How to Solve the European Sovereign Debt Crisis

“It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.” 

That is what is needed to resolve the European sovereign debt crisis.  So says Christine Lagarde, the managing director of the International Monetary Fund. (http://www.bloomberg.com/news/2011-12-15/imf-s-lagarde-says-escalating-european-crisis-requires-more-cooperation.html)

Need one say more?

But, she stated, the world economic outlook “is quite gloomy” with a pervasive downside risk.

So, the international community must work together. 

Working together means that, starting at the core…the European countries…economic and fiscal union must be achieved.  This would be attained through fiscal solidarity and risk-sharing around the globe. 

Unfortunately, one has to ask…is this “actually facing the issues…accepting the truth…accepting reality...” or is it just another way to postpone what needs to be done for a while longer?

My blog yesterday discussed the underlying economic dilemma faced by the European nations.  Over the past ten years or so, unit labor costs in Germany have increased 20 percent to 30 percent less than in other eurozone countries. (http://seekingalpha.com/article/313888-the-problem-is-germany)  That is, German labor has consistently become more productive than non-German labor.

And, the non-German countries, in an attempt to keep their labor as fully employed as possible given the divergence in labor productivity, engaged in programs of fiscal stimulus which created a credit inflation that was unsustainable.  Hence, the sovereign debt crisis.

Since the eurozone is subject to a single monetary authority and a common currency, fiscal budget tightening, at this time, can only bring on the “pain and suffering” of a recessionary restructuring.

The problem is that countries within the European Union have been allowed to get “out-of-line” with one another, economically.  And, in a union of countries like this, nations cannot “paper-over” the differences in labor productivity by the creation of lots and lots of debt.  In fact, such behavior only can exacerbate the problem.

The countries in the European Union are facing a need for a massive restructuring of their economies, their labor markets, and their industrial structure.  Yet, “fiscal solidarity and risk-sharing” will not do this job. 

As I mention in my blog post yesterday and Alan Blinder states in his op-ed piece in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj) we have reached the stage where the only possible solution may be a substantial change in how people do things.

According to Blinder, the only path left may be debt deflation. The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

A possible response to this, however, is social unrest.  We have already seen protests in Greece, and Spain and Italy and France…  But, protests have become a worldwide phenomenon.  We have protests in Russia.  These movements are also seen as a kin to the events of the Arab spring.  Furthermore, there are the “Occupy” efforts…in the United States…and in other parts of the world that cannot be totally divorced from these other events.  Modern information technology is being felt everywhere.

It is difficult to see how the protests and unrest in the non-German countries of the eurozone are going to resolve the situation.  Just as with the idea of “fiscal solidarity and risk-sharing”, a movement that does not address the fundamental misallocations that exist within these societies will not come up with viable alternative solutions.   

The issue is that many countries are “out-of-line” economically.  German labor productivity exceeds that of other European nations.  The industrial structure of Germany is more competitive than the non-German eurozone countries in the global marketplace.

I am not in favor of returning to a world of mercantilism, as I mentioned in yesterday’s blog.  But, as many emerging nations have recently managed their economies so as to improve their relative position in the world, those developed countries that have focused just on buying off labor unrest over the past fifty years, may have to alter their approach to how their economies are managed.  “Soft” solutions will only enlarge the gap they face with more competitive nations.   

Remember, one conclusion about the internal management of a nation’s economy within the framework of world trade is that a country can only choose two of the following three alternatives available to them: the nation can have a fixed exchange rate; it can have a free flow of capital internationally; or it can conduct an economic policy independent of all other countries.  This problem is referred to as the “trilemma.”

Well, the countries within the eurozone have a fixed exchange rate and they have a free flow of capital internationally.  Therefore, they cannot conduct their economic policies independently of the rest of the world.

The only thing left for these countries to do is to create an environment in which the productivity of their labor and capital become more competitive within world markets.  If not, the most productive capital and labor will move on to other nations. 

This solution has little to do with “fiscal solidarity and risk-sharing.”

The labor and capital utilization within the countries that are not doing so well…must be restructured.

As managing director Christine Lagarde stated, “It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

I’m not sure she is there yet…but neither are a lot of other people.  

Euro Solvency?

The financial markets hate uncertainty. It is the unknown that creates uncertainty and unexpected new information often creates uncertainty because investors must not only absorb the new information but must also translate what they have learned into action!

