Morgan Stanley On How Only A "Deux Ex Machina" Can Save The European Periphery, And Why The Fed May Have To Do God's Work Out Of The Machine

Morgan Stanley's Arnaud Mares, who a few months ago made the jarring claim that a European default is all but inevitable (and the only question is what shape it will take), has followed up with the next piece in his Sovereign Subjects series, in which he attempts to quantify the practical inputs that would lead to sovereign default, and, more importantly, to government overthrow. Obviously the two are linked, and as Mares notes "out of 19 cases surveyed, on 18 occasions default was followed by the incumbent government losing elections." Which means that Europe is certainly interested in resolving its unresolvable issues in a way that affords fiscal adjustment in a way that does not almost inevitably lead to some form of government overhaul. The problem is that as the following chart demonstrates, the "fiscal adjustment" option which is the only one that at least gives the possibility of preserving incumbency, and unfortunately, this option is that one that not only impairs only taxpayers and not creditors, but is also prolonged over time and not instantaneous. This is also the option that guarantees a build up of resentment not only toward the ruling politicians, but toward the banking oligarchy, has the potential to result in a far greater, and more violent outburst of "social discontent", and just happens to be the state in which America will be trapped for a long time. Yet back to the core topic at hand: in looking at the only feasible way in which a "fiscal adjustment" could work, Mares approaches the issue from a game theory angle, and finds that only a "Deux Ex Machina" can prevent a systemic collapse. While he refers to the IMF, we believe the Federal Reserve, and its various systemic backup facilities (such as the FX swap line), are a much more appropriate subject to fill these shoes. We believe that since to every quid there is a quo, the Fed will not give Europe an infinite handout for free: the leverage the Fed will use, will be to force the ECB to keep the Euro artificially high, threatening with pulling all support if Europe defects in a world in which its consistency is predicated upon the Fed's ongoing generosity. Which is why in the race to the bottom, an eventual EURUSD parity thesis may have to be revised.

More from Mares, whose full note is a must read, but these are the key observations:

Does fiscal austerity cost elections? Not necessarily. It is worth noting that, contrary to widespread belief, fiscal consolidation does not necessarily run into such popular opposition as to make it unsustainable. A study by Alberto Alesina and others, looking at government  and policy changes over the past 25 years in Europe, shows that governments do not lose elections more often when they engage in  large fiscal consolidation than when they do not. In particular, governments engaged in large expenditure reduction do not get punished by the electorate any more often than they would be in normal times. Further, a change of government does not necessarily lead to a change of policy. So, while political risk (the likelihood of government change) is a reality, policy risk (the likelihood of policy change) ought not to be overstated. In this context, it is worth recalling, as Elga Bartsch and Daniele Antonucci have several times underlined, that some of the European leaders most engaged in implementing expenditure cuts, such as George Papandreou and George Papaconstantinou (Greece) or Brian Lenihan (Ireland), enjoy comparatively high rates of personal approval. By contrast, an IMF study found that the political cost of default was extremely high. Out of 19 cases surveyed, on 18 occasions default was followed by the incumbent government losing elections.

The fiscal pain is bearable…The conclusion at this stage is that the sort of fiscal pain required to avoid default does not seem unbearable. So debt ratios can be stabilised. What, however, would make the pain unbearable? The impact of lower growth on the burden of adjustment is often discussed, but the role of the government’s cost of funding is arguably more important, because interest rates are both more volatile and – with external assistance – more controllable. We now focus on this relationship.

…as long as governments do not have to pay market rates. As can be seen from the formula presented earlier, the target primary balance to preserve debt sustainability is directly proportional to: i) the spread between interest rates and the nominal growth rate of the  economy; and ii) the level of debt. Because so many governments of advanced economies are now highly indebted – and debt is still  rising – they are all increasingly sensitive to even minor changes in their cost of funding. In the case of Greece, each permanent rise of  100bp in the average cost of servicing the debt would raise by 1.5% of GDP the primary balance required to maintain debt sustainability, on top of the 4.25% discussed earlier. Clearly, it would not take a very large rise in borrowing costs to challenge our constructive assessment of the political feasibility of the fiscal adjustment. If Greece had to pay interest on its debt at current market yields, it would eventually have to generate a primary surplus of approximately 14% of GDP to stabilise its debt – an unrealistic prospect under any scenario.

