Markets, World Affairs

The Never-Ending Greek Debt Slavery Saga Revisited


Obedience is not enough. Unless he is suffering, how can you be sure that he is obeying your will and not his own?

George Orwell, 1984

‘To say [Varoufakis’ Adults in a Room] is the best memoir of the Eurozone crisis,’ writes Adam Tooze, ‘is an understatement.’ I would second that had I read others. Memoirs are simply not my genre. But the former Greek finance minister’s testament is a different matter altogether.

Although far from disinterested, Varoufakis is a reliable reporter from the trenches. His critique of the Troika is truly devastating. Simply put: They knew. They knew that their plan was guaranteed to fail. They knew that Greece was bankrupt and would never be able to pay back all the money that it owed. They knew that without debt relief in one form or another, there was simply no path back to sustainability. They knew that austerity was devastating the Greek economy and worsening its debt burden. They knew that pouring good money after bad was a non-solution. They, Varoufakis insists, did not even want their money back.

Yet, utilizing an impressive arsenal of Kafkaesque red tape they obstructed all potential solutions, and using all available means of diplomatic and financial coercion, arm-twisted successive Greek governments to submit to never-ending debt slavery. Why? Adam Tooze explains it best:

The main function of disciplining Greece, Varoufakis tells us, was to serve as a warning to the French of the price of fiscal indiscipline. In other words its purpose was to perpetuate and widen discipline. But that in turn was not so much an economic as a political problem. Berlin wanted to avoid the terrifyingly difficult distributional politics of even larger scale exercises in cross border bail outs and “transfers”. Holding the line in Greece was a way of containing what could have become a spiraling political disaster for the CDU and their coalition partners.

We will return to the strategic rationale for putting Greece in debtors’ prison. But first, How did we get here?

Greece was a victim of global macro forces well beyond its control. In 2001, Greece gave up monetary independence and adopted the euro. This meant that regaining lost competitiveness and correcting macro imbalances would require a real devaluation (ie, wages would have to fall in nominal terms); thus requiring an extraordinarily painful ‘structural adjustment’ programme in IMF-speak.

Bond markets responded to the advent of the euro by compressing sovereigns spreads; meaning that Greece could borrow at virtually the same interest rate as Germany. (See Figure 1.) Greece was thus able to borrow large sums from bondholders—debt that was only revealed to be unsustainable when sovereign spreads widened with the onset of the eurozone crisis.


Figure 1. The spread between Greek and German sovereign bond yields.

At the same time, northern banks dramatically expanded their lending to Greece. Greek debt to foreign banks grew from €135 billion as of 2004Q1—surely up from a much lower level since 2001—to €217 billion in 2008Q1. (See Figure 2.)


Figure 2. Foreign banks’ credit to Greece.

More generally, Shin (2012) has shown that a banking glut in Europe was the principal driver of the financial boom in the European periphery as well as the United States. The idea here is straightforward: Fluctuations in the risk-bearing capacity of global banks drive fluctuations in the supply of credit. But let me offer a more precise thesis.

The credit boom preceding the financial crisis in the US and peripheral Europe was the great sucking sound of the wholesale market for collateralized funding. The extraordinary expansion of mortgage credit to, say, US households was due to demand for raw material (ie, mortgages) required for the manufacture of private-label mortgage-backed securities. (There was a persistent ‘shortage of safe assets’ in the global financial system.) In 2003-07, Pozsar (2015) shows, Wall Street was hard at work feeding the machine it had constructed to intermediate between cash pools (central banks, corporate and state treasuries, money-market mutual funds, et cetera) demanding ultra-safe assets in the money markets and portfolio managers demanding risk assets for their relatively high yields in capital markets. No wonder that Mehrling et al. (2013) describe shadow banking as ‘money market funding of capital market lending’.

Note that the centrality of the wholesale funding market does not undermine the role of the dealers’ risk-bearing capacity as the main state variable (or explanatory variable). To the contrary, funding markets exist in only as much as dealers make them. Physically, the interdealer funding market—the supercore of the dealer ecosystem and hence the global financial system—is a network of phone and Internet connections between traders at global banks. The point is that Shin (2012)’s finding—that fluctuations in balance sheet capacity drive fluctuations in credit supply—is only being fleshed out here; not superseded. [Of course, the risk-bearing capacity of the sell side ought to be measured relative to the financial size of the buy side. See Farooqui (2017) for the primacy of the relative scale of balance sheet capacity in pricing the cross-section of stock returns.]