This is what I tried to emphasize in my post of April 28, 2010, “Greece: The ‘Surprise’ That Breaks The Camel’s Back” (http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back). Recently we were given knowledge that the budget deficit of the Greek government was much worse than we had been told, and, as a result of this news, the rating on Greek bonds was lowered. Immediately, investors began to sell off these bonds.

The financial market unrest continued. Then the European Union and the International Monetary Fund came up with its bailout package of €110 billion “to save the euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so.” (http://seekingalpha.com/article/202754-greece-and-insolvency-finding-a-way-out)

The problem is, as I pointed out in this last post, that the response was aimed at preventing a liquidity crisis and not a solvency crisis. These two types of financial crises are different and a failure to understand the difference and react in the appropriate way can just exacerbate a problem and not solve it.

The Federal Reserve under Ben Bernanke has been guilty of this very thing and, as a consequence, has contributed to the lingering solvency problem in the “less than mammoth” banks in the United States banking system today. (I have discussed this in many other posts.)

A liquidity crisis is a short run phenomenon related to the disclosure that the price of a certain financial asset should be different from what it had recently been trading at. The buy side of the market disappears and the price of the financial asset drops, sometimes precipitously. In the classical case, the central bank comes into the market and makes sure that there is sufficient liquidity in the market so that the price of the asset in question stabilizes and trading can resume.

The prices of other similar assets may be caught up in this uncertainty but the response of the central bank is enough to stabilize the market.

A solvency crisis is different. In a solvency crisis the value of the assets must be written down, but the concern is over the ability of the institutions that own the assets to cover the value write down with the equity capital they possess. Of course, the value of the assets may go up at some time in the future but in general these institutions must “work off” these assets over time in a way that does not exhaust their capital base.

Otherwise, if the effected institutions have to write off these “underwater” assets immediately they may have to be closed.

A solvency crisis takes a much longer time to get over than does a liquidity crisis. That is why so many small- to medium-sized banks are still having so much difficulty even with massive amounts of liquidity available in the banking system.

The problem with the current situation in the European Union is that the situation is not one of liquidity, but one of solvency. There is a very real concern in the market for sovereign debt about whether or not certain nations within the EU can maintain their solvency given the debt load their governments have assumed and given the very weak nature of their economies.

There is a question about the ability of certain governments to be able to pay-off their debts. And, if these debts cannot be re-paid, what will happen to the solvency of the banks and other institutions that now hold this sovereign debt. Special concern exists about commercial banks in Germany and France. Some think that the real reason for the Greek bailout is to keep several major banks in Germany and France from failing. (See the second post mentioned above.)

Just providing Greece the ability to be able to roll over its debt in the next twelve months or so is an attempt to make Greek debt “liquid”. The hopes are that this will buy time for the Greek government to “right its ship” so that it will be able to meet its financial obligations and then go bravely forward. The financial markets have responded by saying that the Greek situation is not a problem of market liquidity but a problem of government solvency: the government, as it appears now, cannot pay its bills.

The concern over solvency has spread. If Greece lied to its debtors, maybe other countries have been doing so as well. Maybe these other countries are not as well off as was thought. Hence, a need to check other “undisciplined” countries out.

The credit ratings of Spain and Portugal were lowered (with Portugal facing additional review concerning its credit rating). Isn’t this evidence enough. But, of course, other countries are on the radar screen: countries that have been particularly profligate like Great Britain where the Labour Government outspent the rate of inflation since 1997 by 41%! But also Italy and Ireland.

What we seem to be seeing in the world is a realignment away from countries that have over-stayed their welcome in the credit markets. We see this especially in the currency markets. The value of the euro has plunged against the dollar and other major currencies. Today, May 6 it hit a 52-week low around 1.26. In other areas of the currency market the move seems to be away from the currencies of countries having “debt problems” to those that appear to be more secure.

The same thing has occurred in bond markets. The rush to United States Treasury bonds has been phenomenal over the past week. The two-year Treasury was yielding about 1.07% April 23 while the ten-year Treasury was yielding around 3.82%. These two yields have dropped to 0.79% and 3.39%, respectively, a major move!

When uncertainty increases, market volatility also increases. If we look at one index of market volatility, the CBOE’s VIX index, we see it peaking over 40 today, up from around 20 or so over the past week and in the 15-20 range before that. The market appears to be spooked and this means one might expect the volatility of the financial markets to remain high in the near future.

