PIIGS or Not?

         Each proud in their great accomplishments, Portugal first globalized the world through its trades, Ireland gave the world some of its greatest poets, Italy shined as the center of the Roman Empire, Greece gave birth to democracy , and Spain conquered half of the world. Yet, during the past few years, they have been known as the “PIIGs.” This simple acronym is not merely a coincidence and reflected to some degree, people’s pejorative attitudes toward these countries’ governments.

         Protested by the government and press of these countries, many media groups and firms have either banned or phased out on this phrase. But before we completely toss the word out of our dictionary, let us take a look at why someone came up with this term and whether the reason deserves merit.  

         Since this is not a trivia game, we will not spend any time guessing why these countries belong in the same group. All of these countries, Portugal, Ireland, Italy, Greece, and Spain are the trouble makers in the sovereign debt crisis. To simplify the term, it basically means that these countries have spent more than they could make or borrow and are now asking for help.  As we went over in “Greek Tragedy,” it is common for countries to borrow money to spend, but it is less common for countries to either make so little, or borrow so much, or a combination of both, that they cannot sustain their spending. Let us also think about it this way. It is good when a person chooses to spend within a budget. Some call it frugality, financial responsibility, or simply, being an adult. On the contrary, it is bad when a person spends more than the budget and asks for more money. Therefore, it is easy to understand why investors would want to call them “PIIGS” when these countries overspend so much that they need help.

         While all of these countries are in trouble and are in need of bailout funds from the European Commission, do they deserve to be known as the “PIIGS?” Let us take a look at each country individually and give them a chance to speak for themselves.

         Portugal, like the rest of the countries, not only spends more than she makes, but also spends so much that she is unable to properly find investors to lend her money. So what did she spend all that money on anyways? For Portugal, the bloated government spending in public works and services was one of the root causes. Portugal is essentially a restaurant owner who owes a great amount of debt when customers stop coming because he or she pays heftily to the chefs and constantly renovates. The Portuguese owner claims that customers love the restaurant and for some reason (ie: the financial crisis of 2008), people just stopped coming. As a result, now the Portuguese owner has to go around and ask for more money.

         Going back to the restaurant owner example with Ireland, now the Irish owner has to ask for more money because the owner promised to take care of the chefs and six chefs have lost nearly their livelihoods gambling on housing prices. In bailing out the six main banks in Ireland who financed and lost money in the property bubble, the Irish government put itself in financial danger. As a result, regardless of how good the restaurant is, the Irish owner has to go and ask for money.

         As for Italy, the Italian owner simply owns a bad restaurant. For years, the restaurant has become dated and less competitive. Times are changing and people just do not want to go to the restaurant anymore. Especially with the overall decline in the restaurant businesses in the area, as with Europe, the Italian owner faces tough choices. Yet stubbornly refusing to adapt the restaurant or cut down on spending, the owner sees the restaurant going the way it is. As a result, Italy, just like the Italian owner is struggling. The restaurant is losing money and the owner may need to go ask for money soon.

         The Greece owner also has it pretty tough. Having a restaurant in the beautiful Mediterranean Sea, the Greek owner used to be able to cash in on all the tourists. During the heydays, the generous Greek owner paid the chefs and workers handsomely and promised riches. But with the declining number of tourists due to the bad economy (ie: the financial crisis of 2008), the Greek owner is struggling to come up with ways to continue to pay the employees like kings. As Greece’s tourism driven economy suffered hard blows in the economic downturn, it finds itself in trouble having to fulfill its obligations. As a result, the Greek owner has asked for money, and plenty of it.

         Lastly, the Spain owner has woes similar to the Portugal owner. While both of them had their fair share of good businesses and took on renovations and high paying chefs, their declining earning has different reasons. For Spain, the owner used to be able to make a lot off of tips. When the tips are good, there was no problem paying all the wages and expenses. But when the tips go bad because people are overall poorer, the Spanish owner will start to have sleepless nights. Similarly, when the housing bubble was brewing in Spain, the government enjoyed strong revenues from the property taxes. Yet, when the bubble burst and home prices went down, the government lost its luxury of the high property tax revenues. As a result, the Spain owner has also asked for money.