The preceding paragraphs may seem like a digression. They are anything but. For the ‘excess elasticity’ of global finance was the fundamental reason why Hollande and Merkel had to impose debt slavery on Greece. The denouement of the financial boom unleashed by the unprecedented expansion of European balance sheet capacity came when excessive bank leverage met mounting losses on subprime loans. Germany and France could not acknowledge the scale of the bailout required by the banks to their audiences at home. They had to be bailed out without recourse to more public funds. While American policymakers used the AIG bailout to secretly bail out Goldman Sachs and JP Morgan, the Europeans used the Greek bailout to secretly bail out French, German and Dutch banks.

The [big] three French banks’ loans to the Italian, Spanish and Portuguese governments alone came to 34 per cent of France’s total economy – €627 billion to be exact. For good measure, these banks had in previous years also lent up to €102 billion to the Greek state.…

Why did Deutsche Bank, Finanzbank and the other Frankfurt-based towers of financial incompetence need more? Because the €406 billion cheque they had received from Mrs Merkel in 2009 was barely enough to cover their trades in US-based toxic derivatives. It was certainly not enough to cover what they had lent to the governments of Italy, Ireland, Portugal, Spain and Greece – a total of €477 billion, of which a hefty €102 billion had been lent to Athens. [The €102 billion in this quote is quite likely a typo—that’s the French banks’ exposure to Greece. As Varoufakis tells us later, the German banks’ exposure was €119 billion.] 

So, of every €1000 handed over to Athens to be passed on to the French and German banks, Germany would guarantee €270, France €200, with the remaining €530 guaranteed by the smaller and poorer countries. This was the beauty of the Greek bailout, at least for France and Germany: it dumped most of the burden of bailing out the French and German banks onto taxpayers from nations even poorer than Greece, such as Portugal and Slovakia. 

This disturbing transformation of the banking crisis in the northern core into a sovereign debt crisis on the periphery was accomplished in the very first phase of the eurozone crisis; well before Varoufakis arrived on the scene.

As soon as the bailout loans gushed into the Greek finance ministry, ‘Operation Offload’ began: the process of immediately siphoning the money off back to the French and German banks. By October 2011, the German banks’ exposure to Greek public debt had been reduced by a whopping €27.8 billion to €91.4 billion. Five months later, by March 2012, it was down to less than €795 million. Meanwhile the French banks were offloading even faster: by September 2011 they had unburdened themselves of €63.6 billion of Greek government bonds, before totally eliminating them from their books in December 2012. The operation was thus completed within less than two years. This was what the Greek bailout had been all about.

Thereafter, the European strategy was to enact a morality play to cover up the crime; complete with bloodletting—aka austerity—and moral sermons blaming the victim. The Troika’s treatment of Greece was tantamount to economic warfare. By the time Varoufakis got in the cockpit, the Europeans had developed the full apparatus of control. The reason he found the Troika to be Kafkaesque, is that the insiders were committed to controlling the narrative. They could not negotiate honestly with Varoufakis both because they feared the markets and because they would then be admitting guilt. While some individuals involved in the ‘institutions’ even admitted the crime to Varoufakis, institutionally the Troika was designed to bury the dirty little secret.

This is, of course, not to disagree with Adam Tooze about the role played by political constraints in Berlin, Paris, and indeed, Washington. Indeed, political constraints are precisely what drove the bank bailouts underground and started the Greek Debt-Slavery Saga.

VAROUFAKIS SAYS he had a financial deterrent to get Draghi to back off from financial strangulation and give him breathing room.

[The €33 billion] Greek debt to the ECB were legally momentous: any haircut of that sum or delay in its repayment would open Draghi and the ECB up to legal challenges from the Bundesbank and the German Constitutional Court, undermining the credibility of its overall debt-purchasing programme and causing a rift with Chancellor Merkel, who would never take on both the Bundesbank and the German Constitutional Court at the same time. Facing their combined might, Draghi was sure to find his freedom drastically curtailed, thus undermining the markets’ faith in his hitherto magical promise to do ‘whatever it takes’ to save the euro – the only thing preventing the currency’s collapse. 

‘Mario Draghi is about to unleash a major debt purchasing programme in March 2015, without which the euro is toast,’ I said. ‘The last thing he needs is anything that will impede this.’…I had no doubt that if a Syriza government signalled early on its intention to retaliate by haircutting the Greek SMP bonds held by the ECB in this way, it would deter the ECB from closing down the banks.

Calling the deterrent “potentially very powerful,” Tooze reports that

…the faction within the Tsipras cabinet that wanted to avoid a break was too strong. Varoufakis was never allowed to make the critical threat at the right moment. Greece was driven to a humiliating compromise without ever having deployed its deterrent.

