In a much needed white paper just released by GMO's Rich Mattione, title "Et tu, Berlusconi? The daunting (but not always insuperable) arithmetic of sovereign debt" the author does just that: an overdue deep dive into the maths of the European, and global, sovereign bail out. "Much needed", because everything we have heard over the past month leading to a 20% surge in the market in the past 23 days, has been full of broad strokes and completely absent of any details. Cutting to the chase, Mattione's conclusion is that "the arithmetic of Europe’s sovereign debt crisis is daunting, but not insuperable." Which means it can be done, at least in theory, but at great costs, and will need something that Europe has never demonstrated until this point: proactive planning and tackling problems before they develop into full blown systemic crises. How does he get there? Here are his key observations...
- In a world of low growth, it would take a miracle for Greece to escape without negotiating a large cut in the principal of its debt;
- It is, however, credible that defaults can be limited to a few small countries, and perhaps only to Greece, while the rest can string things along until a somewhat more normal global economic growth pattern resumes later this decade;
- The probable need to recapitalize commercial banks to cover defaults casts a long shadow on the process; and,
- The eurozone is likely to need more resources than it has gathered so far, with the European Central Bank (ECB) printing more money probably the easiest way to find those resources.
Of particular note to Keynesians is the following broad observations that without austerity things topple quickly - completely contrary to the accepted by Ivy League professors assumptions that the only way out is to spend and to issue debt:
Without austerity things deteriorate rapidly
Another “wow” moment. If one starts at a tough debt-to-GDP ratio, say 100%, in a low-growth, low-inflation environment, it is imperative to get the budget deficit under control. Austerity, as measured by the primary surplus, can bring down the debt-to-GDP ratio noticeably over the course of a decade – noticeably enough that the austerity can be eased, or market interest rates fall, before the decade is over (see Exhibit 3). But without austerity, the debt piles up faster than GDP can grow, so the policy is not credible.
Here the policy questions start to get a little more difficult. In Keynesian models, increased government austerity removes a source of stimulus from the economy. Or, as a recent paper put it, there is a “speed limit” on fiscal adjustment – “the pace of tightening after which the corrosive impact on growth starts to undermine the fiscal position itself.” This, of course, is why adjustment programs insist on asset sales and various liberalization measures – reduced price supports, freer labor markets – to help offset the negatives of fiscal consolidation. And, in the old days, there was the option of currency depreciation to kick-start demand, an option not directly available to any of the individual members of the eurozone.
And while that is all too logical, it is neither here not there. What is important are the practical conclusions for the PIIGS:
Portugal has dug itself a deep hole. It has failed to transform its traditional economy into a globally competitive economy, and it may be too late. Seen more as a source of textiles, shoes, and, of course, wine, Portugal has lost out to China and other emerging markets in the first two categories (heaven forbid that it should lose out in wine!). It has the right language to access one of the world’s more dynamic markets, Brazil, but may not make much of that opportunity. The new government has bravely gone forward with a plan of austerity under which Portugal might be able to pay its debts, though some autonomous regions have provided surprises by finding more debt on their books.
If this is not enough, then Portugal is a candidate for a steep haircut. But with debt of 161 billion euros outstanding at the end of 2010, Portugal does not of itself pose a systemic threat.
Ireland, the Celtic Tiger, was until recently a model of success. A low tax rate attracted multi-nationals, and a lovely accent and well-trained work force gave the country access to international service markets. Admittedly, some of that success was fueled by easy credit to the property and construction industries. The good attributes have not disappeared, and a nasty recession has made Irish wages even more attractive, even if based in euros. Ireland’s real problem is that it tried a very large version of the bank scenario outlined above. Ireland forced a small haircut on its banks and then bailed out the creditors the rest of the way. However, the amounts required were so big that it moved a manageable sovereign debt problem (a debt-to-GDP ratio around 40% pre-crisis, one of the best within the eurozone) into daunting territory. Ireland has been restructuring longer and harder than most other countries, so the problem has to be ruled daunting, but not insuperable. And, in any case, Ireland’s debt is relatively small.