         After understanding each country’s individual predicament, one may ask an interesting question, “why cannot these countries just borrow more from its normal lenders? Are there no investors that are willing to lend to them?” This is another topic that is essential in understanding the sovereign debt crisis. The quick answer is that there almost always will be investors willing to lend to them, but these investors will also ask for much more in return. As a result, it may be a bad idea for these countries to continue to borrow from these investors. As for the long answer, keep on reading.

         When a friend borrows money, a lot of times you will lend the money based on your own financial situation, your friend’s reason for the money, and your relationship with the friend. When a country borrows money through government bonds (see “Greek Tragedy”), the investor goes through similar considerations. One, when the economy is good and the investor is rich, there may be more people to borrow money from. (One thing to note is that when the economy is good and the investor is rich, it is not necessarily cheaper to borrow money because of financial policies and the characteristics of interest rates. That is a topic for another time.) Similarly, when the economy is good and your friends are rich, it may be easier to borrow money from your friend. Two, while people do care about what they money is for when the friend borrows the money, most investors do not care as long as the country will repay the amount based on the terms. Three, when a friend asks for money, your level of friendship and your understanding of his character and background play a factor. Furthermore, the public perception of the friend may also affect your willingness to lend the money. As for countries, investors get to know the country’s character and background through debt ratings. Rating companies such as S&P and Moody’s rate a country’s credit as if rating a friend’s trustworthiness. Instead of spending time on these countries, investors believe in these ratings and make decisions off of these ratings. A higher rating means a country is more likely to pay back and vice versa. This became a key factor in the sovereign debt crisis.   

         During the crisis, rating companies downgraded many PIIGS countries’ debt ratings. As their ratings dropped, investors become more cautious about their lending to these countries. Some back off completely and those willing to stay will ask for more in return. For example, countries used to be able to borrow from investors through bonds paying a low rate, yet after the rating downgrade, they could only borrow with bonds paying a high rate. Furthermore, the self-fulfilling prophecy of risk also plays a factor. Similar to vicious rumors about a friend, concerns about a country makes it more expensive for countries to borrow, which put them in even more financial ruin. As a result, in a world inundated by information, these concerns turn into self-fulfilling prophecies in the markets and make it harder for these restaurant owners to make a comeback.

         Fortunately, there is still hope for these countries. Turning the disadvantage of these rating influenced and rumor prone investors into advantages, governments have been able to pacify these antsy investors with strong political and economic figures. Putting the Milgram experiment on obedience to authority figures into good use, European Central Bank’s Mario Draghi, Federal Reserve Bank’s Bernanke, and Germany’s Angela Merkel have been authority figures for the world. While the extent of their influence is arguable, we need and rely on their impact. It may worth your time to listen to what they said the next time they speak and how the market reacts. 

Well Paid or Overpaid?

         “Ugh, now I have to go find a husband in finance,” says Kaylie Hooper, the character by Chloe Grace Moretz in the finale of the hit show, 30 Rock. After losing to her arch nemesis, Jack Donaghy, in the final show down for the control of Kable town’s NBC, she says the line to poke fun at her own misfortune. Outwitted by Jack’s clever and ingenious plot, she now has to find a new way to make money rather than take over NBC as Hank Hooper’s favorite granddaughter. This may seem like a tangent, but behind the witty line that gave all of us this light chuckle, there lies a truth about the financial industry. People think and know that financial professionals are well paid.

         Out of all the jobs in the world though, why do the financial professionals get paid more?

         Well, for the people in the financial industry, some think they are paid well because they work hard. From the preparation and degrees required, the skills and knowledge preferred, and the long hours demanded, a career in the finance does seem like it takes a lot. It takes years of hard work in High School to do well on exams, get good grades, and gain valuable extracurricular experiences for a shot at a good business school. After that, the process is repeated again in college for a chance at a good internship. Then, after a summer (or summers) of going into work early, leaving late, picking up projects, and networking with everyone, they may be able to land a full time offer after graduation. Yet, even then, the hard work continues. People are not only expected to increase their value at work, but also expected to further themselves in different degrees, certifications, and licenses as time goes on. In such a rigorous career path exacerbated by the cut throat environment, financial professionals see their salary as the fruits of their labor, and why shouldn’t they? Factoring into all the preparation done for their career in finance, it is not unreasonable to see why finance people see their pay as a justified reward to their long term trade off. While this is a big generalization, it does capture some sentiment of the people on the inside. A major flaw with this explanation is this disclaimer: working hard does not necessitate better pay. I am sure all people work hard in their job to make a living and it is important not to discredit the work of others. Just like my professor once said, “while great investors like Warren Buffet do work really hard to get to where they are today, I am sure the factory worker who has labored himself all his life diligently did not have it any easier.”

