By John Mauldin
Government bond investors are a curious breed.
They invest in government bonds because they actually think there is not
supposed to be any risk. They want their money to be safe. If they wanted risk,
there are lots of opportunities to invest with the potential for more reward.
The moment that government bond investors begin to
think they might be at risk, they leave. And history suggests they tend to
leave seemingly all at once. It is the Bang! moment. Someone fires the starting
gun, and they all head for the exits. They start selling their bonds to
speculators at discounts, which makes the effective interest rates in the
market rise, sometimes by a lot. That means that if a country wants to borrow
more money, it will have to pay the effective price in the market, or maybe as
much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which
of course makes it even more difficult to pay their debt as interest costs
rise.
Now, let's add a twist. The other countries that have bought those bonds are not actually countries, but banks in other countries. And because the regulators of those banks knew it was impossible – inconceivable – that a sovereign country might default, they allowed their banks to buy 30 times as much sovereign debt as they had capital in their banks. They did not have to reserve against any losses, so these were "free" profits for the banks. You pay 2% on deposits or short term commercial paper and buy bonds paying at 4%. You make a 2% spread, which you then do 30 times. Now you are making 60% profits on your capital and deposits. It is a very nice business – as long as everyone pays the interest. And because it is such a good business, you just roll over the debt every time the bond comes due, because you want more easy profits.
Let's say that banks bought up to 10% of their total
government sovereign-debt holdings in our problem country. If the country gets
into trouble and says, we will only pay 50% of our debt (we will discuss why
below), then that means the banks lose 5% of their total assets. But they only
have about 3% capital, because they were allowed to leverage. That means they
are functionally bankrupt.
Without a functioning banking system, other countries
now have to step in and take the losses (and perhaps wipe out the shareholders
and owners of their banks). That would be bad for the other countries, as that
much spare cash is not just lying around in government coffers. They are ALL
borrowing money already and have their own deficits to worry about.
So everyone gets together and they tell the bankrupt
country (because that is what it really is), we will lend you more money to
keep you alive, but you must agree to balance your budget. And since that is
the only way the problem country can get more money, they initially say,
"Sure. We can do that. Just give us some money now so we can get it
figured out and get everything under control."
In the world of government, living within your means
is called austerity. And it's an uphill slog. Let's say your deficit started
out at 15% of GDP (somewhat like Greece's). If you agree to cut that deficit by
4% a year for four years running, if everything stays the same, you could be
back in balance. But the other counties would have to agree to lend you the
difference between what you budgeted to spend and what you took in as tax
revenues. Just to keep things going. Otherwise you'd have to default on your
debt. If the countries simply have to guarantee the loans and not actually
spend the money, it is a lot easier than having to find real money to save their
banks, so they agree.
But the cuts you have to make are not as easy as
everyone hoped. It seems that employees don't like having their pay cut, and
unions don't want pensions cut, and retirees certainly expect the government to
fulfill its promises; and don't even get started on cutting healthcare, which
is a God-given right.
So you raise taxes and cut spending by about 4% the
first year. But a funny thing happens. That reduces the private economy by
about 4%, so the base on which taxes are collected is reduced, which means less
revenue is raised, which means that the deficit is much worse than projected.
And then the following year you have to make another 4% in cuts, plus the last
shortfall, just to make your plan and get to the agreed-upon deficit, in order
to get more loan money. It becomes a very vicious circle.
And let's look at the endgame. That debt-to-GDP ratio
will rise to at least 150%, while the economy is actually shrinking. If
interest rates settle to a mere 7% (hardly likely), it means the people of the
country are going to have to pay over 10% of their total production to foreign
banks each and every year for decades, never mind paying down the principle.
Let's throw in one more twist. The country has been
buying about 10% of GDP more from other countries than it sells to them. That
is because the relative wages in the problem country are about 30% higher than
in the "good" countries. The good countries get the money from what
they sell and have a nice surplus. The problem country soon runs through its
savings, trying to buy the goods and service it wants; and the private sector,
as well as the government, must cut back.
What happens is that you are locking in what feels
like a depression initially, and then you have a slow- or no-growth economy for
many years, as so much of your work goes just to pay back that debt to the
banks of other countries.
Understand, your government has freely obligated
itself to pay that debt. But it means that its citizens in effect become debt
slaves for a generation or two to foreign banks. Not a very popular platform
for a politician to run on for re-election.
Long-time readers know I think the neo-Keynesians do
not have a proper view of the world. They live in a theoretical world divorced
from what really happens. But in this respect they are deadly right. Austerity
on the scale needed by many countries will only reduce potential GDP. The
Keynesian prescription is to therefore run deficits and borrow money until you
get growth again; but when you have already exhausted your ability to borrow
money, it just doesn't work.
