European Defaults: Portugal is Next After Greece

It ain’t over until it’s over…

The yield on the 10-year Portuguese government bond closed above 14.80 percent yesterday, a new record for the euro-era. 

“The markets are pricing in a Portuguese default with 10-year bonds trading at about 50 percent of par, a deeply distressed level in the eyes of many investors.” (http://www.ft.com/intl/cms/s/0/49916f7a-468a-11e1-89a8-00144feabdc0.html#axzz1kTbnc8Yy)

“Friday the 13^th may be an unlucky omen for Portugal.  On that day, almost two weeks ago, Standard & Poor’s became the last rating agency to downgrade Lisbon to junk, marking the moment for many investors when default looked inevitable for Portugal as well as Greece.” 

For more on this see my post on blogspot “Credit Downgrades and Europe” for January 16, 2012. (http://maseportfolio.blogspot.com/).

The downward spiral in defaults will continue as long as Europe fails to honestly face its problems. (See my post on blogspot for January 25, 2012 titled “How Long Will Europe Continue to Lie to Itself”: http://maseportfolio.blogspot.com/.)  

In the past, analysts, including myself, tried to explain what officials in Europe were doing by casually remarking that their actions amounted to “kicking the can down the road.”  Basically, the actions of the European officials were an effort to postpone dealing with the real issues, hoping that by delaying what was needed to be done the situation would eventually correct itself.

Now, it seems that the days of “kicking the can down the road” are reaching a climax. 

European officials hope to reach a deal on the Greek debt situation by the end of this month.  The current write down seems to be somewhere around 50 percent of face value, but there still remain issues to be decided like whether or not the European Central Bank will have to write down the Greek debt it has on its books. 

Bond markets have responded to this reality by dumping Portuguese debt.  Note that the yield on the ten-year government bond was about 10.40 percent (compared with 14.80 percent yesterday) around the middle of November, a time when it still seemed that maybe the European Union might be able to pull things together and avoid a Greek default. 

As the officials of Europe finally seriously travelled down the path to restructure Greed debt, the price of Portuguese debt started to weaken.  The price declines accelerated, as the possibility of a Greek write-down became more of a reality.  Today, the yield on the 10-year bond was around 15.00 percent.

I know that governmental officials hate to give in on these write-downs because they hate to concede to the “bond markets” and “speculators”. 

It is hard for governmental officials to admit that maybe the “bond markets” and the “speculators” might be right. 

It is a very difficult lesson for governmental officials to accept the fact that they cannot continue to cater to their constituencies with jobs and other benefits ad infinitum.  Over the longer-run, either taxes have to be raised or money has to be printed because the bond markets will not continue to underwrite debt that will be repaid, both principal and interest, by the issuance of more debt.

The economist Hy Minsky referred to this kind of debt financing as a “Ponzi” scheme.

 “Ponzi” schemes come to an end and the end cannot just be blamed on the “bond markets’ and the “speculators”.  In fact, the governments just line the pockets of the “bond markets” and the “speculators” by extending their uncontrolled spending until the collapse of the market becomes a “sure thing.” 

So the charade continues and Portugal seems to be next. 

Who will follow Portugal?  Spain…or Italy…who knows?

Yet, this is not the only concern that many of these officials are facing.  The austerity programs enacted by governments throughout Europe are not setting well with the people.  There is “discontent” and “upheaval” arising in many countries.

“The only consistent messages seem to be that leaders around the world are failing to deliver on their citizens’ expectations and that Facebook, Twitter, and other social media tools allow crowds to coalesce at will to let them know it.  That is not a comforting picture for the 40 heads of state  or leaders of governments who are attending the World Economic Forum (in Davos, Switzerland)…”  (http://www.nytimes.com/2012/01/26/world/europe/across-the-world-leaders-brace-for-discontent-and-upheaval.html?_r=1&scp=1&sq=across%20the%20world,%20leaders%20brace%20for%20discontent%20and%20upheaval&st=cse)

The situation is quite uncomfortable.  But this is what happens when you fail to deal with a problem…when you continually try to “kick the can down the road.”  The situation does not go away and the delay in dealing with the situation often turns out messier than if the situation had been dealt with earlier. 

The only way for the officials to resolve a condition like this is to get in front of it.  I don’t see anyone around in a position to do this.  The only real possibility is Merkel but the resentment that already exists against Germany makes it that much more difficult for her to achieve what is needed. 

If no leader arises then the defaults will continue…and the austerity will grow…as will the “discontent” and the “upheaval.” 

“Europe risks being handicapped if it doesn’t deal decisively with this challenge to democracy.”  Thought provoking way to end the New York Times article.    

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.      

No. 1 Issue of 2012: Recession in Europe

I believe that the number one economic issue for 2012 will be a recession in Europe.  I don’t see how this will be avoidable. 

The sovereign debt crisis in Europe has not ended and a lot of the debt is turning over this year and must be financed in the face of greater scrutiny by the rating agencies. 

The solvency problems in the European banking system has not been resolved and with more severe capital requirements and a rising level of troubled loans on their balance sheets, commercial banks are not going to be in the mood to increase lending levels.

And the governmental austerity programs of Greece, Italy, and Spain are just beginning to hurt.  The pain will only rise over the next year or two.

Furthermore, the lack of leadership on the European continent (and elsewhere) is astounding!  How do you resolve a difficult situation when there are no leaders around to realistically deal with the problems embedded within the situation?

A European recession has a high probability of occurring, but the depth of the recession is still to be determined.  On the surface, one might think that the recession would be relatively shallow, but there are other factors one must filter into the picture that adds to the uncertainty of how deep the recession might be.

Given this picture as the most likely leading scenario for 2012, I believe that we must further focus our sights on two other factors. 

The first of these is how the recession might spread to other nations.  Contagion is obviously the biggest concern here.  If a recession hits an area as large as the eurozone, even if it is a modest one, the effects of that recession will spread to others.  The exports of non-European nations will drop.  And there will be financial markets consequences. 

It is highly unlikely that a European recession will be contained just to the continent.  And, since many of Europe’s trading partners are already facing economic expansion that is modest, at best, the repercussions could spread to a relatively large part of the world.

 The second factor is even more disturbing.  If we have a European recession in 2012, given the austerity programs that are being embedded in the economic policies of eurozone states, the likelihood that social unrest in these nations will accelerate both in the current year and beyond. 

We have already seen outbursts of social unease in 2011 and with the increasing information on greater income inequalities, higher levels of unemployment, lower pensions, and so forth, that will be in the news, social unrest can only increase. 

But, these protests will have the examples of the Arab spring to build upon.  As was seen in 2011, the use of modern information technology can only strengthen the capability of protesters to organize and to disrupt.  What happened in 2011 has not been lost on the discontented of the developed world.

And, what happens if a European recession spreads to other areas of the world.  The seeds of protest have already been planted in many areas, including the United States.  Just mention the word “occupy” and you will get your response.

Which leads me to one final point.  I believe that modern society is now going through a period of substantial transition, and, like most periods of substantial transition there will be a lot of suffering as the “new world” emerges and there will be a substantial period of uncertainty as we grapple with the issues and move into this “new world.”

Of course, this will be one of the major problems we have to face…the problem of identifying what needs major changes and what needs only minor adjustments.

With certainty, however, I will argue that the evolving information technology is going to play a huge role in whatever results.  People are going to be dealing with more and more information and they will have this information is “real time.”  There will be much greater connectivity between people.  Due to this there is going to have to be greater openness and transparency in life and this is going to force major changes on the way we do things and the speed at which people react.  Governments are going to have to respond to this.  Corporations are going to have to respond to this.  And, whole societies and their social structures are going to have to respond to this. 

Changes in the availability of information have resulted in major upheavals in the world from the use of mobile type in printing which occurred around 1450 CE and resulted in societal changes like the Renaissance and the Reformation…and the Enlightenment…to the creation of the typewriter, the telephone, the telegraph, the radio, and television.

