The presumption that a developed world country could always finance its deficit hit the wall last week in an event that will henceforth be simply known to economic and market historians as “Greece.” The Greece bailout or more generally, the Euro bailout package that it created is a mega trend event. It will be a game changer for economic policy, for the economy of Europe and others, for Europe’s governance and redefines its central bank (the ECB). Mega change like that leaves financial markets adrift in attempting to discern the significance of the changes with no previous model to extrapolate forward.
While the endless extrapolation of government debt and the ratio of government debt to the income necessary to service the debt defied logic it stood up with government bond participants as recently as a month ago when Greece’s sovereigns traded at risk premiums barely north of the German Bund. This was despite government debt not being retired but simply and endlessly being rolled over at rates awarded to more fiscally sane governments.
Such endless market participation in the sovereign debt market caused the implicit notion among government planners that a doubling of debt leads to a doubling of interest expense and at such cheap rates they had room for endless multiples of debt accumulation. However, last week the relationship between the cost of debt and the amount of debt was shown to be exponential not multiplicative as the terms of finance for Greece hardened from 6% to 12% and finally to 18% yields in the secondary market. This is sovereign risk pricing. Since government debt must be refinanced at maturity, the higher secondary market yields then eventually are applied to all debt as it is rolled over (if it could be rolled over) and hence the government’s cost of capital leaps relative to the income stream to support it. The inexorable logic that debt costs eventually rises more than in proportion to debt finally prevailed on the European government bond market that was already concerned with not only rollovers but very large additional chunks of debt that needed to be sold to foreigners as a result of a zero domestic saving rate.
The situation had to deteriorate to the proverbial dilemma better known as a Ponzi Scheme (pay interest with more debt) which is the short cut to financial ruin. Apparently the lessons of the US sub-prime mortgage defaults was lost on the sovereigns when Option ARM sub-prime borrowers had their interest meter increased and were forced to commence principal payments hence making the subprime mortgage debt crises the precursor and the model for the sovereign debt crises.
Given the problems of Greece and other Euro sovereigns generally referred to as the Olive Belt Countries, the EU crafted a sizable bailout to support all given an anticipation of contagion among sovereign bonds. The total is in the vicinity of $1 Trillion (and well exceeds the TARP funding) and can go higher given the open ended participation of the European Central Bank. How then can the Euro zone governments that are generally facing the same problem come to the aid of everyone? In the logic of governments, we simply sell more debt to purchase the debt that markets will no longer pay up for. Not very long ago when the government bond market still bought into the notion of government financial invincibility it might have been possible. However “This Time Is Different” as explained by Reinhart and Rogoff and the market has suddenly become skeptical as it should. Hence selling more debt to provide the funding to purchase the very same debt the market won’t otherwise purchase requires some smoke and mirrors1 as camouflage and a Rich Uncle as the Euro zone income is stagnant at best. Of course it would also help to reduce government spending and reduce government deficits and some pretense of that is occurring but mainly the recruitment of the Rich Uncle and lots of smoke and mirrors constitutes the European Rescue Plan.
Employing some imagination for a government and having learned some lessons from the Enron scandal as well as the craft employed by US financial institutions to hide undesirable assets, the rescue plan creates a “Special Investment Vehicle” (an SIV) whose special purpose is to hide the bad government bonds so they are not sold on secondary markets at embarrassingly low prices. Basically, a special investment vehicle with more specific details to be forthcoming is being created to purchase and hold the weak Olive Belt sovereign bonds. The SIV in turn requires funding to purchase the Olive Belt sovereigns of Greece, Portugal, Spain, Italy, etc. and removes them from market view. The proposed funding source of the SIV is the EU which is a larger group that includes non-Olive Belt countries and non-ECB countries. Other funders of the SIV will be the IMF and with the majority of the funding by private investors who it is hoped will feel good about purchasing the SIV’s debt because it is “guaranteed” by the same insolvent countries (and some Rich Uncles) whose debt the SIV will purchase.
