Sovereign debt bubble thread

[Sheilbh]

As an aside I just saw this Martin Wolf blog, in response to a letter from a senior German Ministry of Finance official:

http://blogs.ft.com/martin-wolf-exchange/2012/06/07/the-german-response/#ixzz1x7W51s9M

The German response
June 7, 2012 12:48 pm

Last week I wrote a column entitled The riddle of German self-interest. To my surprise, it received a lengthy response from a senior and highly respected official of the German finance ministry. I am very grateful for this reply, because it clarifies the German finance ministry's position and raises a number of profound issues.

In the interests of clarifying these issues further, I comment below on some of the statements made in that letter.

From Mr Ludger Schuknecht:

Sir, Martin Wolf ("The riddle of German self-­interest", May 30) voices a fundamental critique of the European fiscal and economic policy strategy in the context of the current debt crisis. He argues that the "eurozone is now on a journey towards break-­up that Germany shows little will to alter" given its many "neins" to anything that would break the "doom loop".
Mr Wolf's solution for the current problems is risk transfer via eurobonds (of some sort), and demand stimulation via cheaper money and less fiscal consolidation in Germany. But the public and markets have been led to believe in short-­term measures for far too long. And they know there is too much moral hazard already. Eurobonds would only make it worse and the healthier countries − mainly Germany and France − cannot even afford them.

Comment: At least three points are worth making here.

First, the aim is not risk transfer, but rather substantially to reduce the problems members of the currency union now have in retaining liquidity in their sovereign bond markets. Mr Schuknecht argues that such multiple equilibria are impossible. There is good reason to believe he is wrong, as the Belgian economist, Paul de Grauwe has written. I discussed this issue at length here .

Second, I do not know what "short-term measures", Mr Schuknecht is referring to. But the public presumably expects the eurozone at least to hit its inflation target. At present, there is good reason to doubt that it will.

Third, "moral hazard" is not the clincher Mr Schuknecht believes it is. We have fire brigades, despite moral hazard, because it is bad for the neighbourhood for a house to burn down. Nobody enjoys the experience of watching his house – or in this case, his economy – burn down. The idea that offering countries a cap on borrowing costs would encourage them to repeat the current experience is, to put it mildly, implausible. Governments really do dislike having 25 per cent unemployment rates (as in Spain today). The penalty is sufficient to discourage repetition.

Mr Schuknecht:

I would rather believe that the public and markets want to see a credible path towards a prosperous, sustainable and competitive euro area. This is what they were promised at the start of the economic and monetary union. Indeed, it is expansionary policies and weak fiscal positions that created the current problems of high debt and low competitiveness in the crisis countries in the first place. This is why the European strategy to deal with the crisis seeks to regain confidence through a combination of fiscal consolidation and structural reforms that will improve competitiveness and growth prospects. Such reforms have invariably succeeded wherever they have been implemented.

Comment: Mr Schuknecht surely knows that "expansionary policies and weak fiscal positions" did not create "the current problems of high debt and low competitiveness in the crisis countries in the first place".

As the chart below (taken from the International Monetary Fund's World Economic Outlook database) shows, Ireland and Spain had exceptionally low net public debt before the crisis. Portugal's was close to that of France. Only Greece and Italy had relatively high debt. Italy's net public debt fell substantially, relative to GDP, in the period leading up to the crisis, though not perhaps enough.

What did cause the crisis were huge balance of payments deficits, induced by excessive private lending, most of it to private borrowers (with the exception of Greece). The responsibility for such lending and borrowing surely rests on the shoulders of both lenders and borrowers.

As to the claim that "Such reforms have invariably succeeded wherever they have been implemented", I can think of important cases where they failed: Argentina in the 1990s, for example. I fear this is a tautology: where such policies failed, they were not tried, by definition.

