The Eurozone Bailout – Are We Still Standing?

As we are about move into the fourth day of the week where EU policy makers together with the IMF and the ECB launched an unprecedented series of aid tools to combat the mounting risk of a collapse in Greece and elsewhere in the European periphery I am finally ready to move in with some comments. First of all, there has been no shortage of comments, opinions and market calls on the back of the bailout package and while risky assets have indeed rallied, it is if the underlying reality of the situation looms ever more prescient underneath the surface than what one would have expected from such a colossal dose of stimulating policy.

And for good measure, let us re-cap the list of stimulating efforts taken by Europe and the IMF based on, no less than, Macro Man’s last post as a financial blogger;

* €60 billion in cash from the European Commission, funded by bond sales
* €440 billion in loan guarantees, via pooled support of member governments
* Up to €220 billion from the IMF
* Outright bond purchases from the ECB, to be sterilized (this has evidently already started)
* 3m and 6m full-allotment LTROs
* Reactivation of FX swap lines

This is an impressive laundry list if there ever was one and among the points is the very, very interesting u-turn at the ECB which will now, albeit sterilised, be buyers of real assets. This last change of policy and the effectual skydive on the part of Trichet and his accomplices out of the ivory tower may be what eventually clinches it for Europe. Together with the most recent news this week that Portugal and Spain now seem to be getting the message in the form of introducing some very onerous austerity measures of their own (which as the song goes are of course completely voluntary and pre-emptive [1]) this might just be the combination of policy moves that Europe needs to see this through without a nasty default or a further intensification of the crisis.

But then again, it might not. I am sceptical here although I concede that if it is backed up by serious and real measures to rein in deficits I might just be turned into a believer here. However, there are some things that still bugs me.

Firstly, it should not escape us here that what our dear policy makers effectively are doing is fighting fire with fire. Debt will thus be substituted with even more debt and it is not clear just what the end game is supposed to be. However, one thing which is now crystal clear to me is that if there is any way that the EU and the Eurozone are to get out of this in one piece it will mean a much tighter coordination of fiscal policy. This will require a monumental rethink of the EU setup, and, while I believe that the joint effort of EU policy makers could indeed be pooled to make this happen, the chance of it actually materialising is slim. In this sense it will be interesting to see what exactly fiscal coordination (if any) will mean now that Eurozone economies are jointly asking the market for funds to pool in that loan guarantee entity.

Secondly, the introduction or implementation of all these so-called austerity measures are not linear and we can’t feed them into linear models and expect these models to come up with usable results. In this sense, and abstracting a minute from the general risk of doing too little too late, the road ahead is very difficult. On the good side it now appears that Spain and Portugal have awoken to the fact that they too need to turn the screw, and that what ultimately distinguishes them from Greece is merely market timing. This is universally good news, but it this is only the statement of intent. In fact, before we close the book on 2010 this is all we are going to see since the 2010 budgets (already passed) are thoroughly in the red. The biggest problem here is simply that, for all the good intentions in various EU commission and IMF proposals, the actual process of implementation on the ground may prove near impossible. And here I am not talking about some innate laziness or non-voluntarism on the part of the Greek, Portuguese and Spanish people; I am simply talking about the near impossibility of letting the entire burden fall on internal price and competitiveness adjustment from within a fixed currency union; but this, of course, has been the main issue all along. As I noted in another context, any state can only take so much of having to fight its own citizens with water and teargas week in and out even if they are trying to do good.

The considerations above have slowly, but surely convinced me that, while I support the efforts by EU policy makers (both in spirit and in terms of the technical measures), I have increasingly converged on the idea that some form of debt restructuring in Greece (and possibly elsewhere in EMU) has to be included in what we could call the main scenario going forward. In coming to this conclusion of course, I am met with formidable resistance.

Take for example the IMF’s communiqué on the situation in Greece and why a debt restructuring would be a very bad idea (see also Emmanuel’s take).

Restructuring debt would not help Greece’s capacity to grow. The type of fiscal and structural reforms being put in place under the Government’s program are designed to do that – to bring down costs, to make the labor market more flexible and to improve the business and investment climate.

The web of economic and political inter-linkages—including that Greek bonds are held by a wide variety of private investors and public entities—severely complicates alternatives to the program the government has put in place. Any perceived positive near term effects of a debt restructuring need to be weighed against contagion effects.

Most of the adjustment in Greece is needed to eliminate its large primary deficit (the deficit net of interest payments). This is the main issue for Greece, not the level of the debt.

My main problem here is simply I think the IMF misses the main point by a mile. It is thus exactly the combination of too high interest rates and negative nominal growth rates (deflation) which make the situation in Greece unmanageable and also why I believe it was a mistake not to include some form of hair cut on Greek sovereigns (up front) as part of the Sunday’s shock and awe move. Now, I don’t dispute the point that the fiscal and structural reforms wouldn’t help, but the numbers just don’t add up. Greece is currently running a fiscal deficit to the tune of 12-15% and even if we assume that this will come down during the envisioned horizon Greece will still be caught in a debt trap once we are done. For a lack of a better comparison, Greece will come to resemble the Baltics and trust me, this is not a comparison you would like to be branded with. In this way, it is in fact the level of debt that will eventually force a debt restructuring in Greece and it will do so exactly because the terms with which Greece is about to embark on her structural adjustment are unsustainable from within a monetary union.

This brings us to the newfound QE profile by the ECB which could, in theory, make a lot of the problems of Greece (and Spain and Portugal) go away. However, we are all moving into uncharted territory here. Consequently, echoes from Japan are coming closer and it is not altogether clear how the ECB would deal with the fact that it would have to permanently [2] massage the yields of Greek sovereign bonds in order keep the boat afloat. I emphasise permanent here since there is a real risk that the ECB has now decisively had its Japan moment and should the ECB commit to unwavering support for the Eurozone periphery it would not be a misnomer to dub the Eurozone Japan 2.0.

Among the long list of comments and analysis that has so far been ditched up to provide a view on the situation, I think that the one by John Hussmann comes very close to an adequate picture of the situation where you will forgive me, I hope, the following lengthy quote;

Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.

Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.

"Failure" and "restructuring" mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.

I agree with all of the above and it echoes my general sentiment which is not that Europe is about to sink into a hole, but that a real hard look at the face value of the obligations in Greece and elsewhere is needed. Naturally, and as a counter argument to this point is the increasingly worrying barrage of numbers purporting to show the exposure of European and US banks to Greek sovereign bonds and indeed the bonds of the Southern Europe. No matter where you look, the numbers aren’t small and it does not take a lot of imagination to see how this could very easily turn into a Lehman 2.0 moment for banks and thus the real economy. The only problem this time would be that we would be, for the most part, all out of firepower. It is important for me to point out that it is not because I discount this event too easily that I am calling for a preliminary look into debt restructuring. It is simply because I believe that with the current road map, the end game is given in advance. This won’t of course make the exposure any less grave, but did we really think that a haircut on the debt could be avoided here?! Especially, if we are talking about banks playing the funky chicken on the short end  of the Greek yield curve (is there any other?!)by sucking up liquidity in Frankfurt only to park it a couple of thousand kilometers further south, then it really escapes me if people had seriously imagined that this would not unravel at some point.

We all know that it will be a regime change when the first OECD economy pushes the restructuring button, but it was bound to happen at some point.  I’d thus recommend that we stopped kicking the can down the road and instead picked it up and threw it away; only in doing so will be able to say that we are indeed still standing.

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[1] – This is pooh-pooh of course, but as long as they believe it themselves I am happy to indulge them.

[2] – Let us say for 10 years to begin with.