naked capitalism

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The EU, IMF and friends have rolled out the shock-and-awe bailout package for Greece and the Euro. This package supersedes earlier packages and has already generated a significant volume of comment and criticism. The financial markets were awed, but political foundation is showing cracks, i.e. the German election results and the earlier riots in Greece.

Unfortunately, there is no agreed-upon set of criteria to grade or evaluate financial rescue packages. The stakes are high, decisions must be made with imperfect information and in a dynamic setting, and there are numerous uncertainties. Hence the decision to mount this financial rescue package and decisions to go to war have much in common. This suggests that it might be useful to examine this financial rescue package in light of what has become known as the Powell doctrine. Named after the former US Secretary of State Gen. Powell Colin, it specified the criteria under which the US would take military action. It provides a pre-existing, independently determined set of criteria by which complex international decisions can be judged.

The Powell Doctrine consists of eight criteria, all of which must be satisfied for the US to take military action. Unfortunately, a quick review suggests that the EU and the IMF would not be able to justify this rescue package if the Powell doctrine were employed as a test. The criteria are:

A vital national interest is threatened (In this case, a vital supra-national interest is threatened)

The current crisis is clearly seen by the European political leadership as threatening both political and economic stability in the EU. The behavior of the financial markets suggests that market participants also see profound repercussions should Greece or any country in the EU default on its debt.

There is a clear, attainable objective

There is a clear and attainable objective, i.e., preventing a default by Greece. The package is large enough to prevent an immediate default by Greece and stabilize markets in the near-term. There are, however, questions as to whether or not the bailout package will be structured in a way that will prevent this crisis from re-emerging, spreading or encouraging future similar crises.

The risks and costs been fully analyzed

It is doubtful that all the analyses have lead to a clear ordering of the possible outcomes. The full nature and extent of an unchecked crisis is unknown and the authorities are clearly operating in the context of Knightian uncertainty and unknown unknowns. Given that not making a decision is to make a decision, a course of action must be adopted, but should allow for course changes in the event of unforeseen developments. However, it seems unlikely that the cumbersome EU decision-making machinery is capable of drawing up or acting on contingency plans.

All other policy means been fully exhausted

Given market conditions, there is no alternative to official intervention if Greece is to remain in the currency union. However, there may be alternative strategies.

If the ultimate goals — preserving the economic and political stability of the EU — are more important than any single country remaining a member of the currency union, perhaps the EU should take a step back from its borders and choose a more easily defensible position. It would also serve to reduce any moral hazard incentive that rescuing Greece might create.

There is an available exit strategy to avoid an endless entanglement

Assuming the package is adopted, do the EU and the IMF have an agreed-upon operational plan to extradite themselves from supporting Greece, et al if the agreed-upon economic and fiscal reforms are not enacted or do not succeed in reducing Greece’s et al fiscal and external deficits? Is there agreement on exactly what will constitute non-compliance and initiate the exit plan? The absence of an agreed-upon exit plan might increase the probability of agreement and near-term stability, but it would imply greater instability and cost should the package fail after having been implemented.

The consequences of the action been fully considered

Have the EU states and the IMF considered all the possible outcomes of their action and the ramifications thereof? Given the speed with which the crisis broke, it is probably impossible for the EU and the IMF to have evaluated all the possible contingencies and outcomes. However, not to make a decision is to make a decision, but whatever the decision they must have contingency and exit plans at the ready.

The American people support the action (In this case, the electorates of the EU countries support the plan)

Is there sufficient political support within the EU, especially Greece and Germany, that the agreed-upon plan can succeed? If there is a change of government in one of the EU countries and that country becomes unwilling to do its part, what will happen to the plan? Is the EU in a position to force a democratically elected government of a member state to adhere to a plan agreed to by the prior government? The political opposition to the financial rescue package in many countries across Europe is reminiscent of the political divisiveness in the US associated with the Vietnam War, which gave rise to the Powell doctrine.