In a very real sense, I believe that a worldview is passing.  A recession in Europe during 2012 would accelerate changes that are already in motion.  If I am correct, this conclusion does not present a real comfortable picture for the next five to ten years but in terms of the human suffering that will result and in terms of the needs involved in adapting to the changes.    

U. S. Businesses Shop Europe

“As Europe struggles with its debt crisis, American businesses and financial firms are swooping in amid the distress, making loans and snapping up assets owned by banks there—from the mortgage on a luxury hotel in Miami Beach to the tallest office building in Dublin.” (http://www.nytimes.com/2011/12/26/business/us-firms-see-europe-woes-as-opportunities.html?_r=1&scp=2&sq=nelson%20schwartz&st=cse)

Where in our current understanding of macroeconomics does it indicate that a sovereign debt crisis might end up with foreign interests owning large chunks of a country’s physical assets?  How much of Ireland will United States interests buy?  How much of Spain will Middle Eastern countries end up owning?  And, how much of Italy will China possess?

Macroeconomics just cannot pick up the complexity of real economies.  Too much of the reality of an economy takes place at the micro-level and cannot be comfortably incorporated into the simple structures of the aggregate models of the economy. 

Macro-models just cannot include all of the incentives that are created within the total economy that lead to results that can even produce contradictory outcomes to what the macro-economists had been predicting. 

One of the most egregious results of the past fifty years is the prediction of the macro-economist that inflation can help the working classes and the middle classes.  Yet fifty years of credit inflation in the United States produced exactly the opposite effect in that the income/wealth distribution in the U. S. became highly skewed toward the wealthier in the society.

For one, the economists used aggregate models to show that there was a favorable tradeoff between employment and inflation.  The policy implication: if a little more inflation can be created then more people will be hired and unemployment will decline.

These models did not pick up micro-behavior that indicated that the “less wealthy” could not protect themselves from credit inflation whereas the “more wealthy” could not only protect themselves from credit inflation but could actually benefit from it.

Furthermore, these models did not include the fact that the credit inflation would provide incentives for manufacturing companies to move more into financial services while shifting their focus away from their historically productive enterprises.  Who would have thought in the 1960s that General Electric and General Motors would, by the end of the century, be earning more profit from their financial wings than from their manufacturing capacities?

Another macroeconomic idea that I have repeatedly used in discussing international financial arrangements has been that of the “trilemma”.  The “trilemma” analysis concludes that a country can only achieve two of the following three policy objectives: a free international flow of capital; a fixed exchange rate; and the ability to follow an independent economic policy.

Since 1971 when the United States went off the gold standard, many countries floated the value of their currencies in foreign exchange markets.  This had to occur, the argument went, because in the 1960s, capital began to flow freely throughout the world. 

Therefore, if governments wanted to gain the favor of those that worked in manufacturing and the labor unions by conducting a policy of credit inflation to keep unemployment low and, in many countries, housed in their own home, they had to be able to conduct an independent economic policy.  Within this effort, popular pension programs were also expanded to encourage people to retire earlier and governments became a large supplier of jobs to the economy.   

Thus, the value of the currency could be allowed to decline as governments created massive amounts of debt often financed by foreign interests.  Governments were able to keep the pedal to the floor during this period by generating a relatively steady flow of credit to their economies.

And, what was the micro-impact that the “trilemma” models did not pick up?  It was the declines that occurred in labor productivity that made many nations uncompetitive in world product markets. 

Here we see Greece…and Spain…and Ireland…and Portugal…and Italy…and, others...

And, corporate interests in the United States…and elsewhere…have lots of cash available…either on their balance sheets…or through financial markets that have been generously supplied by the Federal Reserve.