Italy is on the border where daunting can turn into insuperable. It probably is not worth going for a restructuring of the sovereign debt; small haircuts on the debt’s principal accomplish little besides damaging one’s credit rating (this is distinct from the “haircut” on a bank’s Tier I capital that might be imposed during a regulatory review of capital backing those holdings). The political situation does not help; the Berlusconi government might not last long enough to make the hypothetical call to Chancellor Merkel with which this paper started. But the Italian restructuring must start soon, probably bolstered by the sale of some state assets to accelerate the date by which the progress is sufficiently evident so as to restore the market’s full uptake of Italian debt, both new and refinanced.
Greece is broke. Fortunately, Greece is small. It is not clear that leaving the euro would help, because Greece would still be broke. The only question will be the amount by which to write down the debt and the terms for the new debt to be issued. Cutting the debt in half but paying anything resembling market rates probably only sets up Greece for new problems down the road, but if the debt is restructured at very long maturities (for example, 30 years as is commonly suggested) those problems can indeed be postponed.
Spain’s previously exuberant construction sector has become an albatross around the country’s neck, and little improvement can be expected soon on that front. Still, the impact of the real estate collapse on employment and government revenues has already occurred. Labor laws are being eased, the central government has pursued a vigorous and tight fiscal policy, imposing even more constraints on regional governments that had been profligate, and has guided the cajas (saving banks) to a needed restructuring. The ratings agencies have worried about local governments hurting Spain’s adjustment, but the logical conclusion would be for the central government to let a few of the smaller authorities go into bankruptcy while continuing to clean up the central government’s financial mess. As a share of GDP, the debt is under better control than in many other cases, but it is large compared to the eurozone’s resources, so contagion is a risk.
If the problem with the PIIGS can be confined to Greece, Ireland, and Portugal, the amounts are well within European resources. It is even better if only Greece needs to be restructured. But it would be difficult to think of any of the PIIGS countries as much better than a “BBB” investment rating on a casual basis, so it would also not be surprising if there are further downgrades while the solution proceeds.
For the other eurozone countries, we remain cautious on the capital situation of banks, though we have addressed only one aspect of that problem here. Large-scale and amorphous bailouts could worsen the position of core eurozone countries such as France and Germany, especially if they were to take on overly broad responsibility for all debts in the region. The European Financial Stability Fund remains too amorphous a concept to judge on this basis, save to note the risk that it could worsen the sovereign debt position of core countries if they guarantee it. Directly it currently has 440 billion euros of resources, some of which have already been expended; including some other eurozone resources and the IMF plan, the total is a more impressive 750 billion euros, against the 3.1 trillion of general government debt outstanding at the PIIGS at the end of 2010. Overall, though, easier money at the ECB seems an easier solution to the question of resources.
And, the extended conclusion:
Will there need to be future reforms? Yes, and the following quote from Arthur Salter is a fine summary on that point: “To establish a sounder foundation for foreign lending in future is therefore one of the two or three most important reforms the world needs, if a recurrence of our present troubles is to be avoided.”
Arthur Salter wrote this long before the current crisis broke. Along with a co-author, I used this quote from 1932 in our 1983 publication for the Brookings Institution, “Managing Global Debt,” which dealt with the problems of the early 1980s centered on loans to Latin America.
Then, as now, policymakers had grand solutions – longer maturities, reduced interest rates, involvement of multilateral institutions – supposedly able to fix the system for the future while imposing, at most, minimal losses on lenders and borrowers. The only thing somewhat new this time around is the notion of increasing fiscal union in Europe as a way to prevent future problems. Even that is a play on the notion of thirty years ago that some outside source was needed to evaluate the financial position of countries before they could borrow. Grand solutions may yet come, but they probably will not come soon enough. Now is the time to separate the daunting from the insuperable, and to fix both sets of nations.
It is, indeed, time, however, if Europe has proven anything is that it won't move until it is far too late.
Full report below: