brought this case.

In this connection, Scalia writes:

“…the Affordable Care Act displays a congressional preference for state participation in the establishment of Exchanges: Each State gets the first opportunity to set up its Exchange, 42 U. S. C. §18031(b); States that take up the opportunity receive federal funding for ‘activities . . . related to establishing’ an Exchange, §18031(a)(3); and the Secretary may establish an Exchange in a State only as a fallback, §18041(c). But setting up and running an Exchange involve significant burdens—meeting strict deadlines, §18041(b), implementing requirements related to the offering of insurance plans, §18031(d)(4), setting up outreach programs, §18031(i), and ensuring that the Exchange is self-sustaining by 2015, §18031(d)(5)(A). A State would have much less reason to take on these burdens if its citizens could receive tax credits no matter who establishes its Exchange… So even if making credits available on all Exchanges advances the goal of improving healthcare markets, it frustrates the goal of encouraging state involvement in the implementation of the Act.” (pp. 15-16 of Scalia Dissent)

In contrast, Roberts concludes at the end of the Opinion of the Court:

“Congress passed the Affordable Care Act to improve health insurance markets, not to destroy them. If at all possible, we must interpret the Act in a way that is consistent with the former, and avoids the latter. Section 36B can fairly be read consistent with what we see as Congress’s plan, and that is the reading we adopt.”

Roberts is right. Because of the legislative situation (especially after Scott Brown's win of Senator Kennedy's Senate seat, though Roberts does not mention this), Congress did not carefully vet the language for sloppy drafting, but interpreting the Affordable Care Act the way Scalia does makes a mockery of the law. This case was brought to the Court for blatantly political purposes by lawyers who searched for and found some plaintiffs who did not want to receive health insurance subsidies.

A Few Observations about Greece, Debt, and the Euro

New twists and turns in the current Greek disaster keep coming rapidly. Last Saturday (Friday in the U.S.), Prime Minister Alexis Tsipras announced a surprise referendum to take place next Sunday (July 5) on the latest offer by the troika for an extension of the “bailout.” The Greek parliament subsequently approved this referendum. The European Central Bank then announced that it capped the amount it will lend to Greek banks, which are faced with large withdrawals by understandably nervous depositors. This forced the Greek government to close the banks until at least next Monday and to limit Greeks to withdrawing 60 euros per day from ATMs. Tourists with foreign bank cards are not limited, and one assumes that Greeks who have foreign bank cards can get around the restriction. However, ATMs are running out of cash and the lines to use them are long. Then on Tuesday morning came the news that Tsipras had written a letter saying he is willing to accept the terms of the latest troika offer with some amendments. The Germans maintain though that there is nothing to negotiate until after the referendum, and Tsipras is still urging Greeks to vote no, that is, to say that they do not accept the troika’s offer.

There has obviously been a negotiating failure here on a scale that one rarely sees. The Greeks want to stay in the eurozone; most European governments want Greece to stay. (There may, though, be some disagreement between German Chancellor Angela Merkel and her finance minister, Wolfgang Schäuble.)  The apparent dislike and disdain of each side for the other, along with less than diplomatic public statements and differences on the underlying economics, has made agreement difficult, if not impossible. It is often remarked that the Europeans, when faced with problems, like to kick cans down the road; in the current situation, they have yet to find the right can to kick.

What is distressing is that the Europeans do not want to admit what is perfectly obvious; the Greeks cannot pay all of their debts.  It needs to be restructured and effectively partially forgiven (as would happen if there were a bankruptcy option for  countries similar to that available to corporations). It is not in anyone’s interest to perpetuate a situation where Greek creditors effectively advance new loans to pay off old ones, all the while strong arming Greece to follow economic policies that hinder economic growth. This hurts Greece and the creditors, since it weakens Greece’s ability to pay down its debt. The creditors need to admit that they will not be fully paid back.

The pressure being applied to Greece suggests that some of the Europeans want to cause the current Greek government to fall. What other reason would there be not to discuss how to restructure and partly forgive the outstanding debt? If the goal has been to punish Greece for its profligate ways, that certainly has been accomplished. The past, though, cannot be changed; the parties need to agree on what is the best for all of them going forward.

Also, what the current crisis demonstrates is the folly of the euro. (In 2011, I wrote about this.) Too many countries, with different economic situations, cultures politics, languages, legal systems and so on were allowed to join. There is no way that the current eurozone is an optimum currency area. Moreover, the necessary additional surrender of some sovereignty to a central government with respect to fiscal policy has not been accomplished. And Greece got admitted to the club by cooking the books, while the other members apparently looked the other way.

Catherine Rampell of the Washington Post wrote in a recent column about the euro:

“…Milton Friedman, among other Cassandras, explained why nearly two decades ago in an essay detailing the best (the United States) and worst (Europe) conditions under which to create a currency union. In Europe, where countries are divided by language, customs, regulatory regimes and fiscal policies, a common currency would inevitably prove disastrous, he wrote. Shocks hitting one country would heave themselves across the continent if individual countries could not easily adjust prices through their exchange rates.

“Rather than promoting political unity, Friedman argued, ‘the adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues.’”