“At Kohlberg Kravis (Roberts), Nathaniel M. Zilkha, co-head of the special situations group, is expanding his London team to eight, from two, and hoping to take advantage of opportunities in Europe.  The firm is even considering potential investments in the country where the crisis began, Greece, despite headlines warning of a default by Athens or the possibility that Greece may withdraw from the eurozone…

Besides Greece, Kohlberg Kravis bankers have also been looking for deals in Spain and Portugal, where private companies are having a similarly hard time winning new credit or extending existing loans.”

As we see over and over again, the excessively loose monetary policy of the Federal Reserve is not helping the “working people”, those 20- to 25-percent of the labor market that are under-employed.  The Fed’s largesse is going to those that can use the money to “do the deal”.  Now, it seems that the flow of funds is going into the acquisition of assets formerly owned by Europeans.  Earlier, we saw Fed injections creating bubbles in commodity prices and in the stocks of emerging markets.   Even earlier than that, we saw Fed injections creating bubbles in the U. S. housing market and in U. S. stocks. 

The macroeconomic models are becoming less and less useful because the world works at a more micro-economic level.  It is at this micro-economic level that we can really observe the complexity of human behavior and also see how markets can self-organize and emerge to take on a life of their own.  Until governments become more sophisticated in their analysis of economic problems, they will continue to create opportunities that the wealthy and the better connected can take advantage of.  And, a Fed guarantee that short-term interest rates will remain at levels that are close to zero only exacerbates the situation.      

How Do You Cover Up Your Failure: the Greek Case

I believe that Gretchen Morgenson of the New York Times has done investors a big favor in writing her piece for the Sunday morning paper of November 20.  This article reveals the extent that officials will go to try and avoid the consequences of when they royally “screw up”! (http://www.nytimes.com/2011/11/20/business/credit-default-swaps-as-a-scare-tactic-in-greece.html?_r=1&ref=business)

The situation: “the debt mess in Europe.”

The event: “bankers are pressing Greece’s bond holders to swallow big losses.”

The intended consequence: “Leading the charge is BNP Paribas, the big French bank, which has been hired by the Greed government to help persuade investors to accept a deal that would cut the value of their investments in half.”

The cover-up: “On paper, this restructuring would be voluntary!”

The reason for this behavior: the Credit Default Swaps that are supposed to cover the losses on a write down like this.  “If Greece stops paying after the restructuring (the swaps that investors bought as insurance on the Greek debt) are supposed to cover their losses, much the way homeowners’ insurance would cover a fire.” 

The effort: if the restructuring is declared voluntary then the “credit insurance may not pay off down the road, because after the restructuring is completed, the terms of the old debt might be changed.”

Who stands to gain: “BNP which stands to profit from the restructuring.”  BNP will “generate fees from the exchange” or is concerned about “its own exposure to Greece.  A question being discussed is whether or not “BNP Paribas has written a lot of insurance on Greek debt.  If so, getting people to unwind such swaps now would be less costly for BNP than having the insurance pay off.”

Most suspicious, an official of BNP Paribas, Belle Yang, is also on the “powerful” International Swaps and Derivatives Association (I.S.D.A.) “determinations committee” that will decide what constitutes a “credit event” both in Greece and elsewhere in Europe. 

When you don’t do your job, things happen.  And, when things happen and you deny that things are happening, things get worse.  And, when things get worse you sometimes do very stupid things in order to keep avoiding what you really have to do.

Just ask Penn State University officials about this!

Politicians in Europe created too much debt in trying to remain in office by paying off their constituents in order to get re-elected.  When financial markets started to complain about the excesses of debt created, European officials claimed that the problems were caused by speculators and other “greedy bastards” that were trying to disrupt things for their own gain.  When things got worse, officials claimed that there was a liquidity crisis at hand, not a solvency crisis.  And, because it was a liquidity crisis, bailouts could resolve the issue by giving governments enough time to get their budgets in order. 

This did not work and when these officials finally came to accept the fact that they might have to deal with the insolvency of their countries, they began working on a “new gimmick” that a default really was not a default…if it were voluntary.

And, if the default was just voluntary then contracts written to insure against a default could not really be collected upon!

