Where Does Sovereign Credibility Come From? The European Sitaution

As usual, when Bob Barro of Harvard writes something it usually contains some provocative ideas.  In the Monday morning Wall Street Journal, Barro writes about how Europe might get out of the Euro. (http://professional.wsj.com/article/SB10001424052970203462304577134722056867022.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

What interested me most in Barro’s piece was the emphasis he placed on the credibility of the organizations that issue a currency. 

In essence, as I read the article, Barro argues that the credibility of the Euro comes from those within the eurozone that are fiscally sound and carry those that are not fiscally sound, the “free riders”, along with them. 

This credibility is maintained for as long as the “free riders” conduct their irresponsibility within limits.   In fact, this is what the original charter of the eurozone called for…limits to how irresponsible the “free riders” could be.

But, the limits must be enforced.

“Greece…has been increasingly out of control fiscally since the 1970s.  But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.” 

The bailouts have become serial, as bailouts have also been given to Portugal, Ireland, Italy, and Spain. 

Thus, the only way credibility can be maintained is for Germany to continue to be fiscally strong while the union continues to provide bailout packages that will carry the “free riders” along for as long as possible.

Meanwhile, the internal effort of the members of the eurozone has been to create a stronger “fiscal” bond within the zone itself…ultimately moving to a “centralized political entity” that will oversee the fiscal and currency policy of the whole eurozone. 

Europe, to achieve such a “centralized political entity”, would have to overcome many, many issues that have existed on the continent for a long time.  For one, the internal rivalries that have existed for centuries would have to be overcome.  Already the resentment against Germany has grown as Germany has become a more demanding partner within the union.  Even statements like “Germany is achieving through economics what it could not achieve militarily at an earlier date” demonstrate some of the underlying emotions that exist on the continent.  Then you have the cultures, languages, and other hurdles to overcome to achieve the needed unity.

Even so, Barro continues, in the shorter run, the credibility of the nations is vitally important because of the sovereign debt that has already been issued by the governments of Europe and that rest on the balance sheets of the banks within the eurozone.  This is the reason there is rush to achieve the near term austerity in the budgets of Italy, Spain,…and France…among others. 

Greek debt is now yielding more than 34 percent on its ten-year bonds.   Portuguese bonds are yielding more than 13 percent.  The debt of Italy is yielding more than 7 percent.  And Spanish bonds are above 5.5 percent.  These rates are unsustainable!

French debt is yielding around 3.5 percent and the rating agencies are soon expected to remove their AAA rating.

The status of this debt is important because, “the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on.  Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany, and elsewhere.”

Credibility is lacking because “it is unclear whether Italy and other weak members will be able and willing to meet their long-term euro obligations.” 

Not only is the banking system threatened by this lack of confidence, the uncertainty that exists surrounding the future structure and performance of this area does not contribute to the achievement of stronger economic growth.  If anything, this uncertainty works to reduce growth.

Only as independent nations with their own currencies would these countries be able to meet their own obligations and achieve the credibility a nation needs to function within the global economy.  “This credibility underlay the pre-1999 system in which the bonds of Italy and other eurozone countries were denominated in their own currencies.  The old system was imperfect, but it’s become clear that it was better than the current setup.”

The issue is one of credibility. 

Right now, Germany seems to possess credibility.  But this credibility is based on its maintaining the position of fiscal responsibility it has already achieved.  And, this is just what the Germans seem to be doing. (“Germany Resists Europe’s Plea to Spend More,” http://www.nytimes.com/2012/01/09/business/global/germany-resists-europes-pleas-to-spend-more.html?_r=1&ref=business)  

As long as the current economic structure exists for the eurozone, the credibility of the eurozone will depend upon it’s ability to provide sufficient “band aides” to piggy-back on the credibility of Germany.   My guess is that it will become harder and harder for financial markets to buy-into this piggy-back arrangement. 

Credibility requires the provision of actions that backup promises.  Barro is suggesting that the only way that the fiscally irresponsible will become credible is for them to be “out-on-their-own” again where they will have to be totally responsible for their own actions.  Unless this happens, there is too much historical baggage carried by the eurozone that will not be overcome.      

Merkozy Posts A Win!

Greek prime minister George Papandreou cancelled the referendum.  Angela Merkel and Nicolas Sarkozy called Papandreou back to the “shed” Wednesday for a tongue-lashing…and worse…to set him straight on the marching orders he had been given. 

