GMO Does The Euro Bailout Math, Finds That Arithmetic Of "Sovereign Debt Crisis Is Daunting, But Not Insuperable"

Tyler Durden's picture

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...

  1. 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;
  2. 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;
  3. The probable need to recapitalize commercial banks to cover defaults casts a long shadow on the process; and,
  4. 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:

 

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Deadpool's picture

I have white paper in my bathroom too.

Unprepared's picture

That's some high quality capital you have there.

Eligible as collateral for swap loan at the Fed. Quick to the window.

Deadpool's picture

at least mine is two ply, the Euro and greenback ain't.

IQ 145's picture

When I check the numbers on debt, I get insuperable, and not daunting. This is good, because you don't have to look serious, and buckle down, and try harder, and all that shit; you're already fucked. So, you can laugh while you wander out into the traffic lanes, or giggle while you put the pistol barrel in your mouth and cock the hammer; you could take up wearing women's clothes; it doesn't matter what you do.

LawsofPhysics's picture

expected.  So is the forthcoming treasury rout.

SeverinSlade's picture

Banking on Keynesian economists to actually prevent economic collapse is like banking on Robotrader getting laid by anyone other than a hooker.

Pretty sure even hookers make him pay a little extra for their services.

Deadpool's picture

Hey! I already took a swipe at Robotooter today in the post on the 80's...pick on someone your own size.

SeverinSlade's picture

I heard Robotard went long NFLX the same time Whitney Tilson did.

Robo should be here any moment to tell us to go all-in long and to sell our PMs while they're trading up.

Note to self's picture

Normal growth, later in the decade?  That's a laugh!

Pool Shark's picture

 

 

I too laughed when I read that line.

"Normal" compared to what? The last 3+ decades of artificial booms fueled by profligate government/consumer spending and ZIRP? This time around, we're starting with virtually-unserviceable debt (both public and private).

Good luck trying to reproduce that "normal"...

Bwahaha WAGFDSMB's picture

They never factor in the hubbard curve.

merizobeach's picture

The link you provide at the beginning of your article is extremely informative: http://www.drmillslmu.com/peakoil.htm

Thank you very much for this.

The Axe's picture

I have seen this movie before Hank writes some shit on a napkin, market soars.

navy62802's picture

The European nations now have no incentive to control their spending. When they run up the debt-GDP, they'll just perform a "voluntary" debt write-down and everything will be hunky dory again. Money and debt mean less and less everyday.

UP Forester's picture

Funny, I don't see Iceland's current status explained in the paper....

Josh Randall's picture

uhhh, I was told there would be no Math...

SeverinSlade's picture

If you believe in using math to figure out whether or not the EFSF bailout plan will work then you're a conspiracy theorist.

I'm calling DHS right now because since I see something, I must say something.

Enjoy your FEMA camp.

navy62802's picture

Truth be told, math is unnecessary in today's economic environment. Only a ministry of truth and information.

Unprepared's picture

That's why we are starting with arithmetics. If that doesn't work either, we will devolve to Numerology to make the point.

Deadpool's picture

As long as the greatest trick ever pulled on mankind (aside from the Devil convincing everyone he doesn't exist) which is fiat money continues this farce will continue.

GotFood's picture

In the end I believe the American taxpayers will pay to bail out the Europeans.

s2man's picture

Are you saving that puppy for food?  You are a REAL survivalist.

SheepDog-One's picture

OH right, Im sure the Eurozone, like the FED central banksters, has learned their lesson this time and will now become super serially responsible and do things right from here on out.

Uh huh.

Bwahaha WAGFDSMB's picture

"a somewhat more normal global economic growth pattern resumes later this decade"

False assumptions lead to wrong conclusions.

NEOSERF's picture

Even if "normal" returns to the rest of the world, it ain't returning to the PIIGS.  Normal in the last 20 years was fueled by a tech bubble and then a housing bubble both from too easy money.  Assuming that we have learned our lesson and that 3-4% growth rate really would have been half that without the bubbles of easy money, then we should expect 1.5% growth on average going forward...this is not enough for the old Western economies to soak up labor and feed entitlements...expect more pain.

SeverinSlade's picture

The EU wants to ban rating agencies from being able to downgrade...