That is, the legal contracts that were written to insure parties against default are really worthless!

“If investors think debt terms can be changed by fiat, they will flee the market.  Ditto, if they find that their insurance can be made worthless.” 

“The discussions with BNP Paribas confirm the view of some investors that credit default swaps are not insurance at all, but rather instruments that big banks use to benefit themselves.”

Hello, Occupy Wall Street!!!  

My prediction: “the debt mess in Europe” is not going to be cleared up until people stop lying to themselves and really start to address the issues that are outstanding.  The problem with this, as I have written about many times before, is that I see no leaders in Europe that are willing to stand up and really discuss the issues that are outstanding. (See my post: “In Europe the Issue is Leadership,” http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)  

The sovereign debt problems that Europe faces are problems of solvency.  How many times does someone have to say this!  Until the officials of Europe address this problem “head on” and really try to “get their hands around it” they will continue to come up with “screwball” ideas like the one that Morgenson writes about in the Sunday NYTimes.

Resolving solvency problems are not easy and I’m sure this is why many European officials “put off” going for a real solution.  Solving solvency problems are going to cause a lot of hurt and pain…and will take a lot of time to correct. 

Unfortunately, there was a lot of hubris connected with the conceit of many European governments, a conceit that these governments could engineer high rates of employment and a social infrastructure that took care of all ills within a world in which there would be no international repercussions for such excessive and undisciplined behavior.

Unfortunately, there are no “good” solutions to living beyond ones means for an extended period of time.  If you “screw up” you finally end up paying for it.  And, solving the problem can hurt many, many people.     

China and Others are Waiting to See How the West Solves Its Problems

“Germany’s continued prosperity has helped fuel growing anger in countries like Greece and Spain against what is increasingly viewed as harsh German domination.  More and more, Germany is cast in the role of villain, whether by protesters in the streets of Athens or by exasperated politicians in the halls at the Group of 20 meetings in Cannes, France.” (http://www.nytimes.com/2011/11/16/world/europe/germanys-success-and-advice-anger-european-partners.html?_r=1&hp)

This quotes reminds me of a quote of Warren Buffet’s: You have to wait until the tide goes out to find out who is wearing a bathing suit and who is not wearing a bathing suit.

During an extended period of credit inflation like the one experienced by the United States, the UK, and Europe over the past fifty years “success” seems to apply to everybody.

An example I have experienced in my years as a bank executive is the area of residential real estate construction.  During this fifty-year period of credit inflation it seemed as if almost everyone and his brother or sister could build houses and become a successful real estate construction executive. 

One found out, however, when the credit inflation stopped who was a good builder and who was just coasting along on the inflationary wave and who really built very good houses. 

And those that just “put up” houses resented the success of the really good builders and gripped about those that continued to prosper when times were not so lush.

We are seeing this shake out in Europe these days as Germany, known for the discipline of its people and the work ethic embedded within the society, continues to prosper with a relatively healthy economy and a strong export component of its Gross Domestic Product. 

“When the tide goes out” there is a higher probability that the hard working and disciplined nation will come out on top.  And, we are seeing that in the case of the eurozone. 

The difficulty in maintaining that discipline and commitment to hard work is that during the period of credit inflation you see other nations getting by with a lot less discipline and a lot less work.  It is very easy during this time period to reflect on the fact that the others are getting by much more cheaply and are still doing pretty well.  And, the move to the “easy side” does not have to come all at once…it is easy to give up a little here and a little there…and slide, incrementally into the opposite pattern.

One can think of the comment by former Citigroup Chairman and CEO “Chuck” Prince who famously said that one must keep dancing as long as the music is playing. 

As long as the period of credit inflation continues, increased risk taking, increased financial leverage, and increased interest rate risk taking pays off.  Financial betting also pays as manufacturing firms, like General Motors and General Electric, reduce their focus on production and increasingly become financial companies.  

