Dealing with the Basic problem of Euro Debt vs Financial Engineering

Many imaginative, perhaps, even innovative approaches are being proposed for dealing with Euro crises. They contain a wealth of interesting ideas and mechanisms that can be useful in designing solutions.  There is a danger however, of getting lost in the minutiae of solutions and forgetting the basic fundamental economic problem that has to be addressed.     One of the most important lessons of the financial bubble and the subsequent financial crisis in the USA was that the slicing, dicing and recombining risk through levels and layers does not necessarily help risk diversification; it can as likely help to hide risk from innocent buyers of these products and make it easier to fool them into thinking that the risk has somehow dis-appeared.  In other words, the finest financial engineering cannot make the existing risk magically vanish, it can only hide it and confuse the naïve for a while.  Even the latter will be short lived as long as the memory of the financial crisis remains in the public mind! It is therefore useful to go back to the source(s) of the Euro crises and reiterate the essential economic measures that are required to diffuse the crisis!

There are five elements of any viable solution.  These are presented in their simplest form without bells and whistles, perhaps even in over simplified form in the light of the previous point.

(1)   Countries with unsustainable debt (GIIPS?) must put it on a sustainable path through a combination of fundamental reform of the expenditure, tax, transfer and growth policies.  The objective is to meet the sovereign debt sustainability condition [g-r+Pb > 0, where g = GDP growth rate, r = real interest rate on sovereign debt, Pb = Primary balance]. In this context it is important to remember that a fiscal squeeze by previously extravagant countries is not a morality play but an attempt to meet the debt sustainability condition!  Thus, beyond some point (the optimal) an immediate and sharp fiscal squeeze will reduce growth more than it increases the primary balance or reduces the real interest rate and thus make the fiscal situation less (not more) viable.

(2)   Greece (+Portugal?) is in a situation in which even the optimal policy mix outlined in (1) cannot put it in a sustainable path without debt restructuring.  In other words, Greece has been structurally insolvent for the past year or so.  The ‘grant’ funds needed to convert this problem from one of insolvency to one of liquidity must come from somewhere outside Greece - no amount of financial engineering can make this fact disappear.  Rough calculations suggest that a 60% haircut on Greek government debt would be sufficient to make Greece solvent.  It seems logical and fair that those who took the risk (or deliberately overlooked it) to earn higher returns (profits, bonuses) from Greece should pay when the risk materializes.

(3)   A Greek debt restructuring will have consequences for Euro area banks who have lent to Greece.  These consequences should have been anticipated and dealt with at least a year ago, by recapitalizing the banks.  The European Banking Authority now (reportedly) estimates these cost to be of the order of Euro 80 -100 bi (FT  Oct. 20, 2011).  To the extent that private investors are unwilling to raise the equity in these banks, the home country of these banks will have to provide the capital.  The 60% haircut on Greek debt presumably accounts for the indirect cost to the Greek Govt. of the effect of this default on Greek banks.  Other affected countries would also have to do the needful.  To the extent that the home country is not in a position to recapitalize, support is needed from outside the home country- the EFSF can be used to provide this additional support, either for direct financing or to underwrite repayments.  If the above estimate is correct, there will be money left over in the EFSF to strengthen the provisioning of bank loans to governments of countries that are on the border line of solvency, so as to remove doubts about potential contagion to these countries.

(4)   Once the direct and indirect effects of solvency problem are addressed, the borderline Euro area countries, such as Spain and Italy (along with Greece and Portugal), would be left with a liquidity problem.  If the ECB acted like a normal country central bank, such as the US FED, it could provide as much liquidity as needed to solve the liquidity problems of Spain and Italy.  As there is no explicit medium-long term grant element (once steps 1-3 are undertaken), there is no logical reason for not doing so in a period of low demand and low inflation (only ideology or primordial fear).  To the extent that mark to market accounting will impose temporary balance sheet losses on the ECB, the EFSF could be used to provide fiscal support till the markets stabilize and return to normal (at which point the ‘mark to market’ profits of ECB would revert to the EFSF).

A simple example illustrates.  Assume that the long term interest rate for a solvent Italy is the German rate +0.5%.  Because of all the problems outlined above, the premium above Germany has gone up to 2.5% (say).  Thus the ECB will be effectively picking up the risk equivalent to 2% points for debt coming due in the next 6 -12 months and will therefore constitute ‘mark to market losses’ in its balance sheet of this amount.  This fiscal cost has to be borne by the EFCF till the markets realize that the problems at 1-3 have been addressed (after which Italian interest rate will go back to the German rate +0.5%).  Thus the fiscal cost is borne by the EFCF not the ECB – with Euro 300 billion of Italian debt coming due in the next 12 months (in this example) the temporary fiscal cost to be borne by the EFSF will be Euro 6 bi).  The ECB provides the liquidity, whether directly or through Banks.

(5)  Finally for other non-Euro area countries that may be affected in the days/weeks/months following a Greek debt restructuring, the IMF must stand ready to provide liquidity support to “innocent bystanders”.  The IMF still has sufficient funds for this purpose, and these could easily be augmented to the needed extent, if prior action has been taken on points 1 to 4 above.

The longer the basic problems outlined above remain unaddressed, the more difficult they become to address, as private creditors gradually reduce their exposure to insolvent countries at the cost of official and multilateral lenders and borderline solvent countries are pushed over the line by rising interest rates.