Game-theoretically speaking, whether Varoufakis’ deterrent was effective cannot be answered without knowledge of the preferences of other players. Even if Draghi himself could be deterred, as indeed seems likely, that was only going to grant Greece a short term lease on life. There is no reason to believe that it would’ve forced the Troika to negotiate in earnest. A Greek threat to activate the deterrent could just as easily have yielded a Schäuble solution with the Troika turning the screws to push Greece out of the eurozone in the service of discipline. We cannot answer that without knowing just how much Merkel feared Grexit.

A distinct possibility is that the deterrence strategy was leaked to the Germans by someone in the Greek war cabinet—infiltrated as it was by the Troika—and that Merkel let it be known to Tsipras that the activation of the threat, or perhaps even its deployment against Draghi, would harden the Troika’s stance. What I mean to suggest is this: Tsipras is not a scoundrel. Why did he capitulate if the deterrent was in fact effective? Did he know something about the preferences of Greece’s jailers that Varoufakis did not? Could it be that Varoufakis’ dirty bomb was a recipe for tactical victory but strategic defeat? Is that why Tsipras capitulated instead of deploying the deterrent?


How the US Market-Based Credit System Works

In a recent primary debate, Hillary Clinton suggested that risks in the financial system are now concentrated in ‘shadow banks’. I do not like this terminology. The so-called ‘shadow banking system’ is the very core of the US financial system. It is where money is manufactured and the price and quantity of credit determined. We shall use more neutral terms such as ‘the market-based credit system’ or when the intent is clear, simply as ‘the modern system’ instead. In this essay, my goal is to demystify the system for the reader. In what follows, we shall describe the core institutions and key working parts of the modern system. Readers interested in understanding the system in greater detail should begin with the works of Pozsar, Mehrling and Adrian (see references at the bottom); as well as the excellent treatment by the Federal Reserve Bank of New York.

How money is manufactured in the modern system

In a prison, money is cigarettes; for drug dealers and suchlike, money is cash; for most of us, money is bank deposits. But for those with really big balance sheets—corporate treasurers, money-market mutual funds, institutional investors, central banks and big investment firms—it is paper. What is paper? Paper, or more formally a deposit-equivalent, is whatever can be exchanged at par on demand with near certainty. That is, it is an ultra-safe, short-term asset that can be exchanged without loss for cash or bank deposits on demand. A market-based credit system revolves around the manufacture of paper.

How is paper manufactured? Take a risky asset—a claim on any stream of cash payments such as a mortgage or a standard semiannual coupon bond (which pays a fixed coupon rate every six months)—and break down its price into the price of risk and the price of paper according to the first fundamental equation,

asset = paper + risk.

If you can find someone to bear the risk (and earn the reward) of this asset, you can decompose the cash-flow of the asset into junior tranches of asset-backed securities (ABS) that bear most of the risk and senior tranches that bear little. The senior-most tranche after all the slicing and dicing is paper; stamped AAA for good measure. Let’s work with a concrete example to illustrate the manufacturing process of paper.

Let’s take a pool of 10,000 mortgages. Suppose we create just two tranches of mortgage-backed securities (MBS). The senior tranche gets paid in full unless at least 9,000 mortgages default; the junior tranche gets the rest. Now, the probability that 9,000 of 10,000 mortgages default in any given year mathematically depends on the correlation of the rates of default on the 10,000 mortgages. For uncorrelated mortgages, the probability is vanishingly small. And the higher the correlation, the higher the probability that the holders of the senior tranche will lose money. In the extreme, if defaults are perfectly correlated, then the probability that the holders of the senior tranche get burned is the same as the probability of a single default! In practice, the correlation is essentially zero for prime loans. And as we found out in the course of 2007 and 2008, not quite zero for subprime. Anyway, let’s stay with a pool of prime loans—those that are expected to be repaid with very high probability and have low correlation. Since the probability that the holder of the senior tranche will bear any loss whatsoever is basically zero, the senior tranche is paper.

Overnight paper

There are four kinds of paper in a market-based credit system.

(1) Purely public money, where the asset is public and the state provides a backstop. In the United States, these are Treasury bills (Tbills) issued by the government as well as overnight reserves at the Fed. Other government bonds do not qualify as paper because they are subject to considerable interest rate risk.

(2) ‘Public-private’ money, where the asset is public but there is no public backstop. Secured borrowing (called repo) when the collateral on the loan is Tbills and constant net asset values accounts of government-only money-market mutual funds both qualify as this type of paper.

(3) ‘Private-public’ money, where the asset is private but enjoys a public backstop. Bank deposits insured by the FDIC qualify for this type, as do term deposits in wholesale banks.