Some nations and some corporations do maintain their discipline during these times and although they indulge in the credit inflation game, they control their risk exposure so that once the “dancing” stops, they can maintain their position and continue to prosper.  JPMorganChase is an example of this.  Also, there were a number of manufacturing companies that did not “over indulge” in the financial frenzy created by their governments.  These companies now are sitting on piles of cash, buying back their stock or engaging in a very “ripe” acquisition market. 

During such an extended time, one cannot totally ignore the environment of credit inflation that has been created.  The task is not to be overcome by the exuberance and excesses of the time, and maintain and control the exposure of the nation or corporation to the environment and incentives that has been created by the economic policies of the other governments and corporations.

There is no question that this is a very hard thing to do.  Yet, that is what the ultimate winners do!  Super Bowl champions are invariably built on strong defenses with a good offense.  The winners do not often come from teams that are just built to score a lot of points.  Companies that continually push the edge of financial leverage and risk-taking to gain a few more basis points for their return on equity do not survive over the longer-run.

When the bubble bursts, as it has done now, those that have maintained their discipline throughout the “loose” times are the ones that are usually left to dictate the terms of the future, whether it be the future of nations, or, the future of industries.  And, those that achieve that dominate position are not liked, are resented, and are only grudgingly followed.       

“As the overall health of Germany’s economy and its fiscal position widen the rift with Europe’s poorer periphery, Germans have a ready response.  They say that they already made the structural changes in work-force rules and pension reforms that they are now recommending for the slow-growth countries, and that, by the way, they actually pay their taxes. So if the laggards want Germany’s money, they have to play by German rules.”

This is hard-nose stuff!  And, it seems heartless to those that have to go though the “wrenching” economic changes that are being proposed for the “laggards”.  For, what about those people who were just “unlucky” and were in the wrong spot at the wrong time.  And, what about the “disadvantaged” that had nothing to do with the regime of credit inflation? Just saying that the governments should have been thinking about these people when they went on their credit inflation binge is not very satisfying to these people.

Yet, nations…and corporations…and people…that control their excesses and remain disciplined over time have a better track record than those that don’t.  The loss of control and the loss of discipline seem to come when nations…and corporations…and people…become short-sighted and think that they can continuously maintain short-term gains over the longer-haul. 

But, the philosophy that we should not worry about the longer-haul because “in the long-run we are all dead” is not pragmatic…either for us…or for those coming after us.  The long-run does come about…and we pay…and we may pay a lot…if we have just focused on the “highs” we get from short-term excesses.

The United States, the UK, and Europe are all paying for the excesses of the credit inflation of the past.  The question that remains to be answered is whether or not these excesses will be corrected in the near term.  Others…China…Russia…Brazil…India…and others…are waiting to see what happens.  

Government Incentives Do Matter--The European Case

Gillian Tett’s essay in the Financial Times this morning gives us another example of how government policies can create incentives that have very serious consequences on an economic system, consequences that are very often detrimental to the health and welfare of the economic system.  Tett’s excellent piece “Subprime moment looms for ‘risk free’ sovereign debt,” (http://www.ft.com/intl/cms/s/0/88151ed6-0639-11e1-a079-00144feabdc0.html#axzz1cfzAfdXG) examines the consequences of European bank regulators assuming that all sovereign debt in Europe were “risk free”.

“When regulators drew up the Basel I capital adequacy framework in the 1980s, they gave western sovereign bonds a ‘zero’ risk weighting, in terms of how capital is calculated.  This was subsequently modified in Basel II, to give banks some theoretical discretion to raise reserves against sovereign risk.  In practice, this zero-risk weighting policy has prevailed.

In some senses it has been actually reinforced in the past five years because regulators have demanded that banks raise their holdings of liquid, safe assets, following the subprime turmoil.  Those ‘safe’ assets have been—you guessed it—mostly government bonds.”

Furthermore, one can add that in both applications of stress tests to judge the vulnerability of European banks to a financial crisis, no allowance was made for the writing down of sovereign debt in financial simulations.  Obviously, European banks came out looking pretty good.