And, the Greek prime minister backed down.

It seems as if Merkel and Sarkozy believe that there are only two choices in the current debate.  The first is that the European Union stay together and maintain the single currency zone.

The alternative is that the EU split up with some countries maintaining the single currency zone.

To Merkel and Sarkozy there really is no choice…the EU stays together and supports the euro.

If the EU stays together and supports the euro…then the bailouts will continue. 

It seems to me that there are two most likely outcomes to following this path.  Of course, there are more but they are all derivatives of these two in my mind.

First, financial markets will continue to reject the solution and there will be further “summits” down the road with more bailouts and more distress.  The ultimate result of following this path will be when the EU finally decides that the fiscal policies of all countries in the union will have to be coordinated and there will be fiscal and political union as well as monetary union.

Some have seen this conclusion as the missing component of the efforts to achieve the monetary union right from the start.  Others, like myself, have seen this possibility as the ultimate end to the financial crisis as we now know it.  And, a political union may have been the goal of some EU “leaders” throughout the turmoil. 

If there is going to be a real “coming together” of the nations in the EU, the “strong” will be the drivers (Germany and France and who else?) but in order to achieve the final union the solvency of the laggards (Greece, Italy, Spain, Portugal and who else?) will have to be resolved.  That is, there will have to be some kind of central “Treasury” that will aggregate all debts and pay off those nations still in the union that are insolvent.

One can look at the American after its Revolutionary War where Alexander Hamilton opted for a strong central “Treasury” and the assumption of all of the debts of the states that were then a part of the United States.

The problem with this solution?

The problem lies with the people of the nations within the EU.  Some of these people’s may not want to come under the regime of the “strong” nations that will be the driving force in a strong, centralized fiscal EU. 

There have been riots and protests in Greece…and in Spain…and in Portugal…and in Italy…indicating resistance to the fiscal austerity being imposed on them by especially Germany and France.

And, the resistance is even getting more personal.  For example, a Greek newspaper has a cartoon with a German general manipulating two puppets…the two puppet being the Greek prime minister and another Greek official.  The underlying theme: “The Germans didn’t succeed in occupying Greece through arms because the Greek people resisted.  They try now to occupy Greece through the economy.”

Pretty heavy stuff. 

The Merkel/Sarkozy path to fiscal/political union may be a desirable goal but the question that still needs to be asked is whether or not this goal is consistent with what the people in these countries want.  European officials have often been accused of being an “elite” that wishes to impose its will upon the people of Europe.  Whether or not the “elites” can pull off this union without too great of a popular upheaval is a question that no one can answer at this moment.

The other alternative is that the financial markets may not allow the “leaders” of Europe to get too much farther  along this path. 

Just today, 10-year Greek bonds were trading to yield almost 34 percent, almost 3,200 basis points above the yield on 10-Year German bonds.  The bonds of the Italian government have been trading at the largest spreads above the German bonds in the euro era.  And the same with the bonds of Portugal. 

If these governments have to pay these kinds of yields on their debt there is no way that they will be able to get their fiscal budgets under control.  If these governments cannot issue bonds or can only issue them to the European Central Bank then the fundamental reality of their insolvency will become more and more of a problem. 

Add to this a European recession, where tax revenues take a further nose-dive, and you only exacerbate the problem.

I should add that “Super Mario” Draghi, the new head of the ECB oversaw a reduction in the central bank’s main policy interest rate in his third day in the new job.  The reason for this reduction is to combat weaknesses being experienced in European economies.

Over-shadowing all of this is the fear of the European officials of financial “contagion”.  The spectre of Lehman Brothers hovers over Europe. The fear is that if these “officials” let Greece go “insolvent” in a “disorderly default” kicking off the use of Credit Default Swaps, that there will be a “spill over” effect moving from the sovereign debt of Italy…and of Spain…and of Portugal.  Then, the concern spreads to the commercial banks in Europe…remember the stress tests conducted on these banks did not include a write down of the sovereign debt on their balance sheets.

The problem Europe is facing is a solvency problem.  This is what European officials have been trying to deny for the last four years.  And, many are still in denial!

Solvency problems do not just go away!  Denying they exist only causes the problems to get worse!

Time For Policymakers To Change Economic Models--Got That Portugal?

 Government policymakers just don’t seem to get it!

The economic philosophy governments have been using as the foundation of their budget and monetary policy since World War II isn’t working.  Governments need to change direction.