Life on the edge of sustainability. The implication is that the fiscal dynamics of highly indebted countries are currently inherently unstable. If investors attempt to protect themselves against a plausible risk of default in the form of higher rates, this quickly shifts the cost of fiscal adjustment to unrealistic territory, making default inevitable. The alternative is a form of concerted lending, where creditors consent to keep the government funded at a ‘sensible’ interest rate, thereby preserving at least the plausibility of a sufficient adjustment and the likelihood that they will be repaid in full. While theory suggests that concerted lending is the outcome that maximises return (or minimises losses) for investors, we see three practical issues here:

The first is the ineffectiveness of market discipline in either outcome. If rising rates lead to inevitable default, then market pressure has achieved no positive effect. If, on the other hand, investors agree to keep the government funded at low rates, then the situation is not much different to that which prevailed from 1999 to 2008, when governments enjoyed favourable costs of funding – and did not all use convincingly this breathing space to consolidate public finances. So, while private sector involvement and the resulting market discipline seems desirable in principle, it loses effectiveness when the starting position of government is already at the edge of sustainability (for a broader discussion of this point, see Elga Bartsch, Euroland Economics: The Next Crisis Resolution Mechanism, November 2, 2010).

The second issue is that the ‘virtuous’ outcome relies on coordination. While coordination of creditors might be feasible when there exists a small number of identified lenders, it cannot be easily achieved in the case of governments that have a large, diversified investor base (although in the case of peripheral European governments, the investor base is now becoming both less large and less diversified).

The third issue is an asymmetry of risks. Once debt is deemed to be on an unsustainable path because of excessively high interest rates, loss of market access and default ought to intervene quickly, leaving no chance of reversal. In the alternative path of slow fiscal  consolidation allowed by ‘sensible’ costs of funding, there still remains the possibility of shocks (economic, political or financial) that put the trajectory on an unsustainable path.

Why external assistance is essential to the debtor. So, when government finances stand close to the edge of sustainability – as they are in Greece and Ireland – and when uncertainty over the future is high – as applies to all advanced economies – the likelihood that spontaneous coordination of creditors takes place is very unlikely. An upward spiral of interest rates, loss of market access and eventual default becomes an increasingly probable outcome. This is the chain of events that took place in Greece earlier this year, and appears to be in motion in Ireland now.

Against this background, we think that the presence of a deus ex machina, a creditor willing to keep the more fragile governments funded on an ongoing basis at ‘sensible’ rates is crucial to ensure a virtuous outcome materialises. A credible fiscal adjustment is a necessary condition but, in view of the asymmetry of risks, not necessarily a sufficient one. Even if the fiscal trajectory is on the desirable path (as described in the case of Greece by Daniele Antonucci, see Euroland Economics: Does Greece Deserve More Credit? August 2, 2010), the government is unlikely to rebuild its investor base until public finances have moved much further away from the edge of sustainability. This will likely take a long time, which means that a return of the Greek government to market funding may well need several years. The same might well apply to Ireland, where, despite our constructive view on the ability of the economy and public finances to withstand the successive shocks to which they have been exposed, risks remain substantial (see Ireland: Mastering the Challenges Ahead, September 13, 2010).

Why external assistance is desirable to creditors. We also think that the incentives for this deus ex machina (the IMF and euro area governments through the EFSF and its eventual successor) to fund governments that need it on an ongoing basis outweigh the risks, for three reasons:

  • First, because the risk of damaging contagion that would arise from the default of a euro area sovereign towards other sovereigns and towards the banking system remains high (and nigh on impossible to contain in the absence of sufficient firewalls at the moment).
  • Second, because the most desirable outcome for net creditor countries (including Germany) is that other governments do repay their debt. As discussed at the start of this note, default would mean that it is creditors (including foreign ones), not fiscal stakeholders, that bear the fiscal loss. As in the case of government support to banks, government support to their peers only implies a cost for their taxpayers if the debtor eventually defaults. But that need not be the case if they remain funded at affordable rates.
  • Third, because a sovereign default in the euro area in the near term would undermine the chances of improving the governance framework of the euro area. For the weaker governments to accept the ongoing shift from peer pressure to peer control in the multilateral fiscal surveillance framework of the euro area, they need an incentive. This incentive is considerably weakened if they are left to default.

On that basis, we see the most likely outcome to be that: i) Greece has to rely on IMF and peer government funding for longer than currently assumed under its programme; ii) other countries, particularly Ireland, eventually have to benefit from similar assistance; iii) core euro area governments not only provide this support, but also provide it at rates consistent with fiscal stabilisation; and iv) this allows debt stabilisation to eventually take place at high but sustainable levels.

To paraphrase, while Mares does not say much new, his conclusion is that the unlucky one picked to serve as the God in the Machine (or rather those who end up having to fund the entity, which, as we expect will be the US taxpayers), will have to forgo broad market signals (or essentially become the market), in order to preserve a fake system, with fake inputs, and result in a market made up of fake outputs, prices and indicators that reflect nothing closely resembling reality.

In other words, the entity about to truly do god's work on earth, is the Federal Reserve.

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