Moreover, "structural reform" is a woolly term. If by this Mr Schuknecht means that falling prices, induced by ultra-high unemployment, debt deflation and sovereign and banking insolvencies, will ultimately restore competitiveness, he is correct, provided the country is able to stick with such policies, for a very long period indeed (probably a decade, or even far longer). This is what is required if a country with a large private sector debt overhang and a sizable structural current account deficit is to eliminate its fiscal deficit, regain competitiveness and restore growth, particularly in a currency union whose core country has a structural current account surplus and low inflation. The question is whether democratic politics (or the eurozone) will survive the experience. I doubt it.


Mr Schuknecht:

Rebuilding confidence also entails making European Union institutions more credible. Fiscal and macroeconomic surveillance and banking regulation and supervision are being strengthened. Firewalls worth about €1tn euro have been erected and supplemented by International Monetary Fund money. Given what we have achieved, any decision to disregard the rules or introduce ill­-suited tools such as eurobonds could undermine this effort to rebuild confidence.

Comment: Mr Schuknecht must recognise that the firewall he mentions is in conflict with his desire to eliminate moral hazard. So we are really just talking abut its size. The question is whether the available firewall is big enough to deal with likely crises. The answer is: no. I agree that eurobonds (which would need to be conditional) are only one way to provide a firewall. I agree, too, that long-run fiscal transfers are undesirable (and have said so). The whole of southern Europe must not be turned into a large Mezzogiorno.

Mr Schuknecht:

Moreover, just as the European Central Bank has a duty to focus on the goal of maintaining price stability, Germany must not undermine its role as an anchor of stability via inappropriate and ineffective fiscal stimuli. Incidentally, the social implications of Mr Wolf's recipe are highly problematic too. The short-­term measures he puts forward focus on countering the deflationary tail-­risks arising from financial instability. They would benefit those whose considerable fortunes were built or bolstered through excessive risk-­taking during the pre-crisis boom. By neglecting the tail-­risk of a destabilising loss of confidence in our money, his approach would put at risk the savings of those who have no way out: the cash-holding lower and middle classes.

Comment: I do not think an attempt at symmetrical adjustment inside the eurozone would undermine German stability. But it would certainly be helpful to eurozone stability if, during the lengthy adjustment period ahead, German policymakers focused on policies likely to expand domestic demand. It does not really matter to the outside world what those policies are. An investment boom or a rapid rises in real wages would also be excellent.

As to the question of benefiting those who created the crisis, may I point out that German lenders were part of the problem. Are they (and other creditors) paying the penalty for their mistakes or are taxpayers in debtor countries being forced to assume the bulk of the costs?

Mr Schuknecht:

"Finally, let me reflect on Mr Wolf's riddle of German self-­interest. If one accepts the narrative that the risk of shipwreck comes from excessive "short­-termism", then there is no riddle at all. German and European interests are indeed very much aligned and they are reflected in the jointly agreed strategy. Germany will play its full role in implementing it − in its own and Europe's interest."

Ludger Schuknecht, Director General, German Ministry of Finance, Berlin, Germany

Comment: I fear that austerity without end will bring about a return to the unstable populist politics the European Union was designed to prevent. That could shatter the eurozone and, with it, the EU, thereby ending the most successful attempt to build peace and prosperity in Europe since the fall of the Roman Empire.

Moreover, it is clear – and has long been so – that the responsibility for preventing that outcome rests on Germany, Europe's central power, in every sense. As Charles Kindleberger argued, in a panic, the creditworthy country has to lend freely if a fixed exchange rate system (or in this case a currency union) is to survive.

It is often forgotten, not least in Germany, that the rise of Adolf Hitler to power was preceded not by the great inflation, which occurred a decade before, but by the great depression and the austerity of Heinrich Brüning, in response. Thus, votes for the Nazi party jumped from a relatively insignificant 810,000 in 1928, to 6.4m in 1930, and 13.7m in July 1932. Deep economic collapses are dangerous.

Deep economic collapses are very dangerous. Mr Schuknecht, with his emphasis on the long term, completely ignores these dangers.  If trying to avoid such a dire outcome is "short-termism", so be it. I think of it as trying to find a practical exit from the current trap. Without it, the eurozone may never reach the long term.

