During the crisis of 2007-2008, there was fair bit of discussion of the so-called Minsky Moment, when an economy that has built a house of cards of speculation and over-leveraged “Ponzi units” (creditors that could never make good on their commitments, and are viable only by finding new suckers to give them new debt to pay old lenders) starts to collapse.
But the idea of a Wile E. Coyote moment was less widely discussed. Wile E. Coyote was the famous Warner Brothers character ever in pursuit of Road Runner. One regular bit of shtick was having him run off cliffs and proceed quite a way in thin air, falling only when he looked down and saw the gulf below him.
Despite some occasional sharp falls in equity values in May, and a significant depreciation of the euro, most investors recognize that some serious adjustment is inevitable, starting with a restructuring of Greece’s debt. Yet in a peculiar parallel to the US’s extend and pretend with its financial system, the officialdom seems to hope that if things can be kept on even keel long enough, the system will self-repair, or at least be better able to handle the shock. Yet the contrary evidence continues to mount, with Fitch’s downgrade of Spain to AA+ leaving Moody’s as the sole rating agency that pegs Spain at AAA.
Some of my readers who have high-level political contacts say that the plan in policy circles in the US is for banks to continue to get the soft glove treatment (in particular, super low interest rates) so they can rebuild their balance sheets. Funny how their managements are still being allowed to siphon of a lot of these subsidized profits via outsized bonuses. This may also be true for Eurobanks, whose are even less far through writing down dodgy debt than their US peers.
The problem is that it looks virtually certain that dislocations will hit Europe well before banks are off their covert life support programs. Yet while a restructuring of Greece’s sovereign debt is seen as inevitable by most analysts (well, save maybe Jeffrey Sachs), the denial among the Eurozone leadership appears profound. From an article yesterday by Gillian Tett in the Financial Times:
Last week, some of China’s most powerful sovereign wealth fund officials held discreet discussions with investment banks about the outlook for the eurozone. And one of the hottest topics was the thorny issue of haircuts.
More specifically, as the eurozone writhes in turmoil, what the Chinese (and others) are trying to work out is just how big the losses on government bonds might be if, say, Greece were to restructure. Equally crucial, they (and others) are also trying to work out who might take that haircut.
It is a crucial question for the bond markets. Unfortunately, however, it is also a topic that eurozone leaders are adamantly refusing to discuss – or even recognise.
As Tett points out, holders of sovereign debt in the weaker Eurozone nations are in a not-pretty situation. Bailout-related borrowings are to be senior to existing debt, so if these rescues merely postpone the inevitable and Greece’s (and other) debt is restructured, they are likely to be worse off than if it were to happen now.
It isn’t hard to see, given that the bailouts simply shift risk from the periphery states to the core, that would be better to do triage, and make a first cut at which borrowers simply won’t make it, and restructure those debts. The current program instead is ultimately about protecting Eurobanks from losses, and is destined to fail. John Mauldin, in his newsletters, has been featuring the work of Rob Parenteau, as featured first here on Naked Capitalism (and a source of much reader ire): that deleveraging the public sector and the private sector at the same time is impossible absent a big rise in exports. Pretty much every major economy is on a “reduce government debt” campaign. Many are also on a “deleverage the private sector” program too (which is warranted, given the amount of profligate lending that occurred). The problem, however, is that these states can’t all increase exports, particularly to the degree sought. As Mauldin notes:
Let’s divide a country’s economy into three sections, private, government and exports. If you play with the variables a little bit you find that you get the following equation.
Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current Account Balance (or Trade Deficit/Surplus) = 0
… As Rob [Parenteau] noted, “…keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong.”…
The implications are simple. The three items have to add up to zero. That means you cannot have both surpluses in the private and government sectors and run a trade deficit. You have to have a trade surplus…
Going back to the equation, if Greece wants to reduce its fiscal deficit by 11% over the next three years, then either private debt must increase or the trade deficit must drop sharply. That’s the accounting rules.
But here’s the problem. Greece cannot devalue its currency. It is (for now) stuck with the euro. So, how can they make their products more competitive? How do they grow their way out of their problems? How do they become more productive relative to the rest of Europe and the world?
Barring some new productivity boost in olive oil and produce production, there is no easy way. Since the beginning of the euro, Germany has become some 30% more productive than Greece. Very roughly, that means it cost 30% more to produce the same amount of goods. That is why Greece imports $64 billion and exports $21 billion.
What needs to happen for Greece to become more competitive? Labor costs must fall by a lot. And not by just 10 or 15%. But if labor costs drop (deflation) then that means that taxes also drop. The government takes in less and GDP drops. The perverse situation is that the debt to GDP ratio gets worse even as they enact their austerity measures.
Yves here. Rob Parenteau drew out the implications in an earlier post:
….if households and businesses in the peripheral nations stubbornly defend their current net saving positions [continue to reduce debt levels], the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector. Call it the paradox of public thrift.
As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. European economic growth will prove extremely difficult to achieve if the current fiscal “sustainability” plans are carried out. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability…
It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path – the very outcome policy makers were frantically attempting to prevent but a year ago…
Or to put it more bluntly, if European countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough, then either a) the domestic private sector will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher’s paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, with large private debt/income ratios, this is an especially critical issue.
Yves here. As we have said before, the stresses on the Eurozone could be alleviated if an effort was underway to rebalance internally, meaning increase German consumption. But Germany is also on an austerity kick. Thus the result is very likely to be deflation, which as Rob pointed out, will lead to widespread private sector defaults. That is almost certain to blow back to the financial system. With banks like Deutsche Bank, SocGen, and Paribas part of the core global debt market infrastructure, the potential for another act of the global financial crisis is real. The only other way out is a very large fall in the euro, which as we have pointed out before, would not be well received in the US, China, or Japan, since a deflationary shock that large has high odds of putting their recoveries into reverse gear.
This feels like 2007 all over again, with the authorities insistent that Things Will Be Fine, when a realistic assessment suggests the reverse.