More debt makes if far more difficult to grow your way
out of the problem. If you are already drunk, you can't get sober by drinking
more whiskey. If Greece cuts its deficit by 15% of GDP, the reality is that GDP
over time will be reduced by about 20%, and the debt will grow, both in real
terms and as a percentage of GDP. A 20% decline in GDP is by any standard a
depression and makes it even harder to grow, as so much of what you do make has
to go to basic expenses and not productive capital. And if you have the burden
of massive debt it becomes damn near impossible.
That is why individuals can file for personal
bankruptcy. We no longer force people into slavery or debtor's prison to pay
their debts, at least in most places.
So our problem country goes to its lenders and says,
"We think you should share our pain. We are only going to pay you back 50%
of what we owe you, and you must let us pay a 4% interest rate and pay you over
a longer period. We think we can do that. Oh, and give us some more money in
the meantime. And if you refuse, we won't pay you anything and you will all
have a banking crisis. Thanks for everything."
The difficult is that if our problem country A gets to
cut its debt by 50%, what about problem countries B, C, and D? Do they get the
same deal? Why would voters in one country expect any less, if you agree to
such terms for the first country?
So now let's return to the real world of Europe.
Greece cannot pay its debt without a major depression. So its wants to pay only
50%, but it doesn't even want to guarantee that in any meaningful way; so
bondholders scream, "We get nothing in return for agreeing to take a 50%
haircut?!" Which is today's headline.
Greece cannot print its own money, so unless it leaves
the Eurozone, it's stuck. They can default on their debt, but that means they
are shut out of the bond market for some period of time. That would force them
to make the spending cuts they are now resisting, as they would simply not have
enough money to pay their bills. Even with a 100% haircut they're looking at a
shorter but very real depression. And because no one will sell them products
they need, like energy and food and medicine, unless they can sell or trade
something in return (that trade-deficit problem), they will be forced to change
their lifestyles. Wages must drop or productivity rise to be competitive with
northern Europe. And that differential is about 30%. I am not certain, as I
have not been to Greece in a long time, but my bet is, you won't find many
Greeks who think they are overpaid by 30%.
But that is what the market is going to say. And that
is the third problem, which Europe is not addressing. Germany and the northern
tier are simply more productive than the Southern periphery. (With the possible
exception of Northern Italy, but Italy all gets lumped together, which is why
many Northern Italians want to be their own country and not have to pay taxes
that go to Southern Italy. I am not taking sides, just observing what we read
in the papers.) Until Germany consumes more from the peripheral countries or
the peripheral countries become more productive, the imbalance will not allow a
positive solution.
Prior to the euro, the imbalances would be handled by
currency exchange rates. The value of the drachma would go down relative to the
value of the deutschmark. Things would
balance over time. Now, all of the eurozone countries are effectively on a gold
standard, with the euro standing in for gold this time. Britain, the US, and
Japan print their own currencies. Their currencies can rise or fall over long
periods of time, based on national accounts and the desires of foreigners to
buy goods or invest in their countries.
Greece and the other peripheral countries face a
difficult choice. Do we stay in the euro and pay as much as we can, and watch
our economy drop; pay nothing and watch our economy drop (as we get shut out of
the bond market); or leave the euro and go back to our own currency and watch
our economy drop?
They have no choices that allow them to grow and
prosper without first suffering (for perhaps a long time) some very real
economic pain. As I have written in previous letters, leaving the eurozone has
severe consequences; but the economic pain of leaving would go away sooner and
allow for quicker adjustments, than if they stayed. However, the initial pain
would be worse than the slow pain they'd suffer by staying in the euro. Their
choice is, simply, which pain do they want – or maybe, which pain do they think
they want? Because whatever they choose, they are not going to like it.
And just as I was finishing this section, this note
came from Naked Capitalism:
"The three Troika inspectors—Poul Thomsen from
the IMF, Mathias Morse from the EU, and Klaus Mazouch from the ECB—are supposed
to head to Greece next week to inspect its books; the budget deficit is once
again higher than the revised limit that Greece had vowed to abide by. And
they're supposed to negotiate additional 'structural reforms.' But there
probably won't be three inspectors, according to senior IMF sources. Missing: Poul Thomsen. The IMF has had enough.
"Already, according to more leaks, IMF Managing Director Christine Lagarde had warned
German Chancellor Angela Merkel and French President Nicolas Sarkozy that the fiscal and economic situation in Greece had deteriorated.
Hence, the 'voluntary' haircut on Greek bonds held by private sector investors
should be increased to more than 50% to maintain the goal of bringing Greece's
debt load down to 120% of GDP. And the second €130 billion bailout package,
agreed upon on October 26, should be enlarged by 'tens of billions of euros.'
"The German reaction was immediate. 'There has to
be a line somewhere,' said Michael Fuchs, deputy leader of Merkel's party,
the CDU. 'This cannot be a bottomless barrel.' Even if Merkel were amenable to
committing more taxpayer money to bail out Greece, she'd face a wall of
opposition in her own party. And he wasn't brimming with optimism: 'I don't
think that Greece, in its current condition, can be saved,' he said."
The article goes on with a description of the chaos in
Greece. It is worse than I have described.
Really.
And so terribly sad.
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