Fiat justitia, et pereat mundus (let justice be done, even if the world perishes) is a dangerous motto.

[Crazy_Ivan80]

Some commentary from zh:

As France Lowers Retirement Age, Germany Better Be Ready To Pay For Austerity's Unwind

As noted earlier, Europe has been so obviously crippled by years of brutal austerity (which, as we pointed out before never actually happened), that it has had to experience the supreme indignity - a miserable two years of plunging flat GDP growth. Because under the old normal, it appears that unless one is issuing massive debt, pardon "growing", society grinds to a halt. Well, it appears that France has finally had enough, and as of today, "the French government approved a measure Wednesday that will lower the retirement age to 60 from 62 for a narrow group of workers, partly reversing unpopular pension reforms made by former President Nicolas Sarkozy as he sought to improve France's public finances." Obviously, this means that more welfare funding will have to be sourced as all else equal, this means less money will be produced by the country's workforce, and more money will be consumed by its retirees. Who will do it? Why German of course. Because after Merkel caved first on Greece, and then on Spain, it is now game over for German "prudence" and everyone will line up at the trough. Congrats Berlin: we can only hope you have discovered those magical money-growing trees. You will need them.

From Dow Jones:

    The reform, which is less sweeping than promised by new President François Hollande during his election campaign, comes just days ahead of legislative elections in France and is likely to further fuel questions about Mr. Hollande's ability to make a serious dent in France's deficit against a backdrop of the deepening euro-zone crisis.
   
    The government's decision will authorize people who contributed to the pension system for more than 41 years to retire at 60, Social Affairs Minister Marisol Touraine told reporters after the weekly cabinet meeting. The government will also take into account maternity leave and unemployment periods in the contribution period, she said.

    Ms. Touraine said the reforms will cost €1.1 billion ($1.37 billion) in 2013 and €3 billion in 2017. The extra expenditure will be covered by increased contributions by employees and employers, she added.

    The measures will allow people who started working early in life and who have paid the required amount of pension contributions over the course of their working life to retire at age 60, instead of the normal minimum retirement age of 62.

    Ms. Touraine said 110,000 people will be affected by the reform.

We don't know about 110,000 people but we know about one: Angela Merkel. Have fun paying for French early retirement as austerity dies a miserable death.

someone nuke france from orbit please, and hit Wallonia too while you're at it.

[MadImmortalMan]

ZH's assertion that austerity is not happening is false. It's just that it's mostly coming in the form of higher taxes.

[Sheilbh]

Fitch downgraded Spain to BBB (lower than Ireland) from A apparently large downgrades of banks are on their way.  Here's a quote the Guardian picked up on:

The dramatic erosion of Spain's sovereign credit profile and ratings over the last year in part reflects policy missteps at the European level that in Fitch's opinion have aggravated the economic and financial challenges facing Spain as it seeks to rebalance and restructure the economy.

The intensification of the eurozone crisis in the latter half of last year pushed the region and Spain back into recession, exacerbating concerns over sovereign and bank solvency. The absence of a credible vision of a reformed EMU and financial 'firewall' has rendered Spain and other so-called peripheral nations vulnerable to capital flight and undercut their access to affordable fiscal funding.

Here's the Guardian's read on the 5 main problem Fitch have:

• The likely fiscal cost of restructuring and recapitalising the Spanish banking sector is now estimated by Fitch to be around €60bn (6% of GDP) and as high as €100bn (9% of GDP) in a more severe stress scenario compared to Fitch's previous baseline estimate of around €30bn (3% of GDP);

• Gross general government debt is projected by Fitch to peak at 95% of GDP in 2015 assuming a €60bn bank recapitalisation, compared to Fitch's forecast at the beginning of the year of 82% by the end of 2013;

• Spain is forecast to remain in recession through the remainder of this year and 2013 compared to Fitch's previous expectation that the economy would benefit from a mild recovery in 2013;

• Spain's high level of foreign indebtedness has rendered it especially vulnerable to contagion from the ongoing crisis in Greece; and

• The much reduced financing flexibility of the Spanish government is constraining its ability to intervene decisively in the restructuring of the banking sector and has increased the likelihood of external financial support.