Most governments in the developed world need to do a “turnaround.”  But, turnarounds are only successful when the organizational model is changed.  Often this change requires a new management team.

For the past fifty or so years, the governmental leadership in most countries in the developed world have assumed, basically, the same economic philosophy.  And, as in the American case, both political parties have assumed the same fundamental economic model. 

This economic model got us to where we are, and, as in the case of most turnaround situations, the old model must be re-placed before the turnaround can be achieved. 

The financial markets understand this!

The governments involved don’t seem to get it…yet!

We have several “case studies” going at this time.  These “case studies” are called Ireland; Greece: and Portugal. 

Of course, the initial response of these governments when financial markets began to become skeptical of their performance was…the market behavior was driven by speculators…it is not our fault.

The next response was the attempt to bail out these countries.  And, what does a bailout achieve?  A bailout “buys” time with the assumption that given time these governments will be able to get through this period of turmoil. 

Not once do we hear of the possibility that these governments might be operating with a philosophy of government that doesn’t work!

And, the financial markets don’t respond positively to these efforts.  The leaders of these governments shrug their shoulders, get a puzzled look on their faces, and ask why the financial markets continue to punish them and their people.

Portugal cuts a deal with the European Union and…”Portugal was forced to pay a higher interest rate to raise  1.12bn in short-term debt on Wednesday, shortly after announcing a  78bn bail-out agreement.” (http://www.ft.com/cms/s/0/1cb74060-7642-11e0-b4f7-00144feabdc0.html#axzz1LTb4L5XR)

The financial markets seem to be saying…”Nothing has changed!”

Portugal, you still are living off the same model.  You have not really altered anything!

And, this dance has been going on since the beginning of 2010.  Yet, no one seems to think that they need to do anything differently.

Is Spain next?

That, of course, is the question that everyone is asking.  And, some analysts are saying that Spain has gotten the message.

The question is…has Spain really gotten the message?

If not, then, who is next?

As I wrote yesterday and the day before…some things have changed.  The world is in a period of transition.  The next fifty years is going to be remarkably unlike the past fifty years. 

Assumptions are going to have to change.  Leaders are going to have to adopt new models and new philosophies.  And, as we are seeing, the transition is not going to be easy.

The ultimate question relates to the United States…when, along the chain of dominoes, is its turn?

A major problem of the transition will be the speed at which it can occur. 

When a company gets into serious problems, a turnaround specialist can be brought in to change the operating model of the company, enforce discipline, and execute the new plan.  The new leader has substantial authority to make these changes.   

The owners, the shareholders, give the turnaround specialist the authority to make the changes needed.  And, the changes are imposed, not on the owners, but on the employees of the company.  

In democratic governments, executing such a turnaround is not as feasible because the people that do the voting are the people that will bear the brunt of the changes.   It is hard for people to vote in favor of their own pain. 

So, the transition will not be over until it is over.  The future of the governments in the developed world will probably be very much like the last sixteen months have been.  Band aids in order to keep things afloat…but a failure to really get to the heart of the problem.  We will continue to try and “muddle through.”  

Step on the Gas; Hit the Brakes; and at the same time!

There has been lots of words and press spilled on the recent revelations about who the Federal Reserve “bailed out” during the recent financial crisis. Let me just use one such article to capture some of the attitudes being expressed about this information.

Sebastian Mallaby, a senior fellow at the Council on Foreign Relations and the author of the book “More Money than God”, writes in the Financial Times” (http://www.ft.com/cms/s/0/9f5584f2-fe1d-11df-853b-00144feab49a.html#axzz173T61Eok):

“The point is that the Fed bail-outs were hair-raisingly enormous, and that neither the regulators nor the regulated should be allowed to forget that. Wall Street institutions that now walk tall again survived only because the taxpayers saved them. Goldman Sachs turned to the Fed for funding on 84 occasions, and Morgan Stanley did so 212 times; Blackrock, Fidelity, Dreyfus, GE Capital – all of these depended on taxpayer backstops. The message from this data dump is that, two years ago, these too-big-to-fail behemoths drove the world to the brink of a 1930s-style disaster – and that, if regulators don’t break them up or otherwise restrain them, they may do worse next time.”

There doesn’t seem to be much movement afoot to “break them up” at this time, but there has been, and will continue to be, great efforts to “restrain them”. I don’t see the will or the leadership to “break them up”. I have my own views about the ability of the government to “restrain them” but I treat that question elsewhere.

