Goldman knows a thing or two about European equilibria (and the lack thereof): after all, it was its "bleeding financial innovation edge" currency swaps that allowed perpetual fiscal transgressors such as Greece (and who knows who else) to be allowed into the Eurozone in the first place despite never meeting the required Maastricht criteria of 3% deficit/GDP in the first place. Which is why we are happy to bring to our readers not only the latest in peak amusement in the form a podcast from GSAM head Jim O'Neill, but GSAM's "European Game Of Life" where in flowchart form, the Squid summarizes the various good/bad equilibria outcomes for Europe that lead to either Happiness or Misery. Frankly, we fail to see how any country in the European periphery, and soon, core, does not belong in the bottom left. But we are confident that Goldman will tell us, even as it hatches yet another scheme with its top clients on how to short the countries that paid Goldman the big bux for the pig lipstick a few short years ago...
Multiple equilibria could arise from the vulnerability of sovereign borrowers who constantly have to refinance themselves. The good equilibrium is where yields are low, refinancing costs are low and debt sustainability is high. The bad equilibrium is where yields rise, refinancing costs rise and debt sustainability falls. Once a country moves into the bad equilibrium, bond prices accelerate to the downside, with lower valuations justifying increasing yields. Primary markets dry up, bonds settle at recovery values and, in the absence of support from the IMF, the country defaults.
The diagram shows the decision tree leading to a country remaining in the Euro (Happiness) or exiting from the Euro (Misery). In this framework default and Euro membership are separate decisions. A country exits the Euro if the ECB stops providing its banks with liquidity or if the country chooses to exit from the Euro.
Taking Greece as an example, we start at the top and ask if there is enough of a growth model for Greece to stand by itself. If the market thinks “yes”, then it moves to the good equilibrium and it does not need any more ECB liquidity support. If the market thinks “no”, then the ECB provides more liquidity support until either inflation concerns rein back the ECB’s liquidity operations or Greece chooses to leave the Euro. If neither of these happens, we repeat the cycle, asking again if there is enough of a growth model for Greece to stand by itself.
Other troubled countries today are also in a transition state between the good and bad equilibria and are essentially on temporary life support from the IMF, EU and ECB. In addition to Greece, Ireland and Portugal are currently getting liquidity support under adjustment programmes administered by these institutions. Italy and Spain are getting liquidity support through the ECB’s secondary market bond buying programme. We hope these countries can make sufficient adjustment to move firmly back into the good equilibrium of strong growth, low deficits and low bond yields.
Full GSAM report - link
And here is the most recent Jim O'Neill (of GSAM and BRIC fame) podcast:
20111007 JimONeill by zerohedge