         For people on the outside, they think financial professionals “make bank” because they are smart. While finance is really not “rocket science” and anyone with commitment and education can do it, they do have a point. What they are saying is that by supply and demand, finance pays well. Since the finance industry provides many important functions in society such as bank deposits, mortgages, insurance, and investments, there will be a demand for finance. As a result, the finance industry’s pay depends on the supply of the people who can perform these roles. When there are not a lot of people who can do these jobs, naturally, they will have more bargaining power with the employer to get more money. While there are a lot of aspiring investment bankers running around every college, if we look at the entire population as a whole, these people are definitely still a small segment. If the picture is not clear enough, let’s look at it this way, if we look at the number of people who are able to value Facebook’s growth potential and cash flow versus the number of people who are qualified to be the store greeter Wal-Mart, then we can see how supply and demand is at work here.

         While supply and demand makes sense and can also be used to justify the sky high pay of professional athletes, I believe there is more to the reason behind finance’s high pay. To me, financial professionals are paid well and will always be paid well because their business directly deals with money.

         From the early subsistence economy where goods and services are merely exchanged to the complex global economy we are in today, people continue to build wealth through the exchange and use of goods and services. One thing that differentiates these two different forms of economies though, is money. Money provides a store of value and a universal medium of exchange. Back then, farmers plant crops and trade with fisherman who fishes. One party receives protein and one party receives grains. Yet, they traded for just the amount they needed. Since the raw fish will go bad in a few hours, the farmer will not trade for more fish than he needs despite how much the fisherman needs his grains.  He would rather trade for something else no matter how many fish the fisherman is offering. Yet with the advent of money, everything changes. The farmer can now “sell” his grains to the fisherman for as much as the fisherman wants and use that money to “buy” some fish and save the rest. The saving, a newly generated value that was previously wasted, can now go on to help the farmer buy more goods and services. This allowed the economy to grow and developed into the world as we know it today.

         Fast forward to centuries later, the financial industries have evolved into the biggest beneficiary of the invention of money. The financial industry has been able to maximize money’s durable, divisible, transportable, and non-counterfeitable characteristics. For example, banks deal directly with money by collecting money from customers’ deposits and investments and lending them out as mortgages and loans. For their business, they earn interest from lending out and borrowing money from others. By taking advantage of money’s inherent characteristics, they save cost effectively and sustainably. For instance, banks’ assets, its reserve of money, do not rot due to heat, do not go out of fashion, and do not become obsolete in any shape or form. They also can be divided into smaller bills, coins, and fractions of pennies as well as wired and transported over a split of a second. Lastly, the government protects the value of the money and forbids counterfeits. While other industries need to refrigerate its supplies, have massive sales to clear out unwanted inventory, pay hefty sums for cargo transportations, and fight in lawsuits against counterfeits, banks are completely free of such concern. As a result, the financial industry can effortlessly pay its employees in money without the time and value loss other industries go through in converting their goods or services into money.

         I understand that this idea may cause some confusion, let’s also look at it this way. As we know, the sun indirectly provides us the energy we need. The sun’s power goes through several rounds of conversion, decreasing the level of energy in reach round, until it reaches us. From grass’s photosynthesis, cattle’s grass grazing, to the food in our stomach, energy is lost on each level. Similarly, a company loses value to its middle men in each round of good and services’ conversion money. On the other hand, the financial industry is the equivalent of absorbing solar energy directly without the loss in value or energy. This is why the financial industry is able to pay out such big salaries. This analogy may help, but readers have to take note of one thing. While the sun generates its own energy as a star, the financial industry relies on the activities of other industries. This is a big reason why the bankers’ pay have come down and a story for another time.

         For many, the financial industry is paid more than its social value, arguing how many financial services are merely mirroring the overall market activities. Some go even further to criticize financial professionals as overpaid and irresponsible bet takers. Regardless of the merit of the financial industry, it is interesting to always ask and answer the question of “why are financial professionals paid so well?” Especially resonated in the public in the Occupy Wall Street Movement and the recent European decision to cap bankers’ bonuses, this debate will continue to go on.