How Long Will Europe Continue to Lie to Itself?

“Bank Seeks To Avoid Taking Loss On Bonds.”

So reads the headline for the New York Times article on the dilemma of the European Central Bank. (http://www.nytimes.com/2012/01/25/business/global/eu-officials-continue-to-press-for-a-quick-deal-on-greek-debt.html?_r=1&ref=business)

“European leaders have begun discussions with the European Central Bank on several options that might keep it from having to take a loss on its 55 billion-euro portfolio of Greek bonds.”

“The deal could address what has long been one of the more vexing questions in reaching a broad agreement on reducing Greece’s mountain of debt: how to get the central bank, the largest holder of Greek bonds, to participate in a debt restructuring without having to take a large loss that would have to be covered by European taxpayers, German ones in particular.

Private sector investors, including large European banks and hedge funds, have complained bitterly—and in some cases threatened legal action—over the central bank’s insistence that its 55 billion euros in Greek bonds were exempt from the loss that the private sector is facing, which some have estimated at 60 cents on the euro.”

The European Central Bank cries, “You can’t hold me responsible for my actions!”

There are articles all over the place on this issue. 

For example, on the front page of the Financial Times: “IMF urges ECB to take a hit on 40 billion-euros in Greek bond holdings.” (http://www.ft.com/intl/cms/s/0/74d2b31a-46b2-11e1-bc5f-00144feabdc0.html#axzz1kTbnc8Yy)

Greek debt will be written down…finally.

But, will people still be avoiding reality in some affected areas?

And, remember, this is all voluntary to avoid kicking off the credit default swaps outstanding…what a crock!

Still on the list of lies…Portugal…Spain…Italy…

Lies have a long life and can come back to haunt you in many…often, unfortunate…ways.  Just ask people up at Penn State these days. 

The resolution of a situation in which people cover up and try to avoid the truth never ends well.  The leaders (and I use this term lightly) of Europe that are perpetuating this comedy continue to draw it out as long as possible. 

The problem is that the European dilemma will continue to exist until it is dealt with.  For more on this see my blogpost “Credit Downgrades and Europe” posted on January 16, 2012 on my blogspot site (http://maseportfolio.blogspot.com/).  

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.      

Now Back to Europe

Silvio Berlusconi, Italy’s prime minister spoke to the Italian Parliament yesterday about the economic and financial situation facing Italy. 

Mr. Berlusconi “pointed the finger at speculators, global economic weakness and general problems in the eurozone.” (http://www.ft.com/intl/cms/s/0/088747fc-bdf5-11e0-ab9f-00144feabdc0.html#axzz1TyUqwXts) 

These words were an almost exact copy of those issued by the Greek government, the Irish government, and many others from within the eurozone over the past year or two. 

Gotta stay on message…the problem is “out there”!

Now that we have a modest pause in the news coming from the United States concerning sovereign debt and all that, we can return to the European sovereign debt situation…which is far from resolved.

When are people in Europe (remember that there are no leaders in Europe, “In Europe the Issue is Leadership”, http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership) going to realize that “kicking the can down the road” is not going to get them out of the situation they are in. 

In fact, as southern Europe continues to burn, the banking system in Europe is having to endure greater and greater stress. (See, for example major articles in the New York Times, http://www.nytimes.com/2011/08/04/business/global/europes-banks-struggle-with-weak-bonds.html?ref=business, and the Wall Street Journal, http://professional.wsj.com/article/SB10001424053111903885604576486671709242408.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj.) Only very short term loans seem to be available between banks but even these loans require borrowers to pay a premium over similar borrowing costs in the United States. 

The cost of borrowing 10-year money in Italy has now risen above the “crisis” level of 6 percent this week and Spain is now borrowing at interest rates not seen since the creation of the Euro.  Even Belgium and France are facing near term highs in borrowing costs.

As I wrote yesterday, the problem is that there is too much debt outstanding in Europe (and America) both in the private as well as the public sectors.  We, in the Western world, have lived off of the debt idol for too many years (See http://seekingalpha.com/article/284276-the-problem-too-much-debt).    

 How do we determine whether or not there is “too much debt outstanding”? 