The US has genuine broad international support (In this case, countries inside and outside the EU must alter policy so as not to frustrate adjustments required by the plan. The financial markets must be supportive of the rescue.)

Given that adjustment of the external accounts is necessary, will the non-crisis countries be willing to see deterioration in their external positions in order to facilitate the external adjustment of the countries in crises? Given the economic climate, it is unlikely that leadership in any country will be in a position to sacrifice growth and jobs.

There is a corollary to the Powell doctrine: when a nation is engaging in war, every resource and tool should be used to achieve decisive force against the enemy, minimizing casualties and ending the conflict quickly by forcing the opposition to capitulate. In the context of financial market bailouts, this corollary translates to: the size of the bailout package must be sufficient to preempt any market challenge.

On Sunday night, the EU acted in a manner consistent with the corollary. It rolled out a package with a headline number that awed the markets.

However, the use of financial shock and awe reveals an internal inconsistency. In the original military context, the corollary did not conflict with any of the criteria. In this case, a package large enough to guarantee success in the short-run will increase the moral hazard incentive, preclude any market-based pressure on politicians to enact fiscal reform, and may increase political opposition in the countries supplying the assistance.

There are other inconsistencies, or more correctly trade-offs, inherent in financial rescue packages. The absence of any explicit exit strategy may increase the likelihood of short-term success, but it increases the moral hazard incentives and increases the opposition in countries whose participation in part depends on well-defined end games. The degree of austerity involves trade-offs between reducing the opposition to austerity in Greece on the one hand and both decreasing opposition to any rescue package in Germany and promoting a long-term solution on the other. The desire to minimize downward pressure on real incomes and insulate financial balance sheets may mitigate any efforts to promote sustainability.

The stance of the ECB is also telling. The ECB could have agreed to take the lead as the Fed did in the USA, but it did not. Given the political dimension of the crisis, it could prove to be very costly to the ECB in if it losses credibility as it is perceived to have compromised its political independence. The Fed’s involvement in the bailouts in the US has certainly proven to be costly as the Congress appears set on expressing its displeasure by requiring a wider range of GAO audits.

The package is clearly an effective short-term palliative. Its curative powers remain in question. In the absence of market signals and discipline, it is not at all clear that the political elites in Europe will have the will to discipline each other. After all, Europe is in this crisis, because fiscal discipline has been absent despite long standing pledges and limit fiscal deficits.

If fiscal discipline emerges in the near term, it will only have happened because the markets said “no mas”. Yet, the first act of the politicians was to use shock and awe to discourage any further market protest even though they agree that the fiscal trajectories were unsustainable and prior international agreements had been totally ineffective in promoting fiscal consolidation. We know that markets are not always correct, but the record of policymakers is certainly no better.

The shock and awe strategy is a clear sign to the markets: trade based on the fundamentals at your own peril. What are the markets to use in evaluating European sovereign debt if not fundamentals including debt burdens? Are they to trade based on politicians’ promises that all the PIIGs will be little Germanys? (In fairness, the EU is not alone in shooting the messenger when it doesn’t like the message.)

The repeated interventions in major asset markets by policy makers also runs the risk of leaving investor and market decisions unmoored from fundamentals. This would be most ironic. The original criticism of the markets in this crisis was that they ignored the fundamentals (LTVs, borrowers’ income, debt service ratios, etc.) when making real estate loans and investments, but now the authorities are taking action to discourage investors and the markets from considering debt burdens etc.

The opposition in Greece which is openly opposed to the level of austerity agreed to by current government, and the election results in Germany, indicate that the national agreements necessary to put the plan in operation are far from a certainty.

Conspicuous in its absence in the Sunday night announcement was any mention of what the cost might be.

There is the problem of the absence of exit strategies. What happens if the individual countries choose not to be part of the SPV? What happens if deficit reduction targets are not met?
The shock and awe aspect of the plan announced on Sunday night was the easiest part of what will be a long and difficult journey to sustainability. It bought policy makers time. Now all they have to do is deliver what they promised to deliver numerous times before.