And, in the “deal” constructed last week by officials of the eurozone, only ‘private’ holders of Greek debt were required to write down the debt by 50 percent, ‘public’ holders of the Greek debt, the ECB and other governmental organizations, did not have to write down the debt at all.  The ‘private’ holders represented only about 60 percent of the total amount of the Greek debt outstanding.

Of course, assuming that the sovereign debt of many of the eurozone countries was “risk free” allowed the governments to issue much more debt than they might have otherwise at the cheapest rates possible. 

In the essay, Ms. Tett also makes reference to the fact that assuming that sovereign debt is ‘risk free’ is one of the most basic assumptions of modern finance.

The result?

“If regulatory systems had not encouraged banks and investors to be so complacent about sovereign risk in the past, markets might have done a better job of signaling that structural tensions were rising in the eurozone—and today’s crunch would not be creating such a convulsive shock.”

Ms. Tett compares this “mis-pricing” exercise to the earlier experience of the subprime market.  In the latter case, subprime securities were repackaged into bonds that the rating agencies gave Triple A ratings to.  Again, this pricing facilitated the purchase of these securities and allowed many financial institutions to acquire the securities, comfortable that they were holding assets of the highest quality.  But, one cannot ignore the pressure put on mortgage originators, lenders, rating agencies and such, by governmental officials pushing hard to provide home ownership to more and more people.   And, this situation, too, resulted in “a convulsive shock.”

My point is that in both cases, the financial institutions and their executives have been blamed or are being blamed for the mess and are assessed the title of “greedy bastards”!

As many people know from reading my blog posts over the past three years, I feel the same way about the credit inflation created by governments in the eurozone and in the United States.  I have argued over and over that the credit inflation that has existed over the last fifty years has provided incentives for banks, businesses, and individuals to leverage up their balance sheets to excessive levels.   This credit inflation has also promoted excessive risk taking and the financing of long-term assets with short-term liabilities.  And, this credit inflation has created perhaps the most desirable environment possible for financial innovation. 

Yet the consequence of people responding to these incentives has resulted in the worst financial and economic collapse since the Great Depression of the 1930s. 

In addition, these incentives have also produced the most skewed income/wealth distribution in the history of the United States since the 1920s.  The wealthy, top executives, and people with access to information and markets can protect themselves from inflation or even take advantage of inflation.  The less wealthy, etc., cannot even hold their own against inflation.

Again, those that responded to the incentives created by this extended period of credit inflation and benefitted from them are labeled “greedy bastards.”

And, nothing is said about the politicians, another set of “greedy bastards” that originally created the incentives because they wanted to get re-elected!

Ms. Tett is correct in wondering what might happen if people change their assumptions about the sovereign debt, assuming now that all sovereign debt is not “risk free”.

She argues that “more realistic assessments” of the debt “would probably fore banks to hold more capital, and raise borrowing costs.”

More realistic assessments might “force the central banks to change how they conduct money markets operations, and impose tougher haircuts not just for obviously impaired debt, but bonds carrying potential risk, too.”

Or, “The other 800 lb—or $500 trillion—gorilla in the room is the derivatives market.  Until now, sovereign entities have generally ot posted collateral for derivatives, partly because of that risk free tag.  But, Manmohan Singh, an economist at the IMF, believes that this anomaly has helped to create a severe under-collateralization problem, worth $1.5 trillion--$2.0 trillion for the 10 largest banks alone.  If ‘true’ counterparty risk were ever recognized in derivatives, in other words, the implications could be brutal.” 

One of the reasons why European public officials are denying that the problem they face are ones of solvency is because someone might discover that a good deal of the blame for the insolvency is due to what they have done in the past.   One of the nice things for politicians about economics is that the consequences of economic policies usually take a long time to work themselves out.  Because of this people find it difficult to connect the policy with the consequences of the policy or may even fail to identify any sort of a connection. 

This is where work like that provided by Ms. Tett is so enlightening and helpful.      

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!