Here's the statement:
http://www.fitchratings.com/creditdesk/press_releases/detail.cfm?pr_id=751942&origin=home

[MadImmortalMan]

Euro dropping now. US stocks too. Thanks, French bastards. 

[Neil]

Don't blame the French.  The market went up yesterday, and so you knew that it was going to come down today.  There is no confidence out there.

[jimmy olsen]

Man, Spain might as well be spiraling down into a black hole, there's no escape from this gravity well.

[Tamas]

This thread now can be closed.

The Hungarian Finance Minister said on CNN that the European crisis is over, and Hungary will experience a big economy boost next year.

[Iormlund]

That's a relief.

[Sheilbh]

This thread now can be closed.

The Hungarian Finance Minister said on CNN that the European crisis is over, and Hungary will experience a big economy boost next year.

  I can't understand why you'd say something that's going to be so obviously and clearly massively wrong probably within the next month.

Edit:  This from Barclays - quoted by the Guardian - is grim:

Following the Bankia announcement, our estimates increased roughly EUR20-30bn, bringing total baseline recapitalisation needs to EUR70-80bn. Our stress level estimate is EUR126bn under an extreme yet plausible scenario. Recently, both Fitch and S&P mentioned amounts on the order of EUR90-100bn under severe stress.

...

Even if the government argues that it does not need a programme, other governments have also denied programmes only to request them soon after. It is clear that official support would come with conditionality attached, even if focused largely on bank recapitalisation. This is perhaps why the government may be hesitant to request a programme, given the stigma attached, and the potential for strict conditionality even in areas beyond banking reforms (eg, fiscal and structural reforms), depending on the type of programme.

...

The overall cost to the sovereign will likely be c.EUR70-80bn, so a programme may not make a large difference in terms of market reaction. Fundamentally, Spain is likely to remain solvent after accounting for those bank recapitalisation costs (see Spain: Dealing with sudden reversal, 4 May 2012). This is crucial because solvency is the benchmark to understand potential PSI discussions in the future, which at this juncture appear unlikely (note that only about 20% of the Spanish government bonds are now owned by non-residents). Obviously, the higher the recapitalisation costs, the less clear-cut solvency is. This is also true because this would generally happen in a scenario of stress macroeconomic conditions, which would be reflected in worse public debt dynamics as well. One aspect in which a programme may help is to add credibility to the completion of the bank clean-up process through strict conditionality.

However, a programme may not be a "choice" but a "need" if Spain were to be forced by market events into an EU-IMF bail-out. If markets events accelerate the ongoing capital reversal, and spreads continue to widen, given the contagion to other weak economies (eg, Italy has been trading at a spread versus Spain of c.30-70bp for 10y bonds), it would be unlikely that the programme could be circumscribed to the banks only or even to Spain alone. And for that, there are no sufficient rescue funds readily available (ie, for multi-year full-fledged programmes for Spain and, depending on contagion dynamics, for Italy as well).

[Iormlund]

And here comes the rescue ...

[jimmy olsen]

[Dr. Evil]100 billion dollars![/Dr. Evil]

http://www.reuters.com/article/2012/06/10/us-eurozone-idUSBRE8530RL20120610

[MadImmortalMan]

Yay now Bankia can buy up a bunch of US Treasuries and bunds to boost their reserves and Spain will still need someone to buy their bonds.

[Sheilbh]

From what I've read and I've not seen much details, I don't think this is enough or done the right way to have a positive effect for Spain/Eurozone.  Hope I'm wrong though.

[Iormlund]

I'm assuming all other Spanish debt is now given junior status, which makes buying our bonds even less attractive.

It might alleviate somewhat the lack of credit, but not lack of demand for it.