Forecasting misconceptions and the likelihood of European financial repression
Market participants, including economists and strategists, are prone to confusing what they believe should be the case with what will be the case.
Paul Krugman’s recent post recognizes this: It’s actually quite remarkable", the Nobel-prize winning economist wrote, "how many sensible people base their analysis on the presumption that the ECB will do what has to be done."
Of course, he means that the ECB should backstop European sovereigns. He has called for the ECB to do precisely. A joint European bond has also been recommended. However, Krugman, perhaps talking as much about himself as others, says "What Anglo-Saxon (sic who are the Saxons he is talking about?) economists need to understand is that Germany and the ECB really, really, don’t share our world view.
Krugman concludes by saying that if presented with a choice between saving Europe and righteousness (by which he appears to mean operating within its legal mandate) that they (Germany and the ECB) will chose the latter. It is not clear what the implication for others is –that they are less committed to principles or lawful activity?
Many, if not most, in the UK and US press and many in the blogosphere argue precisely what Krugman says they do. They want a European bond or a ECB backstop. Even the rating agencies appear to European officials to go down this path, without explicitly saying so. This assessment include Fitch, which is a French-owned rating agency.
We have argued that neither a ECB sovereign backstop nor a joint bond will be forthcoming. But we don’t see the consequences, as many others do, that this dooms European experiment. There is more than one way to skin the cat. Consider a parallel. As H1 2011 was winding down, there was a near consensus that when the Fed finished its Treasury purchases, dubbed QEII, there wouldn’t be a demand for Treasuries. Who would buy them, ran the conventional refrain.
Look at what has happened. The 10-year yield has fallen 94 bp in the past six months. This compares with about a 30 bp decline in H1. Moreover, growth and commercial and industry loans (as a metric of private capital demands) were stronger than in H1.
A ECB backstop and/or European bond are conceived of as ways to address the substantial roll-over risk that European sovereigns and banks face next year. The OECD estimates the gross borrowing needs of its members is $10.5 trillion, which is almost twice the gross borrowing needed in 2005.
If we are right and there is not a ECB backstop or European bond, what does that mean for the roll-over?
In broad strokes it means that 1) auctions especially in the periphery will need to be monitored closer and that they pose event risks, and arguably more potent than this year; 2) that European officials may have to resort to what economists are sure to consider "financial repression", which strongly encourage if not forces domestic entities to buy more government bonds; 3) the debt managers may change tactics, issuing smaller amounts, shorten duration, and perhaps rely more on syndication and private placement than auctions.
There are various measures that European officials can still take, if they felt existential were really at stake. For example, Greece is 100th place of 183 countries for the ease of doing business as measured by the World Bank’s multiple indicator framework. Italy is in 87th place. It takes 77 days to open a business in Italy. It takes more than 3 months to get electricity turned on in Italy. In Spain it take 133 days to start of business and more than two months, for example, to get electricity. In comparison, Ireland, which is 10th overall, takes 13 days to open a business and three months to get electricity.
If Italy, for example, really had its back against the wall, wouldn’t it consider extending its new real estate tax to the largest owner of real estate in Italy, the Catholic Church? If cutting the Greece’s debt burden to more sustainable levels is really desired, shouldn’t the largest holder of Greek bonds, which is the ECB, participate in the haircuts?
If the consensus, including Krugman, get what they seek, it is not clear how that resolves the debt crisis, even if it eases next year’s roll-over risks. The roll-over is a symptom of the debt crisis, but is not the cause. The BBK President compared it to giving saltwater to a thirsty person. It does not quench one’s thirst and in fact makes one even more thirsty.
Krugman argues the ECB and Germany will not do what he (and many others) think is the right thing. On the contrary, if the ECB does backstop sovereigns and/or there is a European bond, ultimately there will be less incentive to do the right thing.