Pretty soon arithmatic will be banned as well.

s2man's picture

As will free speech on forums like this.

Ponzi Unit's picture

What the hell, spelling is on the way out.

WineSorbet's picture

an overdue deep dive into the maths of the European, and global, sovereign bail out.

Au contraire.  I believe ZH contributor Reggie M. has done the homework already!

peekcrackers's picture

the only growth out of the E U with be venereal warts from hookers

mynhair's picture

Ah, more shit on 'The New Normal'.

Just buy, dammit!  I need 1400 S&P!

glepo's picture

No sane investor believes this will stop with Greece. Portugal is in much the same trouble, despite the heroic austerity drive. The country’s total debt will top 360pc of GDP next year, and its current account deficit is stuck near 10pc of GDP. This mix is worse than in Greece. It is untenable.

 

The Sov debt is not even the problem (1tr euro enough till 20130.

The banks need another 200bn$ min.

 

 

 

Then the main problem is NPL in the private debt in Greece, Portugal, Ireland and Spain held, apart from local banks, mostly by French/German/UK/Spanish banks.

http://graphics.thomsonreuters.com/F/09/EUROZONE_REPORT2.html

 

Print ECB print!


mynhair's picture

The only problem is your failure to appear at your local re-education camp as scheduled.

SeverinSlade's picture

Correct Comrade mynhair.

I have DHS on the phone right now. 

slewie the pi-rat's picture

this report was daunting...

...but not insuperable, BiCheZ!

Note to self's picture

Alright, I admit it.  I have no idea what insuperable means.  But its been such an exhausting day, I am too tired to google it.  Saving my strength to watch all the nightly news anchors sum up ALL of today's activities with the astronomical DOW index jump.  Then I can sleep . . . . not.

 

s2man's picture

double-click. right-click. choose Search Google for "insuperable"

(of a difficulty or obstacle) Impossible to overcome.

backseatdriver's picture

Mo money (injections) Mo problems (destruction)

 

Cheesy Bastard's picture

I know this is a European story, but any real extended conclusion must include Illinois, California, New York, New Jersey...

DormRoom's picture

wtf.. Keynes says to down debt during the years of prosperity.  Stop blaming him, instead focus on the inept way policy makers implement his theories.

 

It's like a doctor telling you that you can eat a hamburger a day, as long as you exercise.  You don't exercise. Becoming morbidly obese.  Then blame the doctor for telling you how you could eat humburgers every day.

 

Leaves Keynes alone, and focus on how the financial plutocracy is setting up the system to fail in an epic way--soon.

melanie's picture

Thousands clash with police in China (Huzhou), 8 dead after protest against higher taxes.

http://www.naharnet.com/stories/en/18709-thousands-clash-with-police-in-...

LawsofPhysics's picture

Hey, even the chinese may be waking up to the "here is a 10% raise, now we tax you 20% more" style of governing.

machineh's picture


'easier money at the ECB seems an easier solution to the question of resources.'

Even sober-sided GMO have turned into foam-at-the-mouth inflationists.

We're in trouble, BiTcheZ!

Vuvuzela's picture

From Pravda

http://english.pravda.ru/business/finance/18-10-2011/119355-The_Large_Families_that_rule_the_world-0/

All is a lie the game is rigged

Some people have started realizing that there are large financial groups that dominate the world. Forget the political intrigues, conflicts, revolutions and wars. It is not pure chance. Everything has been planned for a long time.

Some call it "conspiracy theories" or New World Order. Anyway, the key to understanding the current political and economic events is a restricted core of families who have accumulated more wealth and power.

We are speaking of 6, 8 or maybe 12 families who truly dominate the world. Know that it is a mystery difficult to unravel.

We will not be far from the truth by citing Goldman Sachs, Rockefellers, Loebs Kuh and Lehmans in New York, the Rothschilds of Paris and London, the Warburgs of Hamburg, Paris and Lazards Israel Moses Seifs Rome.

Many people have heard of the Bilderberg Group, Illuminati or the Trilateral Commission. But what are the names of the families who run the world and have control of states and international organizations like the UN, NATO or the IMF?

To try to answer this question, we can start with the easiest: inventory, the world's largest banks, and see who the shareholders are and who make the decisions.

The world's largest companies are now: Bank of America, JP Morgan, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.