I would like to raise another issue at this time which I believe to be integral to the situation mentioned above.

Discussions about the actions of the Federal Reserve during the financial crisis tend to be completely void of any discussion about the actions of the federal government or the Federal Reserve in creating the environment that resulted in the financial collapse.

Leading up to the financial crisis of 2008-2009 was approximated fifty years of governmental actions that created the largest credit inflation in the history of the United States. The gross federal debt of the United States government increased at a compound rate of approximately 9 percent per year from 1961 to the start of the crisis. Monetary policy, throughout this time period, accommodated this growth in debt. And, this period saw the greatest burst of financial innovation and credit creation in world history.

Why did this happen?

Two major reasons: first, the short-run emphasis of the government to sustain high, perhaps unsustainable, levels of employment; second, the goal of the government to put as many Americans in their own home and provide them with a financial “piggybank” to secure their future.

The first reason meant that the government had to keep stimulating the economy to keep people employed in the jobs they had. As a consequence, many American workers did not have the incentive to grow and prepare themselves for the “jobs of the future.” As a consequence, about one out of every four Americans of employment age is “under-employed”! Furthermore, the length of being unemployed has trended upwards from the 1950s and in October 2010 the average duration of unemployment is just about 34 weeks, almost three years. (See “Unemployed and Likely to Stay That Way,” http://www.nytimes.com/2010/12/03/business/economy/03unemployed.html?ref=todayspaper.)

The second reason meant that the government had to build programs and provide financial innovation and finance so that more people could own their own homes. The inflation that took place in the real estate sector resulted in home ownership becoming the real “piggybank” of the middle class, producing for them the “best” investment they could experience over this time until, of course, the bubble burst.

The federal government set up the environment and the incentives that everyone else had to live within.

Chuck Prince, the former Chairman and CEO of Citigroup, made the now famous statement that “while the music keeps playing, you must keep dancing.”

The environment created by a government that set the example of “living beyond one’s means” created an almost perfect environment for taking financial risk, mismatching maturities, leveraging up debt, and financial innovation. The “Greenspan Put” during the 1990s and early 2000s sustained this environment by providing downside protection thereby creating greater “moral hazard.” In essence, the federal government “kept the music playing” and businesses, both financial and non-financial, had to “keep dancing” in order to remain competitive.

The question was constantly asked by executives, “How can I get a few more basis points return to be competitive with others in the industry?” The answer within such an environment was more leverage, more risk, and new financial innovations. At least, until the load became too heavy to bear.

But, in the rush to “break” companies up or to regulate and “restrain” them from such activity, most people have forgotten that the whole environment and the incentives set up were created by the same people now interested in breaking up these companies or restraining them.

So, within this call for breaking up these companies and regulating them more closely we hear
the same people calling for more government spending, more tax cuts, more quantitative easy on the part of the central bank, and greater welfare benefits to those that are hurting.

This is why the whole scenario seems to be one of trying to drive your car as fast as you can while at the same time trying to drive your car as safely as possible.

You are stepping on the gas and stepping on the car brakes at the same time!

So, where does this discussion take us? Really nowhere.

In my view, the people calling for the federal government to constantly provide fiscal and monetary stimulus to the economy are still in control and I don’t see their demise anytime soon.
People will try to regulate and restrain the financial sector, but, as I have written many times before, they will not be able to be successful. Given the global nature of finance today and the tools brought to the finance industry by information technology, these attempts to regulate and restrain will not succeed.

And, there will be renewed calls for providing social services and payments for those being hurt by the actions mentioned in the preceding two paragraphs. What is really needed to resolve the problems of the modern economy is of a long term nature and our short-sighted politicians will never implement these solutions, at least, anytime soon.

So, we must continue to face a bumpy ride. Stepping on the gas and the brake pedal at the same time produces such a ride.

Bailouts or Defaults?

This question is the defining question in finance and economics today.

Yet, the predominant approach used in macroeconomic policymaking does not include debt and the possibility of defaults in its model. So, the policy answer is obvious. The policy makers must “bailout” individuals, banks and businesses, and governments.

Well, forget individuals, let them default!

But, we need to save banks and businesses…and governments. Provide them with cash grants. Provide them with excessive amounts of liquidity. Defaults of banks and businesses and governments are not a part of our theoretical picture of the world.