The major problem going forward is leadership: who can lead the eurozone and Great Britain out of this mess? The concern is captured in Landon Thomas’ article in the New York Times, “Bold Stroke May Be Beyond Europe’s Means,” (http://dealbook.blogs.nytimes.com/2010/05/06/bold-stroke-may-be-beyond-europes-means/?scp=5&sq=landon%20thomas%20jr.&st=cse). In the case of the eurozone, there is no leader. And, this has been a problem the detractors of this union have pointed to since before the euro was put into place. There is an economic union but no political union. It is like herding cats and given the cracks that are occurring in the structure, many are wondering if this economic union can last for more than two or three years more.

In Great Britain, there is going to be a “hung” Parliament. But, who really wants to rule in jolly ole England. Some are saying that if the new government (‘hung’ or not) really does what it needs to do with respect to the fiscal condition of the nation, these politicians will not be able to be re-elected for the next ten- to fifteen years because they will be so unpopular. Shades of Greece?

The bottom line: governments have lived beyond their means. Certain ‘brands of economics’ have argued that this is possible because people don’t really take into account future tax liabilities or future inflation. They are very ‘current minded.’ It just seems possible that this philosophy has run its course!

Greece and Insolvency

A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.

Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.

Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.

Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.

But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)

By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.

There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!

The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.

Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.

Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.

Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.

The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.

It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.

Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.

The Piper eventually has to be paid.

The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.

This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?

Inflation is Just Not Understood!

Funny time to be talking about inflation, but the top economist at the International Monetary Fund brought it up.

Oliver Blanchard, now serving at the IMF while on leave from MIT, has co-authored a new paper and has publically presented the results which have been reported in the Wall Street Journal: http://online.wsj.com/article/SB20001424052748704337004575059542325748142.html#mod=todays_us_page_one. Mr. Blanchard is now saying that central banks that were shooting for a 2% rate of inflation in their deliberations concerning monetary policy should shoot for something more in the neighborhood of 4% “in normal times.”

Economists of Mr. Blanchard’s philosophical bent just don’t seem to understand!

Inflation IS NOT the solution!!!

But, Inflation could very well be the problem!!!

As I keep saying, the post-World War II policy favoring an inflationary economic policy gained power on January 20, 1961. The basic format for such a program was followed, almost religiously, by Republicans as well as Democrats, into the 2000s. As a consequence, a United States dollar that could purchase one dollar worth of goods on January 20, 1961 could only purchase about seventeen cents world of goods in the summer of 2008.

Furthermore, inflation could not keep unemployment, or even more important, underemployment, down, as was originally believed and it could not keep industry working near capacity throughout the last 47 years or so. In fact, if anything, inflation forced manufacturing to focus on rising prices rather than productivity and this contributed to rising underemployment and declining capacity utilization. For more on this see my post, “The US Economy: Not Back to Business as Usual,” of January 8, 2010: http://seekingalpha.com/article/181621-the-u-s-economy-not-back-to-business-as-usual.

Inflation did create a “boom-time” for finance. Finance loves inflation because inflation that runs ahead of inflationary expectations reduces the burden of any debt outstanding. And what did we see between 1961 and 2008? We saw the greatest blooming of financial innovation in the history of the world and a rapid expansion of the finance industry relative to the rest of the economy that was even condemned by the people most responsible for the creation of the inflationary environment.

I have labeled this type of environment one of credit inflation (as opposed to debt deflation). It is referred to as credit inflation because it can incorporate price inflation, as in the case of the consumer price index) and asset inflation, as in the case of housing prices, dot.com boom, stock market boom, and so forth. Credit inflation relates to any time credit in the economy or in subsectors of the economy increases at a faster rate than the normal growth rate of that particular economy or that part of the economy.

And, this was a perfect time for financial innovation. I have just reviewed the new book titled “The Quants” by Scott Patterson, and he mentions many times in the book that the period from the 1960s into the 2000s, the period of the Quant-boom, as a period of “money ease”. In essence, monetary ease “lubricated” the Quant revolution helping to underwrite the massive growth in the financial industry and the development of the “shadow banking system.”

Of course, as Patterson describes, there were some consequences to pay for this expansion. But, I will let you read his book, or, at least, my review of his book, to gather his “take” on the subsequent financial collapse.

This gets me to the main point of this post. Blanchard, and other economists who think along similar lines, work with macroeconomic models that do not really include debt or the changing burden of debt in their models. Thus, the inflation in their models cannot provide an incentive for economic units to increase their use of debt and the subsequent buildup of debt can have no negative implications for the future performance of the economy. Inflation that causes an increased use of leverage and additional risk-taking cannot be explained in their models.

