In an excellent treatise on sovereign subtleties, Morgan Stanley's Arnaud Mares (the same analyst who nailed the Greek situation long before most others) once again lays out the increasingly bifurcated path that a broken European 'union' may and must take. Most interesting, and highly prescient in our view, is his consideration that the 'private sector involvement' in the restructuring of Greek debt was not only a major policy error but opens the door for the peasantry to finally comprehend that when sovereign debt is not 'risk-free' then fiscal (and monetary) policy can become pro-cyclical.
With the entire Keynesian dogma resting on this very tenet, we think it well worth a read and as he writes:
Pandora’s Box has been opened. Only fiscal integration accompanied by centralized financing of governments can bring about full stabilization of the market in Europe, in our view. The alternative could eventually be a resumption of the run on governments and a wave of public and private defaults.
Bottom line, in attempting to do things half-assed, Europe may have just destroyed the entire credibility of the one primary voodoo economic theory driving global "growth" (or stated better, borrowing from the future) since the beginning of the 20th century.
Which if you ask us, is long overdue.
Some notable quotables:
Why does it matter that government debt is viewed as risk-free:
What matters is not so much that government debt is risk-free as that it is seen as a safe haven. In our view, this is a precondition for governments to be able to use fiscal policy as a macroeconomic stabilisation tool. Indeed, what allows governments to deploy their balance sheet defensively at a time of recession is two properties of public debt, both of which derive from this safe haven status:
The first is practically unlimited access to finance. This is the property that allowed, for instance, governments to support their banking systems in the winter of 2008/09 by guaranteeing bank deposits and bank debt. In essence, what governments were doing in that instance was to lend their superior access to funding to the banks.
The second property, perhaps even more important, is that in a recession or crisis, flight-to-quality flows towards the safe haven lower the relative cost of funding of the governments. As long as this holds true, governments can cost-effectively deploy their balance sheet, borrowing more to supplement a fall in private sector consumption and investment.
And on the bifurcation:
In our view, this means that we are getting ever closer to a bifurcation point, where either of two outcomes must unfold. Either the aforementioned run must resume and eventually lead to a wave of defaults for (even solvent) governments and banks – a scenario we labelled in the past a ‘debt jubilee’; or, governments must reverse the effects of the use of private sector involvement in Greece by ensuring that they – and banks – benefit again from unimpaired access to funding at affordable costs. Intermediate scenarios (such as the ECB buying time by acting as a de facto lender of last resort) are in our view both transitional and costly.
In this context, we do not believe that the implementation of all the measures agreed by European governments on July 21, 2011, in particular as regards the enhanced capability of EFSF, will be fully stabilising.
As we have time and again noted, the EFSF is not enough. In fact, it will never be enough - because it has to be open ended.
The main issue here is the size of EFSF. As mentioned above, its lending capacity is sufficient to provide a fully credible liquidity backstop – effectively a function of lender of last resort – to Greece, Ireland and Portugal. Its current size provides ample reassurance that these three governments can remain funded ad vitam aeternam, providing of course they continue to fully comply with the conditions of their respective adjustment programmes. It does not have the capacity to act as a credible lender of last resort for Spain and Italy and other governments. To the extent that the problem generated by the use of PSI in Greece has been a broadening of contagion towards governments outside the periphery strictly speaking, and a material risk of a run on these governments, then EFSF as it currently stands is effectively obsolete.