Finally, the mishandling of this crisis by both sides may have some very bad political consequences. It raises questions about whether “the European project” can go forward. Not only is Greece an issue, but the UK is trying to negotiate what amounts to associate membership in the EU before their referendum on EU membership. The National Front in France is pleased with the developments, since it wants to take France out of the EU. The political ramifications in other “periphery” countries, such as Portugal, Spain, and Ireland, is uncertain and there may be growing doubts about Italy’s economic situation. It is not that difficult to imagine the movement towards an “ever closer union” shifting into reverse.

If the Greek situation continues to be handled badly, this may result in Greece moving closer diplomatically to Russia during a period that tensions are on the rise between Russia and the West. Also, Greece is one of the countries that migrants to Europe first go to; a less than cooperative and impoverished Greece would not help address this problem.

Finally, there should be concern about the internal political situation in Greece if its economy continues to deteriorate. The regime of the colonels ended in 1974 and Greece became democratic. That was forty-one years ago, which may seem like a long time, but many people are still alive who had direct experience of that regime. While a military coup would seem to be unlikely, it is unpredictable what will happen when countries are subject to depression for a long time or high inflation, or, worse, both at the same time.

Greece and GDP-Linked Bonds

It is perfectly obvious that at some point Greece’s creditors’ will have to admit that they will not be paid back in full. This morning there are reports that the IMF has highlighted this point.

One idea that the Greek Finance Minister Yanis Varoufakishas has floated is to replace some of Greece's existing bonds with GDP-linked bonds. The merit of this idea is that it is one possible way to make both Greece and its creditors understand that their interests are aligned. With this type of bond, the greater the Greek economy grows, the more the creditors would receive.

There are some obvious problems, though, that would have to be addressed. A GDP statistic that everyone could trust is essential; at this point, creditors may not be willing to trust a number the Greek government produces. Also, GDP numbers are also subject to revision as new data comes in. A decision would have to be made at what point a number is final for purposes of the bond. Also, there is probably not insignificant economic activity in Greece that is “off the books.” How to account for this in coming up with a GDP number is a question.

Consequently, we will probably not see a GDP-linked bond, at least not one marketed to private creditors. However, since much of Greek debt is owned by public sector entities, it may be an idea worth pursuing along with others. The European creditors of Greece have made a mistake in not wanting to discuss ways to restructure and partially forgive Greek debt, and the Greek negotiating tactics have seemed ill-advised. If Greece and the troika find a way eventually to talk seriously about how to deal with the Greek debt problem, GDP-linked bonds are not essential to a solution but are worth considering.

(Some of what I have to say here is informed by my work at Treasury designing Treasury’s inflation-indexed bonds.)

More on the AIG Case

I finally got around to reading U.S. Court of Claims Judge Thomas Wheeler’s opinion in the class action suit led by Maurice (Hank) Greenberg against the United States concerning the terms of the bailout of AIG. Nothing in it changes my opinion about Steven Pearlstein’s article in the Washington Post about this case, which I found to be incredibly biased for a news story.

I am no expert on the applicable law in this case, but Judge Wheeler’s opinion seems quite reasonable. In short, he held that the Federal Reserve exceeded its authority by demanding a controlling equity interest in AIG as condition for a loan that would keep AIG for filing for bankruptcy, but he found that AIG’s stockholders were not due any payment from the government for this action, since the alternative, bankruptcy, would have left them in a worst position economically. In a less noticed part of the opinion, the judge found that AIG’s reverse stock split in a ratio of twenty-to-one was done in order to keep AIG share price over $1.00 so as not to be delisted from the New York Stock Exchange. The judge found no evidence that it was done to avoid a stockholder vote on the government exchanging preferred stock for common stock. In other words, on this issue, the plaintiffs lost.

The judge’s descriptions of the events leading up to the AIG loan do not portray anyone in a very favorable light. In particular, one gets the impression that certain of the actors reveled in acting as the tough guys in the way they acted towards AIG. Left unexplained is why the terms of the AIG loan which involved the effective nationalization of AIG and a very high interest rate were so much tougher than what the government demanded of the banks. As I’ve indicated, the excuse that Pearlstein and Andrew Ross Sorkin proffer, i.e., the government did not regulate AIG, is questionable, since the Office of Thrift Supervision did have supervisory authority over AIG as a thrift holding company. Also the judge mentions, without much comment, that the Federal Reserve decided that AIG’s credit default swap counterparties would be paid the full amount they were owed, even though AIG was in financial distress but for the government backup. This seems to have been a way to help the banks.

As to the legal authority to take an equity interest in AIG, particularly telling is an email from a Davis Polk lawyer who was acting as the New York Fed’s outside counsel. In this email, the lawyer said that the government “is on thin ice and they know it. But who is going to challenge them on this ground?” Well, we know the answer to this question. How Mr. Greenburg feels about winning his case after paying a very expensive legal team led by David Boies but not receiving any payment in spite of this win is unclear, except that he is not satisfied. According to The Wall Street Journal, he plans to appeal Judge Wheeler’s decision on damages and an earlier decision to dismiss claims related to the “backdoor bailout” of banks by making them whole on the CDS contracts with AIG.

Also, of course, AIG is hardly blameless. The company took excessive risk by taking on the mortgage risk that the banks did not want to hold through credit default swaps. It is also true that the government actions led to AIG continuing in business.  Given the pressures of the time, the government officials were making the best decisions they could, and mistakes were inevitable. In retrospect, many think that the biggest mistake was letting Lehman Brothers fail. While Treasury and Federal Reserve officials claim that they did not have sufficient authority to save Lehman, this is not widely believed given their resourcefulness in other matters, including AIG.