Economic Reality: Nowhere to Run, Nowhere to Hide, Part 1


By Satyajit Das

Central banks cut interest rates, governments provided cheap money giving only the illusion of recovery and a normal functioning economy. But the year of wishful thinking is over.

A Year of Wishful Thinking

The period from March 2009 was the year of wishful thinking. Central banks cut interest rates and governments opened their checkbooks, providing a flood of cheap money that gave the illusion of recovery and a normal functioning economy. By pouring a lot of water into a bucket with a large hole, the world sustained the impression that the receptacle was almost full. As Norman Cousins, an American political journalist, noted: “Hope is independent of the apparatus of logic.”

Governments merely transferred the debt from private sector balance sheets onto public balance sheets. The Global Financial Crisis (GFC) has morphed into a Global Sovereign Crisis (GSC) as sovereign governments now face difficulty in raising money.

Stock markets and asset prices have tumbled. Money markets are exhibiting an anxiety not seen since late 2008/early 2009. The year of wishful thinking has run its course.

Cradle of Debt

If sub-prime was the Patient Zero of the GFC, then Greece, the cradle of Western civilization, was the equivalent of the GSC. As historian Arnold Toynbee observed: “An autopsy of history would show that all great nations commit suicide.”

Greece’s significance is not its economic size (around 0.5% of global GDP (Gross Domestic Product)) but its significant debts. Profligate public spending, a large public sector, generous welfare systems — particularly for public servants — low productivity, an inadequate tax base, rampant corruption, and successive poor governments were responsible for the parlous state of public finances.

Several events focused attention on the problems. Greece needed to borrow around Euro 50 billion in 2010 to refinance maturing debt and fund its budget deficit. There were damaging disclosures that Greece, like many other European countries, had used derivatives to manipulate its debt figures. Greece bungled attempts to mask its increasing difficulties in refinancing maturing debt, including statements about a large purchase by China of its debt which was denied by the supposed buyer.

The revelations focused attention on underlying problems setting off alarm bells. Smelling blood in the water, markets pushed up the cost of Greek debt. The Greek stock market fell sharply by around 30%. Gradually, the ability of the country, as well as Greek banks and companies, to raise money ground to a halt.

Greece was also the “canary in the coal mine”, highlighting similar problems in the PIGS (Portugal, Ireland, Greece, and Spain) as well as some Eastern European countries. These countries alone have around Euro 2 trillion of debt outstanding. Larger countries — the FIBS (France, Italy, Britain, and the States) — also have similar problems of large public debt, unsustainable budget deficits, and (in most cases) unfavorable current account deficits (both in absolute terms and relative to GDP).

Going Nuclear

Will Durant, an American historian, advised that: “One of the lessons of history is that nothing is often a good thing to do and always a clever thing to say.” Initially, European politicians and bureaucrats, who suffer from delusions of adequacy, did nothing, but wouldn’t shut up about it. The oft repeated battle cry was “no default, no bailout, no exit.” Germany remained especially hostile to any financial bailout. Repeated invocations of the no-bailout clause underlying the eurozone drew attention to the risks of Greece’s debt.The major problem was contagion — the consequences if Greece was to unable to raise money from commercial sources. Much of Greece’s debt is owed to investors outside the country, mainly banks and investors in other European countries. If Greece defaulted on this debt, then the resulting losses would have serious consequences for the affected banks and banking systems. Countries, such as Portugal, Spain and Ireland, with similar economic problems would inevitably be scrutinized and targeted.

By February 2010, the need for coordinated action by the eurozone countries and the European Union (EU) was evident. While pledging eternal support, the EU postponed action, waiting for Greece to agree to an austerity program to remedy its finances. The cause of European unity wasn’t served by attacks by George Papandreou, the Greek Prime Minister, that the EU was creating a “psychology of looming collapse” and making Greece “a laboratory animal in the battle between Europe and the markets.”

In April 2010, as the market for Greek debt worsened (the additional interest rate that Greece had to pay reached 8.00% p.a. over that paid by Germany), after considerable prevarication, the EU proposed a highly conditional euro 30 billion rescue package. The Haiku writing, Belgian, Herman Van Rompuy, President of the European Council, hoped “it will reassure all the holders of Greek bonds that the eurozone will never let Greece fail … If there were any danger, the other members of the eurozone would intervene.”

Markets considered the proposal inadequate and unlikely to avoid a Greek default. Increasingly desperate as circumstances began to rapidly spiral out of control, the EU increased the package in early May 2010 to Euro 110 billion, including a Euro 30 billion contribution from the International Monetary Fund (IMF) who would supervise the package and the implementation of the economic “cure.”

About a week later, continued market skepticism and increasing pressure on Portugal, Spain, and Ireland forced the EU to “go nuclear.” After months of slow and tortured discussions, the EU acted with surprising speed announcing a “stabilization fund” to the value of Euro 750 billion to support eurozone countries, including an IMF contribution of (up to) Euro 250 billion. The actions were designed in no particular order to salvage the EU, the euro and over-indebted eurozone participants by stopping contagion and further spread of the crisis.

