Nouriel Roubini recently spoke to Handelsblatt, the German financial daily, about the sovereign debt crisis in Europe. I have translated the article reporting the conversation below. If I could sum up his words in a sentence it would be: “Greece is clearly insolvent”. I think this is significant for a number of reasons.
In a debt crisis, the basic role played by regulation, financial aid, and lenders of last resort should be to discriminate between the clearly insolvent and the rest. We can see that as a result of the panic in 2008. When the US was bailing out its own indebted entities, I wrote a post called “Bailouts: catching a falling knife”, saying:
Fear creates an environment in which it is extremely difficult to discern the difference between illiquidity and insolvency. Propping up bankrupt institutions only increases doubt and fear, adding to the economic death spiral.
What needs to be done is to comprehensively review financial institutions in a way that makes clear which are insolvent and which are not. Once this issue is taken care of, solvent institutions can be induced to lend if they are infused with enough capital to reasonably cover capital needs for future writedowns of assets already on the books.
As we move forward, you should be watching to see if policy makers understand these facts. If they do not, they will be bailing out insolvent institutions – and taxpayers will be catching a falling knife. We would expect writedowns to increase further from unnecessary dead weight economic loss, lengthening and worsening the recession.
Note that US financial institutions made an accounting gain of $29 Billion in the last quarter. My view is that banks are under-provisioning for loan losses and that the writedowns are still going to come – in great measure during the next cyclical recession. The credit environment is one reason why growth is going to be poor during this cycle. By propping up weak institutions, the bailouts as conducted will have lengthened the downturn through at least the next business cycle. You could quibble and say that if enough losses are socialised, the downturn will only be lengthened, but not worsened.
The same logic is true regarding the European sovereign debt crisis. What investors would like to know is which debtors are clearly insolvent and how the euro zone will deal with those debtors that stand a chance of avoiding principal reduction.
Greece is clearly insolvent. The Europeans should put a plan in place to deal with Greece and to reduce contagion. The contagion to Italy and Belgium is happening right now because of the debt crisis’ uncertainty and the inability of the EU to put forward a credible medium-term solution to the sovereign debt crisis. At the same time, the EU should demonstrate credibly how it plan to deal with Ireland, Portugal and Spain’s problems – and how they are not bankrupt.
My sense is that the cost will be too hard to bear and that defaults are likely. In Greece’s case, it will be a sovereign default. In Ireland’s case, a bank debt restructuring is likely. Beyond that, there are many potential scenarios. Portugal has a debt-to-GDP ratio about where Germany’s is. There is no reason they can’t make it, if the government and Europe choose the right path, one less dependent on austerity and more dependent on growth and temporary liquidity. Spain needs to steer clear of getting too close to its cajas. It cannot afford to pump them full of taxpayer money and take on contingent liabilities as the Irish have done. This would cause the Spanish to re-couple to the periphery and then the euro zone would be in an existential crisis.
Greece has a solvency problem. The Irish banks have a solvency problem that has become the Irish government’s solvency problem. Portugal and Spain have liquidity problems. The austerity and the defaults will be negative for growth in the periphery but will also boomerang to infect the euro zone core. Growth across the euro zone and in the UK will be weak. That’s my take on the situation.
[For Greece] I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
But, even now the Germans are (at least publicly) backing away from a soft restructuring for Greece that extends maturities and reduces interest rates. Politically, this is toxic as Portugal already has much better terms than Greece. The Greek people will not stand for receiving a substantially different deal than the Portuguese – irrespective of whether that deal is credible over the medium term. The potential for politics creating a negative outcome rise unless we see a restructuring of the terms of Greece’s aid package.
Here’s what Handelsblatt reports on its conversation with Nouriel – and you will notice he makes many of the points I made about a potential solution in my post “Greece will eventually restructure” on Tuesday:
According to US economists, the euro countries Portugal, Ireland, Italy, Greece and Spain will not be able to solve their problems by conventional means.Nouriel Roubini, a professor at the Stern School of Business at the New York University is matter of fact: "Greece is clearly insolvent".
Even with a draconian austerity package, which would amount to ten percent of GDP, public debt would rise in Athens to 160 percent of GDP. Portugal, where growth has stagnated for a decade, is experiencing a fiscal train wreck in slow motion, which will lead to the insolvency of the public sector, the Economist argues.
In Ireland and Spain, the transfer of the huge losses of the banking system onto the state’s balance sheet – in addition to the already escalating national debt – in the end, will lead to the Government’s insolvency.
Nevertheless, to date, the euro community has acted as if the PIIGS countries don’t have a solvency problem, but only have had a liquidity problem. Therefore, loans and guarantees have been provided. This approach of "extend and pretend" or "delay and pray" will inevitably fail.
Roubini proposes other measures to find a way out of crisis. For example, one could encourage the holders of government bonds to exchange their bonds for bonds whose payout is tied to future economic growth. Such instruments would turn creditors into shareholders of a country’s economy.
Europe cannot afford to spend vast sums of money as usual and pray that growth and time will make the difference. Creditors and bondholders will have to take on their share of the burden, the US economist said.
Source: "Verleihen und Beten wird die PIIGS nicht retten" – Handelsblatt