(4) Purely private money, where the asset is private and enjoys no state backstops. Repo with private asset-backed securities and CNAVs of MMMFs as collateral qualify for purely private paper.

The following table reports the total amount of paper outstanding in the financial system estimated by Pozsar (2014). Note that the largest pile is purely private paper accounting for a full third of the total; whereas purely public paper accounts for about a quarter; about the same as shadow money created on the backs of public assets. Bank deposits, the flag bearers of traditional banking money, account for less than a sixth.

Type Quantity Share

(1) Purely public $2.6 trillion 27%

(2) Public private $2.3 trillion 24%

(3) Private public $1.4 trillion 15%

(4) Purely private $3.2 trillion 34%

Total $9.5 trillion 100%

Instead of the traditional ‘originate-to-hold’ banking model wherein the loan sits permanently on the balance sheet of the lending bank, the modern banking system is characterized by the ‘originate-to-distribute’ model that parcels out the risks to those who are most willing to bear it; in the process, manufacturing copious amounts of private money. The manufacture of paper involves warehousing the assets off balance-sheet in artificial firms called conduits in offshore locations; and selling some of their risk to monoline insurers. But the paper itself and much of the risk exposure makes its way to the wholesale market; as is clear from a map of the entire system.

The Wholesale Funding Market

At the core of the market-based credit system sits the wholesale funding market. It is here that almost all the paper manufactured in the system circulates. At the center of the whole system are the dealers or market-makers, who stand ready to buy and sell, as well as borrow and lend, both paper and assets in bulk at posted bid-ask prices. Dealers supply market liquidity by quoting a two-sided market and absorbing the resulting order flow on their own balance sheets (Harris, 2003). Indeed, a dealer that insisted on a matched book at every instance would not be supplying liquidity at all. Both the volume of order flow and the dealers’ willingness to hold inventories is thus necessary for market liquidity. As Mehrling et al. (2014) note, “If customers are able to buy or sell quickly, in volume, and without moving the price, it is because some dealer is willing to take the other side of that trade without taking the time to look for an ultimate offsetting customer trade.”

Dealers interface with two types of actors in the wholesale funding market—yield seekers who want the returns that come with risk and cash pools who want paper.

Yield seekers are asset managers whose motto is “beat the benchmark”. In order to earn returns, asset managers seek to bear risk. There are two kinds of asset managers. Real money investors who have their own risk bearing capacity such as pension plans, endowments and other institutional investors. And leveraged investors such as hedge funds and other alternative asset managers. Instead of holding equities that would yield 12 per cent with a good deal of uncertainty, a leveraged beta investor holds a combination of paper and derivatives to make a leveraged bet whose expected return is 12 per cent (the leverage comes from the derivative, not from outright borrowing). Such strategies allow for ‘equity like returns for bond like volatility’. This can be seen from expanding the first fundamental equation (asset = paper + risk) into the second fundamental equation,

asset = paper + CDS + IRS + FXS,

where the derivatives—credit default swap (CDS), interest rate swap (IRS), and exchange rate swap (FXS)—are the prices of credit, interest rate, and exchange rate risks, respectively. The proliferation of leveraged beta strategies has therefore generated brisk business for dealers who are market-makers in the asset, paper and derivative markets.

Cash pools’ motto is “do not lose”. These are usually money-market mutual funds, corporate treasuries, foreign central banks, and institutional investors—those holding such a large pile of cash that it is risky to park it at a bank! Since the FDIC only insures the first few hundred thousand dollars in any individual account, cash pools prefer to hold Tbills or ‘quasi-Tbills’ instead. That is, cash pools prefer even purely private paper to bulk bank deposits because the former is more secure. They also want paper for yield since the fractions of a cent on the dollar that paper yields adds up quickly when you have billions of dollars to park. As corporate coffers have filled up with cash and the assets of money market funds has skyrocketed, the demand for paper has exploded. Pozsar (2014) estimates that between 1997 and 2013, while US GDP doubled, cash pools trebled (from $2 trillion to $6 trillion).

The wholesale funding market consists of the wholesale money market and the wholesale capital market. The wholesale money market is the market for paper where money dealers borrow and lend paper in bulk. In the wholesale capital markets, the market-makers can be thought of as risk dealers or derivative dealers.