In my opinion, an exact answer cannot be given.  We try and measure this by using statistics like government debt to GDP ratios, or, government deficit to GDP ratios, and the like.  But, we are dealing with human beings and ratios like these can only provide hints at debt loads and clues to times when debt burdens become excessive and unsustainable.

When do people start to realize that they have to make decisions about how they allocate their income rather than just keep spending on everything they want?  When do governments realize that they can’t fund every good social cause presented to them?  When do businesses realize that they just can’t continue to raise their return on equity by adding more financial leverage to the balance sheet?

There is no exact answer to these questions.  Economics is not an exact science no matter how much economists like to project this image to the world. 

And, the Keynesians argue that added spending stimulus will cause consumption expenditures to increase and this will get the economy going again, or, incentive for businesses to increase capital investment will get the economy going again.

Keynesian models have never adequately handled the issue of debt and financial leverage.  One reason is that debt levels and financial leverage are not always limiting factors in consumer and business spending.  In fact, during the early stages of a period of credit inflation, the greater availability of debt and financial leverage may have a positive influence on consumer and business spending. 

That is, debt levels and financial leverage may be positive influences on economic activity…before they become a negative influence. 

This is one of the problems in trying to understand human behavior.

But, back to the situation in Europe.  The world has changed.  The old models are not working and new ideas must be introduced into the efforts being made to get control over the crisis. 

Maybe this is not going to happen until the “old guard” of top government officials is replaced by someone new.  Continuing to try and govern using the assumption that the problem is “out there” is not going to work. 

The problem is with the governments and their officials and until this is recognized I don’t see Europe getting its act together. 

And, the longer it takes for the eurozone to get its act together the greater the opportunity for the BRICS and other emerging nations to prosper and overtake the “ancient regime” now governing Europe.

The United States cannot ignore this dilemma for it faces similar problems.  And, the government of the United States is emulating Europe by claiming that the cause of its problems is “out there” and by postponing any real solutions until a later date. 

The world has changed.  As the West went through a philosophical and social change after the Second World War, we are now going through another sizeable and traumatic change.  But, to stick with existing models of the world and, consequently, say that the problems are “out there” will just “kick the can further down the road”.  It will solve little or nothing.

It Depends Upon Your Definition of "Is"--Greek Bailout 2 or GB2!

Is Greece declaring default on it sovereign bonds?

To some, it depends upon your definition of “is”. 

Is a “selected default” or a “restricted default” a default?

There is only one answer in my book.  Greece is declaring default.

The reason Greece is defaulting is because Greece is insolvent.   (See my post from Wednesday, http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

At least some of Greece’s sovereign debt will be written down by around 20 percent in the new deal reached yesterday among European officials.  (I will not use the title “leaders” for this group of individuals.)  On Monday of this week, Greek bonds were selling at about a 50 percent discount.  As word that a possible agreement might be reached by European officials, the discount declined and the bonds were selling at 60 percent of par or 65 percent.

The question is, is this enough of a haircut?

There are other provisions: new longer-term bonds to replace shorter-term bonds, lower interest rates, and additional help for Portugal and Ireland.

However, it seems as if the most general comment on the new package is that the eurozone has bought itself some time.   

The first response of the financial markets has been positive reflecting that the Europeans have done something good.  However, as the news continued to sink in, markets backed off once again. (“Jitters over eurozone fringe snuff out rally”, http://www.ft.com/intl/cms/s/0/3de1daa0-b451-11e0-9eb8-00144feabdc0.html#axzz1SlzuB7bE.)

GB2 may not be enough.  And, then there is the fear of contagion: Is GB2 large enough to protect against the “Lehman Brothers” effect?  At first the failure of Lehman Brothers on September 15, 2008 seemed to be self-contained…but then problems occurred as financial concern spread to other areas and other firms. 

What about Portugal?  What about Ireland?  What about Spain…and Italy?

And, what about the United States?

There still are a lot of unanswered questions.

My response to this is two-fold.  First when you are in trouble, like Greece…and others within the eurozone…you need to act decisively and in a way that creates a belief that you mean to back up what you do. 

We work in a world of incomplete information.  We don’t know precisely what the correct amount of action is needed to solve a problem.  My view is that a leader needs to act decisively enough so that there is a good chance that the problem will actually be solved.  Also, the leader needs to act in a way that conveys to others that she or he is in charge of the effort and that whatever needs to be done will be done.