Thus, inflation remains the best solution to this brand of economist for the achievement of economic growth and lower rates of employment. The earlier debates about the Phillips curve seem to be irrelevant to them, let alone earlier discussions about debt deflation.

We are currently in a very precarious situation. Even with unemployment remaining so high and the economy staying so sluggish, more and more people are expressing concern about credit bubbles in the economy. China, who has recovered from the world economic collapse as fast as anyone, is showing tremendous concern about the possibility that bubbles may be forming in its economy and has taken measures with respect to its banking system to prevent such bubbles from occurring.

Still, our banking system contains $1.1 trillion in excess reserves and the Federal Reserve is faced with the problem of “undoing” this injection of reserves into the financial system. See my “Tightening at the Fed”: http://seekingalpha.com/article/187292-tightening-at-the-fed-get-ready-for-the-undoing.

Some economists still believe that re-flation is the only real solution to the current situation of a stagnant economy and massive federal deficits.

To me, Oliver Blanchard and these other economists that think like him just don’t get it! Yet they stick with the models that they have used over and over again and claim, if anything, that the reason why their solutions to the problem have not worked is because they either have not been tried or that they have not been implemented in a large enough size.

To my mind, their models and the solutions they have presented, have been tried and they have been found wanting. To me, to come up with a call for accepting higher rates of inflation in the future is, at a minimum, absurd. In fact, it scares me!

The Changing World Financial Order

The economic and financial order of the world is changing. The Group of 20 met in Pittsburgh last week and clearly showed that it was the international body to contend with rather than the G-7. This past weekend there was the annual meetings of the World Bank and the International Monetary Fund. On Friday, Dominique Strauss-Kahn, who leads the IMF, referred to G-7 as the “late G-7”.

The organizations that deal with world financial and economic issues are broadening their base and becoming more inclusive of nations that are playing a larger and larger role in the world. What is clear, implicitly, if not explicitly, is that the United States is being challenged, not only in terms of its leadership of the world, but also financially in terms of the role that the United States Dollar plays in the world.

The economic leadership of the United States, in pre-conference statements, defended the position of the dollar in the world by “mouthing” their commitment to a strong United States Dollar. Before the weekend meeting, both Mr. Geithner and Mr. Bernanke spoke in support of the dollar: “Top U. S. officials threw their weight behind the dollar Thursday, with the Treasury chief stressing the importance of a strong dollar and the Federal Reserve chief addressing concern about the greenback’s future as a reserve currency.” (Wall Street Journal: http://online.wsj.com/article/SB125440283756156107.html.)

The problem with this is that their assurances were exactly the same as those issued by Treasury Secretaries O’Neill, Snow, and Paulson and that of a Federal Reserve chief with the name of Greenspan. For eight years the Bush (43) administration voiced its support of a strong dollar and the value of the dollar dropped more than 40% against other major currencies!

Geithner, Bernanke, and the Obama administration continue on the defensive as the value of the U. S. Dollar is down both against the Euro by about 11% and against major currencies by about 10% since January 20, 2009.

Given the stance of both the Bush (43) administration and the Obama administration over the past nine years the credibility of U. S. leadership in international circles is not very high.

Although the world community speaks very softly on the issue of the changing nature of international financial and economic cooperation, the talk “off-the-record” is expanding with more call for change surfacing from time-to-time. And, the position of the United States continues to weaken as the government continues to pile up huge deficits which ultimately lead to the further decline in the value of the dollar.

The United States cannot have it both ways. It cannot continue to be fiscally irresponsible and financially powerful.

Another piece of evidence supporting this conclusion is the continuing sale of physical assets in the United States to foreign interests. As the value of the dollar has declined over the past eight years, Sovereign Wealth funds as well as private interests have continued to acquire all or parts of U. S. companies. This move to foreign ownership is not going to cease given the fiscal path the United States is following.

And, it is going to be very difficult and take a good piece of time for the government to change the direction it is heading in. First, the mindset of Washington has to change and there is no evidence that anything of that kind is in the works.

We are in the midst of a major change in how the world is organized. It is not going to happen overnight, but, it is going to happen. The United States will continue to be the most powerful nation in the world, but, its relative position is changing and will continue to change. Furthermore, given these shifts, the United States cannot “get away” with the behavior that it has exhibited in the past. It is going to have to cooperate with others and this includes acting responsibly in terms of its fiscal and monetary policy. Until this happens continue to expect a weak dollar.