The repo market for collateralized borrowing, the interdealer overnight lending market, and the off-shore eurodollar market are all part of the wholesale money market. The main one is the repo market. A repo transaction is best thought of as one party borrowing money from another by posting paper as collateral. A reverse-repo is just a repo with the positions of the parties interchanged. Interestingly, while there were runs on the bilateral repo market as a whole in 2007-2008, there were no generalized runs on the tri-party repo market (where the runs were restricted to specific asset classes). This suggests that the panic was about specific counterparties and specific assets. In other words, the plumbing of the system is more resilient that it looks.

Dealers respond to inventory buildups by adjusting their bid-ask prices. But even matched-book dealers bear liquidity risk because they must repay their creditors even if their own debtors do not repay them. The size of dealer books determines the liquidity in the entire wholesale funding market. In turn, the size of dealer books depend on systematic volatility. Dealer balance sheet optimization is inherently procyclical: Dealers respond to low systematic volatility by expanding their books, which in turn further suppresses systematic volatility.

Dealer behavior is also procyclical with respect to order flow. Specifically, dealers move prices to bring buy and sell order flows more into line with each other, but in doing so they move prices away from their matched-book values. This generates a credit cycle. In expansion mode, the boom is exacerbated. And in contraction mode, liquidity dries up.

Pozsar’s central thesis is that the emergence of the market-based credit system can be explained by the growing demand for paper from cash pools on the one hand, and the increasingly frantic search for yield by asset managers on the other. The former is the consequence of a shortage of Tbills—there are only about $800 billion worth of Tbills in circulation. The latter is the consequence of increasingly difficult-to-satisfy obligations of institutional investors. Basically, pension funds and other institutional investors made promises based on overly optimistic assumptions about returns. They were implicitly assuming that productivity would grow at a faster pace than it has. They are thus desperate for excess returns.

Wholesale funding market

These sources of powerful flows on both ends of the wholesale funding market had two consequences. First, they made market-making in the wholesale market extremely profitable. Second, they lowered the price of credit system-wide. Pozsar posits that this mechanism provides a competing explanation (to Bernanke’s ‘global savings glut’ and Shin’s ‘global banking glut’) of Greenspan’s conundrum (the failure of long rates to rise despite rate hikes). [These competing explanations can be tested in a vector autoregression. Yet another project for the Policy Tensor!]

The Fed’s Reverse-Repo Facility

During and after the financial crisis, the Fed moved in to stabilize the wholesale funding market by buying vast quantities of troubled assets; mostly MBS. In addition it expanded the supply of Tbills. The Fed also created an entirely new form of purely public money. This is the Fed’s reverse-repo facility that provides publicly guaranteed paper to the Fed’s counterparties. Moreover, the Fed has given access to the facility not just to primary dealers (who otherwise enjoy exclusive access to the Fed), but also money-market mutual funds. This serves to ameliorate the problem of the shortage of Tbills. Pozsar expects the facility to expand in a big way and drive out much of the private paper in circulation today. So far, the Fed has said that it is a temporary facility that only exists to give the Fed another lever to control the short rate. The facility is expiring in January 2016. It will be interesting to see which way the Fed decides to go in the December meeting. I wouldn’t bet against Pozsar.

A Dealer of Last Resort

The Achilles heel of the modern system is liquidity risk. This is because while credit, exchange rate and interest rate risks end up on the books of those willing and able to bear them (insurers, real money investors and leveraged investors), liquidity risk cannot be so efficiently disposed. This is the familiar problem of systemic risk arising from multiple equilibria—when there is a run on the system, liquidity evaporates. What matters is your ability to make that margin call, not whether you are ‘fundamentally solvent’. What is required, as Bagehot argued in the nineteenth century, is a dealer of last resort. Someone who is willing and able to step in when others aren’t—a role that J.P. Morgan famously played in the panic of 1907. Bagehot’s advice for the Bank of London was to lend freely on (normally accepted) collateral and charge a high rate of interest.

Pozsar, Mehrling, and Adrian counsel the Fed to play this role. On the other side of the pond, the Bank of England has already made moves in this direction. So far, the Fed has declined to accept private paper. My position is that the Fed does not have much wiggle room. It must either produce enough public paper (say through the reverse-repo facility) to drive private paper largely out of circulation, or it must become a dealer of last resort. Otherwise, the market-based credit system will remain prone to runs.

Selected References

Mehrling, The New Lombard Street: How the Fed Became the Dealer of Last Resort, 2010.
Pozsar, “Institutional Cash Pools and the Triffin Dilemma of the US Banking System,” 2011.
Mehrling et al. “Bagehot was a Shadow Banker,” 2013.
Adrian et al. “Repo and Securities Lending,” 2013.
Pozsar, “Shadow Banking: The Money View,” 2014.
Pozsar, “A Macro View of Shadow Banking,” 2015.