Second, the leader needs to create the belief that she or he will follow up on what has been done to close any gaps that might still be found to exist.  Financial markets must come to believe in that the leader will "stick at it" until the problem is corrected.

The officials in Europe have failed on both accounts.  First of all, they have denied and denied and denied that there was any problem they were accountable for.  It was always someone else’s fault. 

Second, the officials in Europe have never wanted to do more than the bare minimum in trying to correct the situation.  “How little can I get away with?” seems to be the question they ask. 

Third, no one seems to want to be in charge. 

Which leads me to my final point, the financial markets do not have much regard for anyone in the European hierarchy.  In this they seem to reflect the sentiment of the citizens of Europe. 

“Restricted default” or “Selected default”?  This seems to be like being partly pregnant: in my understanding you are either pregnant or you are not pregnant!

When will the European debt crisis be resolved?

It looks to me like the can has just been kicked a little further down the road.   

Where Are The Leaders In Europe?

The story unfolding in Europe in a nutshell:

“Undercapitalized banks are supporting over-indebted governments by holding their IOUs; over-indebted governments are supporting troubled banks; and there is insufficient equity in the European banking system to absorb the losses implicit in the solvency gap.  The outcome is that the European Central Bank ends up providing liquidity on an open-ended basis to the peripheral countries to keep their banking systems afloat at the cost of an ever weaker balance sheet.  The one surprise in all this is that more of the retail deposit base of southern Europe has not disappeared in capital flight.”

From John Plender, “Time for Eurozone Policymakers to Grasp the Nettle”: http://www.ft.com/intl/cms/s/0/207fb2a4-ac9d-11e0-a2f3-00144feabdc0.html#axzz1SZnxOYcr.

Almost everyone in Europe seems to have his or her head in a hole in the ground ignoring reality.

Anytime we hear anything from them it is always about who is to blame for the current crisis…the international banking community…greedy speculators…rating agencies…or the cheating being done in world class men’s soccer. 

Real leadership seems to be totally absent from the scene.

Few make such a blatant claim as the New York Times did this morning: “Greece is effectively insolvent.” (http://www.nytimes.com/2011/07/20/world/europe/20europe.html?_r=1&ref=todayspaper)

There, I wrote it!

Greece is effectively insolvent!

It is not the international banking community that is causing the problem.  It is not “greedy speculators” or the rating agencies causing the problem.

The problem exists because of what the Greek government has done.  (For another take on this see Thomas Freidman’s column in the New York Times this morning:  http://www.nytimes.com/2011/07/20/opinion/20friedman.html?ref=opinion.)

Countries…people and businesses…cannot live way beyond their means forever. 

Greece did this to itself, and now the debt is coming due.

Does the Greek debt need to be written done?  You betcha’!

Will the write down be around 50 percent of face value?  That is what the market seems to think.

Can the banks holding Greek sovereign debt weather such a hair cut?  Certainly the “cowardly” stress tests just administered by the eurozone officials give us no such information about this possibility. 

However, sufficient information has been made public about the balance sheets of eurozone banks to indicate that many banks (many more than the nine identified by the stress tests) might have a “hard go” if this amount of a write down did take place.

But, we are in “hard go” country…thanks to the leadership in this area of the world.

Leadership that postpones dealing with problems is not leadership at all. 

“If one says that the problem is ‘out there’…that is the problem!” One of my favorite quotes from Stephen Covey.

I have worked with many failed institutions and in every case when one reviews the records, previous management never assumed that the fault was their own…it was always someone else’s fault. (Are you listening Mr. Murdoch?) 

As a consequence, steps were never taken to correct the problems faced by the organization and, therefore, the problems just got bigger and bigger and bigger.

The same has been true with Greece.

But, the contagion issue arises.  Is this the “Lehman Brothers” moment for Europe?  Will Portugal, Italy, and Spain follow in the footsteps of Greece?

These countries are not immune from the criticism leveled at Greece…and the statement of Plender above.  They have exposed themselves to the fate of the debtor and the debt collector is at the door.  Interest rates now paid by these nations on their debt are exorbitant and unsustainable. 

The losses must be absorbed…they cannot continue to be postponed in the hope that further credit inflation can buy them out of their dilemma.

Read my lips: the debt levels are unsustainable and must be dealt with now!