Look through the book “”Ben Bernanke’s Fed” written by Ethan Harris, a former research officer at the Federal Reserve Bank of New York and published by Harvard Business in 2008. Chapter 2 is called “How the World Works: a Brief Course in Macroeconomics.” Here we get a picture of the basic model the Federal Reserve uses in its analysis of the state of the world.

“Getting into the head of the Fed requires a basic primer on how the economy and monetary policy works, Harris writes, “Nonetheless, a relatively simple framework underlies much of the discussion at central banks today.”

The foundation of the Fed’s analysis, according to Harris is something called “the Phillips Curve” which supposedly captures the tradeoff between inflation and unemployment. This, of course, incorporates the two government policy objectives written into law in 1978 and affectionately referred to as the Humphrey-Hawkins Full Employment Act.

Harris continues that “Bernanke is a proponent of the ‘financial accelerator model,’” which brings the credit market into the picture. “The idea that strong financial and credit conditions and a strong economy can reinforce each other to create economic booms (and that weak conditions can interact to create busts). During booms, both firms and households have stronger incomes and their assets are worth more, encouraging relaxed lending rules. Easy lending makes the economy even stronger and that, in turn encourages even easier lending standards.”

In other words, Bernanke, and people within the Fed, believe that pumping credit into the economy produces “stronger incomes” and “assets are worth more.” Thus there is a wealth effect. But, as long as inflation is “in check” there will be no problems on the “real” side of the economy and unemployment will be reduced. BINGO!

However, within this view of the world, there are no problems with debt loads, foreclosures, and bankruptcies. Piece of cake…just throw more spaghetti against the wall! (See “Bernanke’s Next Round of Spaghetti Tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.)

Remember, Keynes won and Irving Fisher lost the battle for the hearts and minds of the economics profession. To resolve economic downturns just create more and more debt. Forget about the fact that debt has to be paid off. Just toss more liquidity into the markets.

Defaults are not considered in the model because the assumption is that the problem is one of liquidity, not solvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

Therefore, individuals, banks and businesses, and governments can issue all the debt they want and the Federal Reserve, the European Central Bank, the United States government, or the European Union can step in and solve any discomforting situations that arise through bailouts and loose monetary policy.

However, debt does matter! And, defaults should not just fall on individuals and families. Foreclosures and bankruptcies are very common into the world today.

Yet, governments continue to try and sweep solvency issues “under-the-rug” when it comes to banks and businesses…and to governments.

The only time we really hear about problems of this sort within these institutions is the weekly list of bank closings overseen by the FDIC. But, this information tends to end up on the fifth or sixth page of the business section of the newspaper and rarely, if ever, gets into the radio or television news. Maybe this news, week-after-week, is too boring. However, the FDIC is closing three to four banks a week and they have been doing this for more than a year. Still there are nearly 900 banks on the FDICs list of problem banks, and this does not include a thousand or more banks that are sliding into this problem bank list but have not reached the “statistical” test of being on the list.

This has to be the case within the sector of non-financial businesses. How many small- to medium-sized firms are still on the brink of insolvency? My guess is…a lot. It seems like every week there are more and more empty spaces in the strip malls and other business buildings.

And, then there are the state and local governments. The municipal bond market is in a mess!

In the banking week ending November 19, 2010, the Federal Reserve reports that the average yield on State and Local bonds was 4.72 percent. In the same week 30-year U. S. Treasury bonds yielded 4.30 percent. And, State and Local bonds are not taxed.

WHEN HAVE YOU SEEN AN INTEREST RATE RELATIONSHIP LIKE THIS BEFORE?

Now we get into sovereign debt. Let me just start listing the problems: Greece, Ireland, Portugal, Spain, Italy, France…

Need I say more?

And, what about the United States? On September 30, 2009, the Gross Federal debt outstanding was almost $12 trillion; the Federal debt held by the public was about $8 trillion on that date. And, what if the Gross Federal debt more than doubles over the next ten years as I have been predicting? How acceptable will the debt of the United States government be in the world?

DEBT MATTERS!

Why isn’t debt included in the models the policy makers use? We can’t continue to operate under the assumption that debt doesn’t matter and that all we need to do, policy wise, is throw more spaghetti against the wall.

People, other than individuals, families, small businesses, and small banks, must come to realize that there is a penalty for taking on too much debt. That penalty is default followed by bringing one’s books under control. People must learn that the solution to issuing debt is not issuing more debt!