Let us now review who their shareholders are.

State Street Corporation, Vanguard Group, BlackRock, FMR (Fidelity), Paulson, JP Morgan, T. Rowe, Capital World Investors, AXA, Bank of NY, Mellon.

JP Morgan:

State Street Corp., Vanguard Group, FMR, BlackRock, T. Rowe, AXA, Capital World Investor, Capital Research Global Investor, Northern Trust Corp. and Bank of Mellon.

Citigroup:
State Street Corporation, Vanguard Group, BlackRock, Paulson, FMR, Capital World Investor, JP Morgan, Northern Trust Corporation, Fairhome Capital Mgmt and Bank of NY Mellon.

Wells Fargo:
Berkshire Hathaway, FMR, State Street, Vanguard Group, Capital World Investors, BlackRock, Wellington Mgmt, AXA, T. Rowe and Davis Selected Advisers.

 

We can see that now there appears to be a nucleus present in all banks: State Street Corporation, Vanguard Group, BlackRock and FMR (Fidelity). To avoid repeating them, we will now call them the "big four"

Goldman Sachs:

"The big four," Wellington, Capital World Investors, AXA, Massachusetts Financial Service and T. Rowe.

Morgan Stanley:
"The big four," Mitsubishi UFJ, Franklin Resources, AXA, T. Rowe, Bank of NY Mellon e Jennison Associates. Rowe, Bank of NY Mellon and Jennison Associates.

?

We can just about always verify the names of major shareholders. To go further, we can now try to find out the shareholders of these companies and shareholders of major banks worldwide.

Bank of NY Mellon:
Davis Selected, Massachusetts Financial Services, Capital Research Global Investor, Dodge, Cox, Southeatern Asset Mgmt. and ... "The big four."

State Street Corporation (one of the "big four"):
Massachusetts Financial Services, Capital Research Global Investor, Barrow Hanley, GE, Putnam Investment and ... The "big four" (shareholders themselves!).

BlackRock (another of the "big four"):
PNC, Barclays e CIC.

Who is behind the PNC? FMR (Fidelity), BlackRock, State Street, etc.
And behind Barclays? BlackRock

And we could go on for hours, passing by tax havens in the Cayman Islands, Monaco or the legal domicile of Shell companies in Liechtenstein. A network where companies are always the same, but never a name of a family.

In short: the eight largest U.S. financial companies (JP Morgan, Wells Fargo, Bank of America, Citigroup, Goldman Sachs, U.S. Bancorp, Bank of New York Mellon and Morgan Stanley) are 100% controlled by ten shareholders and we have four companies always present in all decisions: BlackRock, State Street, Vanguard and Fidelity.

In addition, the Federal Reserve is comprised of 12 banks, represented by a board of seven people, which comprises representatives of the "big four," which in turn are present in all other entities.

In short, the Federal Reserve is controlled by four large private companies: BlackRock, State Street, Vanguard and Fidelity. These companies control U.S. monetary policy (and world) without any control or "democratic" choice. These companies launched and participated in the current worldwide economic crisis and managed to become even more enriched.

To finish, a look at some of the companies controlled by this "big four" group

 

Alcoa Inc.

Altria Group Inc.

American International Group Inc.

AT&T Inc.

Boeing Co.

Caterpillar Inc.

Coca-Cola Co.

DuPont & Co.

Exxon Mobil Corp.

General Electric Co.

General Motors Corporation

Hewlett-Packard Co.

Home Depot Inc.

Honeywell International Inc.

Intel Corp.

International Business Machines Corp

Johnson & Johnson

JP Morgan Chase & Co.

McDonald's Corp.

Merck & Co. Inc.

Microsoft Corp.

3M Co.

Pfizer Inc.

Procter & Gamble Co.

United Technologies Corp.

Verizon Communications Inc.

Wal-Mart Stores Inc.


Time Warner

Walt Disney

Viacom

Rupert Murdoch's News Corporation.,

CBS Corporation

NBC Universal

 

The same "big four" control the vast majority of European companies counted on the stock exchange.

In addition, all these people run the large financial institutions, such as the IMF, the European Central Bank or the World Bank, and were "trained" and remain "employees" of the "big four" that formed them.

The names of the families that control the "big four", never appear.