Nicolas Sarkozy, the French President, turned the eurozone’s sovereign-debt crisis into a personal triumph. The proposal, he let it be known, was 95% French. Le Figaro led the cheerleaders reporting Sarkozy’s comment that “in Greece they call me “the savior.’ “

Struggling for a telling phrase, journalists spoke of financial “shock and awe.” A single word – “panic” — better summed up the actions. Initially, stock markets rose sharply, especially shares of banks exposed to Greece who would benefit from the rescue. The interest rates on Greek, Irish, Italian, Portuguese, and Spanish bonds fell sharply. As the announcement over the weekend caught traders unaware, the rally was driven largely by the covering of short positions.

“Shock and awe” quickly proved more shocking and less awe-inspiring than the EU had hoped. Wiser commentators mused that if Euro 750 billion wasn’t going to do the trick, then what was?

Brussels, We’re Not Receiving You

Details of the “plan” remain sketchy. The entire package conveys the impression that the EU and ECB are hopeful that the announcement will suffice to bring stability to markets and the facilities won’t ever have to be used.

A problem of too much debt was being solved with even more debt. Deeply troubled members of the eurozone were trying to bail out each other. Given that all have significant levels of existing debt, the ability to borrow additional amounts and finance the bailout remains uncertain.

The reality is that Germany, with its large pool of domestic savings, must be the cornerstone of the rescue effort. Predictably, German credit-risk margins have increased while the peripheral countries’ credit margins have fallen. The effect of the stabilization fund is that stronger countries’ balance sheets are being contaminated by the bailout. Like sharing dirty needles, the risk of infection for all has drastically increased.

Karl Dunninger, a trader, writing at www.seekingalpha.com captured the madness:

The most-amusing part of this is that nations seriously in debt and without a pot to piss in will be “contributing” some of the money to fund the debt. Spain, for instance, has pledged to do so. Where is Spain going to get the money from? Will they sell bonds at 8% to fund a loan at 5%? That’s a very nice idea… let’s see, we lose 3% on those deals. That ought to help Spain’s fiscal situation, don’t you think?

Solvency Not Liquidity, Stupid

At best, the plan provides temporary liquidity to cover immediate financing needs, repaying maturing debt, and financing deficit. In a striking parallel to the early stages of the GFC, the reality that it’s a “solvency” problem not a “liquidity” problem remains unacknowledged.

Most of the countries in the firing line have unsustainable levels of debt. For example, beyond 2010, Greece needs to re-finance borrowings of around 7%-12% of its GDP (around Euro 16 billion to Euro 28 billion) each year till 2014. There are significant maturing borrowings in 2011 and 2012. In addition, Greece is currently running a budget deficit (currently over 12% but projected to decrease) that must be financed. As noted above, Greece’s total borrowing, currently around Euro 270 billion (113% of GDP), is forecast to increase to around Euro 340 billion (over 150% of GDP) by 2014.

The IMF’s publicly available economic analysis that its plan assumes is that Greece is able to refinance long-term debt by early 2012 and short-term debt even earlier. Given that Greece is expected to have a total debt burden of around 150% of GDP and total interest payment of 7.5% of GDP, the ability to raise funds and the assumed 5% cost of refinancing may be optimistic.

The IMF plan calls for a program of fiscal austerity and major structural reform. This would entail a sharp reduction in the budget deficit to less than 3% of GDP and public debt under 60% of GDP. It’s unlikely that Greece, despite heroic speeches from politicians, will be able to meet these targets.

Temporary emergency funding won’t solve fundamental problems of excessive debt and a weak economy. Government expenditure will need to be slashed and taxes raised to reduce its debt. But the government is too large a part of the economy and the suggested austerity measures will most likely cause a severe recession. In turn, this will drain tax revenues and increase expenditures, making it difficult to reduce the budget deficit and funding needs.

The level of indebtedness may already be too high. Kenneth Rogoff and Carmen Reinhart in their survey of financial crises This Time Is Different argue that sovereign debt above 60-90% of GDP restrains growth. Greece’s interest payment now totals around 5% of GDP and is scheduled to rise over 8% by GDP. Rising interest costs will only worsen this problem.

The cure may not be feasible or won’t help make it easier to meet future debt obligations. Ireland has already implemented austerity measures. The government debt as a percentage of GDP has increased to 64% from 44%. The budget deficit as a percentage of GDP has doubled to 14% from 7%. The nominal GDP of the country has fallen by 18%.

The plan may also make further liquidity problems inevitable. Instead of allowing Greece to raise funds normally, the bailout package is assisting investors to reduce exposure via repayment of maturing debt and the sale of illiquid longer-term securities. The package also risks forcing other vulnerable countries to rely on the stabilization fund.

As Woody Allen once observed: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”