I like the quote at the end of the New York Times article quoted above: “The market is far more intelligent and resilient than a lot of politicians realize,” said Lee C. Bucheit, a lawyer who has handled sovereign defaults. “Investors realize that sometimes you make money and sometimes you don’t.  But they can’t abide prolonged uncertainty.”

I would close with a slightly modified statement: “Investors can’t abide a prolonged absence of leadership.”

Are you listening America? 

Greece: Please Take More of the Medicine That Has Already Failed to Treat the Disease

With respect to the Greek sovereign debt situation, two statements reported this morning stand out.  First, Simon Tilford, chief economist at the Center for European Reform in London is quoted as saying: “The Greeks have been told to accept more of the medicine that has already failed to treat the disease.”  The consequence of this is that Greece has already entered a “death trap.” (http://www.nytimes.com/2011/06/23/world/europe/23greece.html?_r=1&hp)

The other statement deals with how the European banks will deal with some of the cost of a second bailout of Greece: “The trick will be for the private sector to take losses on Greek bonds, without Greece being declared in default.” (http://professional.wsj.com/article/SB10001424052702304657804576401471860518598.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The problem: “If the banks are forced to accept losses, ratings companies likely will declare a default.  Even if the banks act voluntarily, Greece could still be considered in default on some of its debts.” 

For more on this issue you might check the column by Satyajit Das in the Financial Times, “Final arbiter in Greek saga is an untested private body.”  Das is referring to something called the Determinations Committee, a group set up by the International Swaps and Derivatives Association.   This body may be the one that determines whether of not Greece goes into default or not.  (http://www.ft.com/intl/cms/s/0/95e3131a-9bf9-11e0-bef9-00144feabdc0.html#axzz1Q6N7EfJG)

Marty Feldstein, the Harvard economist, considers the dilemma facing European leaders: “If Greece were the only insolvent European country, it would be best if its default occurred now…But Greece is not alone in its insolvency and a default by Athens could trigger defaults by Portugal, Ireland and possibly Spain. (http://blogs.ft.com/the-a-list/2011/06/22/postponing-greeces-inevitable-default/)

Oh, oh!  The “I” word!

So, Greece is insolvent.  Portugal is insolvent.  Ireland is insolvent.  Possibly Spain is insolvent. 

And the European leaders are forcing Greece (and these other countries) to just continue taking more of the same medicine.

But, we can’t have insolvency squared or insolvency cubed?  Or, can we?

And the determination of whether or not a default takes place seems to depend upon a private organization that has never rated any debt before and must, it seems, determine what the definition of “is” is. 

This seems like a scene out of an old Peter Sellers movie!

This is nothing more than a Ponzi scheme being enacted by a bunch of comedic characters.  The Ponzi scheme: borrowing more and more money to pay the interest on the growing body of debt. 

This is the “death trap” mentioned above.

My belief is that the financial markets will be the final arbiter of this picture.  I believe that the “leaders” of Europe are creating a “risk-free” bet that many hedge funds and other investors with lots of money are waiting anxiously to exploit.  Governments seem to have a penchant for creating such “risk-free” bets.  Just ask George Soros.

Marty Feldstein has declared Greece insolvent.  So have a lot of other people. 

The financial markets will take care of this.

An aside about the situation in the United States: the Congressional Budget Office just released new projections for the federal budget.  In the new projections, the interest paid on United States debt will increase from around 2 percent of Gross Domestic Product in 2011 to over 9 percent in the year 2035. And, this is with relatively benign projections on interest rate movements. (http://professional.wsj.com/article/SB10001424052702304657804576401592689113956.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

Is this just another rendition of the “death trap”?

What is Causing the Worldwide Government Debt Crisis?

Mohamed El-Erian, the Chief Executive Officer of PIMCO, writes this morning that “It is now commonly accepted that Greece’s predicament is due to two inter-related problems: the economy is unable to grow, and the debt burden is enormous. (http://blogs.ft.com/the-a-list/2011/06/17/only-a-totally-new-greek-approach-can-save-europe-now/)

Yet, El-Erian states, neither of these issues are being addressed in the discussions going on concerning the resolution of the debt crisis in Greece.

The reasons for this are complicated although they very often boil down to the priority to handle short-run problems immediately and postpone the long-run problems to another day.  Of course, the famous quote of John Maynard Keynes comes to mind: “In the long-run we are all dead!”

A good listing of the complicated entanglement of the politics of the Eurozone is present in the Wall Street Journal article “Europe’s Greek Stress Test” by John Cochrane and Anil Kashyap. (http://professional.wsj.com/article/SB10001424052702304186404576389542793496526.html?mod=ITP_opinion_0&mg=reno-wsj) The authors list four key facts:

“First, the Greek government has borrowed more than it can plausibly afford to pay and certainly more than it will choose to pay. It now owes more than one and a half years' economic output.”

“Second, European banks are holding the bag.”

“Third, the European Central Bank (ECB) is now involved as well.

“Fourth, in the end this is all about Ireland, Portugal, Spain and Italy.”

In other words, by ignoring the basic underlying causes of the problem, the sickness has spread and now envelopes nor only Europe…but the world.

In other words, the old economic paradigm is dead, and the political leaders of the western world have only made things worse by trying to keep the old paradigm alive. 

As a consequence, the options available to these leaders are shrinking and those options that are left are becoming less and less desirable.

And, even if the bailouts continue and postpone the resolution of the crisis until another day, the two basic issues mentioned by El-Erian are not being addressed.  These are the issues pertaining to the reasons for slow economic growth and the reduction of the massive debt levels that are outstanding. 

The solution…increase economic growth and lower debt levels.

The problem…over the past fifty years or so the political leaders of most western nations worked with an economic paradigm that resulted in an increase in debt levels to increase economic growth.  That is, credit inflation, whether in the economy as a whole, or in a particular sector like housing, would buy politicians additional votes by keeping economic growth high and unemployment low. 

“The solution” reverses almost 100 years of the economic and political thought of western intellectuals.  It also contradicts the perception of many voters in western countries. 

Keeping a lid on debt exposure is an old-fashioned idea and one that collides with the modern day concept of what governments should do and of the excesses of the consumer society. 

An emphasis on education and training also is an old-fashioned idea although it was the basis of economic productivity and inventions in the nineteenth and early twentieth centuries in the United States.  And, this particular emphasis is one that collides with the modern-day approach to “certification” and the building up of “self-esteem” where everyone passes or everyone gets A’s.

The current sovereign debt crisis is not going to go away with “doing more of the same.”   Yet, changing the economic paradigm is going to be difficult.  We see this on the streets of Greece…and Spain…and Vancouver…oops, sorry…

The focus is on Greece right now and rightfully so.  But, the lessons need to be learned by others…but this will not make it any easier.  Long-run solutions are never “easy”.

There was an interesting article in the Saturday Wall Street Journal titled, “What Kind of Game is China Playing?” (http://professional.wsj.com/article/SB10001424052702304259304576374013537436924.html?mod=ITP_review_0&mg=reno-wsj) The answer is that American leaders need to learn how to play the game of “Go”, an ancient Chinese board game.  The game of “Go”, “emphasizes long-term planning over quick tactical advantage, and games can take hours. In Chinese, its name, wei qi (roughly pronounced "way-chee"), means the "encirclement game."

The economic paradigm of the past fifty years emphasizes “tactical advantage”, the short-run.  Why this approach became so popular was that the political leaders of the western world saw it as the means of gaining their goals…getting elected and then getting re-elected.

What El-Erian and others are arguing for is more emphasis by these political leaders on the “strategic” and not the “tactical.”  The “strategic” aims to achieve “sustainable” results.  The “tactical” way of dealing with a problem always contains the caveat that the other problems will be dealt with when they become the major issue.

Well, the other problems have now become the major issue.

And, this is the lesson for the countries included within the definition of the western world. 

Politicians are going to have to learn how to think “strategically.”  The question is, “Can politicians be allowed to think strategically in a democracy in which winning the next election is the most important thing on their agenda?”

Greece, in my mind, is going to have to restructure its debt in one way or another.  So is Ireland…and so is Portugal…and so in Spain…and so on and so on.  How many more countries will find themselves facing a restructuring of their debt is, of course, unknown. 

It is painful when you find out you have been working with a model that is not correct.  Creating more spending and more debt is not the solution to every problem.  Yet, we have lived by this model for a long time.  And, now the bill seems to be coming due.

To me, this is what is causing the worldwide government debt crisis.