Fiscal Sustainability: Economic Theory vs. Market Fashions

In discussions of Fiscal Policy and Fiscal vulnerability I have repeatedly (over the past 25 years) come across a clash between Economic theory and Market Fashions.  The use of the word “Fashion” might suggest to some a harmless diversion a matter for amusement or entertainment, but a proper understanding of the economics is critical to dealing with the fiscal crises that threaten the World today. Let me illustrate this with four points that have a bearing on Fiscal sustainability.

The first basic principle of economics is the debt sustainability condition: g – r - Pd > 0 (g is the growth rate, r the real interest rate payable on sovereign debt, Pd is the primary deficit).  A sovereign’s debt is sustainable if the growth rate exceeds the real interest rate paid on the debt by the extent of the Primary surplus.  With few exceptions (e.g. William Buiter of Citi), the public discussion of debt sustainability has been carried out without reference to this basic essential data.  Unfortunately this is not new: Over the past 25 years I have often seen even highly respected institutions such as the IMF ignore this simple number when it did not fit with their conclusions and recommendations (which therefore inevitably turned out to be wrong).  Market fashion has shifted dramatically away from this measure since an empirical paper estimated” that 60% was the safe level of gross debt to GDP ratio for every country under the sun.  Subsequent work concluded that this was the safe level for Developing countries but the safe level for Developed countries was higher (90%?).  I am sure that there will many subsequent revisions and refinements to these estimates.  I call this a fashion not because these estimates are not useful, but because it has led to herd behavior in which analysts do not even think it worthwhile to produce and present the basic numbers for the sustainability conditions. It would seem to me that we can easily produce this data, not only for the US, Japan and European countries currently under pressure but also other economies with weak fiscal situations and poorer economic data. This will allow us to define the relative fiscal sustainability of different countries more accurately and identify the source of the problem, the better to deal with it.

Economic theory tells us that, the debt that is relevant to the fiscal sustainability issue is the net debt (debt net of assets) not gross debt.  This is such a simple and well understood (by private individuals) principle of economics that it is almost embarrassing to raise it in a professional context.  Yet public discourse over the last two years barely ever mentions the asset side of the balance sheet or presents the comparative net debt position of countries under stress.  When financial markets sense a crisis, even a minor temporary one, only the short term matters, as each market participant tries to be the first to unload its holding of the concerned sovereign debt or loans.  Only the gross debt, coming due and needing refinancing seems to matter to the markets.  If this is true, why call it a ‘market fashion’?  Because it is the obligation and duty of responsible analysts, including the international financial institutions, to focus not just on the short term but also on the medium and long term – the original definition of “sustainability”.  The short term can be dealt with by liquidity support, whether from the Country’s Central Bank or the IMF, it is or should be the medium term that determines sustainability.

The theorists who emphasize Net debt are quite aware of the problem of maturity mismatch between sovereign debt and sovereign assets (e.g. loans or bond debt and public companies or infrastructure assets) and about the difference in risk associated with the different type of assets (e.g. physical assets versus future tax obligations).  This cannot distract from the basic economic fact that fiscal solvency depends on the net debt position – a country or individual cannot be insolvent if its assets exceed its debt. Further, the fact that a country’s fiscal situation (as against an individual’s) can be sustainable with debt larger than its assets matters even in the short term, because it is possible to loan or sell some assets (perhaps at a discount) to meet short term debt obligations! The safety threshold of 60% or 90% gross Debt-GDP ratio will surely be refined if we put in the effort to determine net debt.   To say that we do not have a perfect measure of sovereign assets or net debt is an evasion; imperfect measures (for instance physical assets valued at depreciated book value) are better than no measures, if we are clear and transparent about the limitations.

The theory also makes a distinction between sovereign debt financed externally and that financed domestically, though mostly in a very elementary manner of differential interest rates. Some of us who have had to advise on fiscal control and fiscal debt issues and to face the consequences of bad or incomplete advice, have long asserted that external financing of sovereign debt is not worth the risk.  The advantage of lower nominal interest is very tempting economically and politically: However the exchange risk is likely to be neglected or ignored and the danger of sudden stops and reversals is very real.  The country can suddenly find itself at huge risk from shocks to global financial markets and overreaction to temporary problems in the domestic economy and polity.  In addition the valuation of assets that go into the determination of net debt, is likely to be asymmetric – foreign lenders to the sovereign are likely to value it much less than domestic debt holders relative to debt.   Besides the home bias and exchange risk, other factors include differential costs of using the legal system.

Recent, preliminary empirical analysis also suggests that the net external debt of a country has a positive effect on the volatility of capital flows (i.e. higher net debt more capital flow volatility).  In other words the lower the cumulative gap between domestic investment and domestic saving (Id-Sd) the more stable capital flows are likely to be.  This implies that higher domestic private and household savings are likely to lead to lower capital volatility lower risk to foreign borrowing (private and government) and a higher threshold limit for safe Debt-GDP ratios. The hypothesis is that (other things being equal), higher domestic private saving rates allow a country to sustain higher Sovereign Debt-GDP levels.[1]  If this is true it would certainly be useful to know the relative household and private saving rates of different countries, along with the other data mentioned above.  We would then be in a better position to judge relative fiscal sustainability and to identify the key problems and  focus on the policies that can make a difference.

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[1] A currency union raises a host of other issues that need separate discussion.  The reference here is to countries with their own currency.