Most of the writers whose work appear on this blog have long warned that the extend and pretend strategy in Europe would fail. Now, it seems that Europe is moving to a hard restructuring for Greece and recapitalisation for bank creditors. The word is the haircut will be 50% with recapitalisation of the weakest banks to happen concurrently. The devil is in the details however.
I have some thoughts on the macro backdrop below.
Now, obviously I am a eurosceptic and have been saying here for over three years that not only is the euro zone too big, but that the EU itself is too big as well. Here’s my view. When thinking about economic nationalism, it should be clear that Europe’s enlargement strategy in both the EU and the euro zone has put together countries which have very different economic profiles. Doing so was always going to create tension in a major economic downturn.
Abrogating currency sovereignty also means limited fiscal space and relinquishing monetary control. I like to say that Spain is the perfect example of a country that never should have joined the euro zone. But, let’s use Ireland as an example too. For Ireland, relinquishing currency sovereignty meant that following the Swedish example proved catastrophic. Where Sweden’s 1990s crisis resolution scheme worked and Ireland’s did not:
- The Swedish banks were not as large relative to the domestic economy. The Swedish government could credibly backstop the banks and the debt guarantees.
- The Swedes have their own sovereign currency. That means currency depreciation helped the Swedes tremendously.
- The backdrop for global growth in the aftermath of the Swedish banking crisis was more favourable than it is presently
The Irish have had none of these advantages.
And let’s not forget democracy. I wrote recently that:
The whole EU apparatus is seen by many Europeans as deeply undemocratic and so when they see these schemes, they recoil in revulsion. It is this revulsion which is driving the politics and makes the situation unpredictable. Minimising it by taking decisive action on a credible solution to Europe’s debt crisis is the only way out of this successfully.
Breaking up the euro zone at this juncture would have untold negative economic consequences both in the core and in the periphery. So when I discuss the euro zone, I suggest ways the euro zone can best remain intact during this crisis.
The political economy of depression
With a background in foreign policy and history as well as finance and economics, I tend to respect how politics, foreign policy and the economy interact. I don’t think you can view any of these in isolation –especially in crisis. Here’s my view on that interaction in Europe. The political economy of the European sovereign debt crisis is driven by a sense that people were going about their business as productive members of society only to be hit by a horrific economic downturn through no fault of their own. In the minds of many ‘those who caused the crisis’ – whether that be specific countries like the US or the UK or specific groups like banks – have been given a free pass. And this has created a deep-seated sense of powerlessness and anger everywhere. The question is what to do about it. To date, the strategy has been to extend bailouts and avoid the bitter pill of credit writedowns. This is true in the US as much as it is in Europe.
It is no coincidence that a globalisation wave preceded the previous Great Depressions that began in 1873 and 1929. What I have been trying to convey about the political economy is that politics and economics interact in a way which amplifies ‘us-versus-them’ thinking. It is natural that people will recoil and reject globalisation as a main contributor to this crisis because globalisation has made individuals further removed from the source of power. People feel adrift and helpless in a economic crisis and want some measure of control. Moving the decision-making process closer to home diminishes those feelings.
And democratic processes seem to be frayed everywhere. The extend and pretend strategy at once reinforces the sense that ‘those who caused the crisis’ are getting a free ride and the sense that globalisation has led to undemocratic processes in which ordinary citizens have no control. I am not making an argument one way or another on that issue but I see it as a force with which to be reckoned. If the anti-globalisation force is not heeded, respected and handled appropriately, it will become extreme and nationalistic in a very negative way. That is what I see as a potentially negative outcome and why I wrote my last post on economic nationalism. As is clear in this post, I believe national/currency sovereignty are important issues. Some readers seemed to think I did not based on the economic nationalism post. Substantively I believe these are important issues. As always, it is the language and the intent of that language that is a problem. Language and narrative that appeal to an us-versus-them animus and emotion more than reason always produce conflict. I believe the sweep of human history tells us that protectionists, demagogues, and ideologues of all stripes are emboldened by this, producing policies which amplify the economic downside.
Getting to default
Eventually, the extend and pretend approach will fail after successive rounds of the same policy response in Greece, Ireland and Portugal. Eventually, a combination of four things will occur:
- the people in the periphery countries rise up and overthrow the existing order forcing a default;
- the poor economy that austerity entails forces leaders to move to the hard restructuring route as fiscal consolidation fails
- markets become skittish about Spain or Italy, which cannot be bailed out. So EU leaders will cut Greece loose
- popular unrest in core countries against bailouts grows so severe that they force a hard restructuring or default
The point for policy makers is to socialise enough of the bank losses onto taxpayers in order to recapitalise the banks, survive the crisis and maintain the status quo. Taxpayers will accept this if the economy is robust enough. As an investor, you should see this as an uncertain political situation. more than most. That means avoiding periphery sovereign debt until the situation stabilizes.
All four of the bullet points above are playing a factor in the move to a hard restructuring for Greece.
Now, as to the substance of the haircuts, it has been clear for some time that a hard restructuring that writes down a significant portion of principal would be necessary.
Last summer I wrote about Pippa Malmgren’s astute commentary on the political economy issues.
Here’s what you should take away from her comments:
- On kicking the can: "If you’re going to make a bet on the European banking system which is purely based on the idea that policy makers will consistently bail them out, then you have to ask questions about the capacity of policy makers to deliver on that promise."
- On markets as a pack of wolves: "That is fine as long as the market doesn’t call their bluff… Do I think the markets are going to call their bluff? The answer is yeah, because that’s what markets do."
- On the psychology of change: "The thing is, in markets and politics, you have to have a crisis to get a solution. That’s the way it works. It always works this way."
You might think policy makers are going to move to a meaningful resolution of national solvency and bank undercapitalisation now that contagion has spread to France, Austria and Belgium. I’m betting they won’t until much, much later.
By April, Marc Chandler wrote that S&P reckons 50-70% haircut for Greek debt restructuring.
Marc did the numbers in April too:
Given the debt levels and the Maastricht goals, perhaps a 50% haircut is more likely. The current spread implies only about a 25% of this. A 50% chance of a 50% haircut would suggest the spread can widen to 2500 bp or more than prevailing rates. On the other hand, we have consistently argued that a Greek restructuring is simply a matter of time. To quantify that belief, lets say it means an 80% chance of a haircut. The current spread implies only about an 80% chance of a 16% haircut. A 80% chance of a 30% haircut implies a spread of about 2400 bp.
So, markets have always been clear what the outcome would be. Finally, finally, the politicians have relented and are moving to the inevitable solution for Greece, a haircut and recapitalisation plan. Let’s hope what they come up with is credible.