This both answers some questions and raises a lot of questions. We find out that the Rich Uncle to add more capital or guarantees that ultimately result in capital contributions are the wider net of EU countries which for example includes Germany and the UK who is a member of the EU but not a member of the ECB currency group. Citizens of the world and US taxpayers should not feel left out since as members of the IMF they have made contributions to the IMF and are subject to additional capital calls by the IMF and the size of the IMF contributions leaves the IMF with bare cupboards. So the cost of the Euro bailout is spread about as far around as one can imagine without a vote of course or even consultation with many governments and citizens. Furthermore the risk exposure of the guarantees is hidden by the Euro governments as they do not appear on their balance sheets as contingent liabilities because guarantees only hit the books when an actual cash payment is needed as with Fannie and Freddie. Now for all the imagination used by the Enrons and the Citibanks to leverage up and hide bad assets in SIVs they never were able to go as far as using someone else’s credit without consultation or compensation thus making this an epic piece of financial trickery.
Not to be left out as a Rich Uncle is the European Central Bank which thus far had not budged from its mandate of about a dozen years ago to never enter the arena of running the printing press to bailout a government’s fiscal lack of integrity by purchasing the government’s debt with currency. Aside from the Treaty provisions, the ECB was constrained by the requirement that bonds eligibility for purchase must be investment grade. Now that the rating agencies recently pushed Greece bonds into junk status, the ECB threw away its independence (the ability to say no) and some would say its virginity and certainly its credibility by allowing themselves to be forced by events to monetize weak sovereign debt.
We now are getting into the larger implications as major effects are cascading. First of which is will investors continue to wish to hold wealth in Euro denominated assets as monetarists are still numerous and naïve to believe that inflation automatically follows disproportionate currency issuance. With a banking system straining to make its minimum capital requirements based on its asset size, bank lending and the multiple bank expansion processes is actually contracting to fit its reduced capitalization. Hence lending, spending and inflation do not occur but the money issuance by the central bank does create inflation expectations from knee reflex monetarists and in turn capital flight. Of course some capital flight is motivated by the logic that governments in fiscal trouble will tax more and economic growth can’t stand up to that making securities overvalued.
Given all that in the last year the Euro has dove about 25% relative to the US Dollar with most of the decline since Greece became the crises of the moment. Other major impacts include a tightening of money and commercial bank lending as Euro bank deposits are being transformed into US Dollar deposits and over-night lending to banks called the Repo market is being reined in so financial liquidity gravitates elsewhere.
Other notable backlash of the bailout is the resentment by Rich Uncle countries of their leaders and political vulnerability quite independent of party so Europe’s political leaders both left and right are impacted. The backlash includes the US where Senate voted UNANAMOUSLY for IMF loans to be certified by the President to be expected to be repaid and if not to instruct the US IMF delegation to vote no on such loans.
Of more importance is the depressing effect on the Euro economy as a result of capital outflows and reduced funding sources, the side effects of some fiscal austerity (less spending and higher taxes) imposed by the IMF as a condition of opening their war chest, and a run on bank funding sources requiring Fed Dollar loans to Euro zone financial institutions via the ECB as they are unable to retain or rollover their debt. One can surmise the shadow repo market is hurting for funding sources and is raising the Repo haircut which further depresses financial prices and adds volatility to the market which in turn depresses all financial prices.
Hence one can surmise that the saving of Greece comes at a cost in fact a very high cost leaving open the question of whether the Euro zone will shrink by throwing out the Greece’s or the Euro governments will band together more tightly with the logic being if Greece gets to use my fiscal and monetary reserves we will only support Greece if we can control Greece. Stay tuned to this epic event as the chips keep falling one of which is any thought of the Euro being a world reserve currency are now off the table and the US reserve currency status wins by default despite our own fiscal irresponsibility. The US has caught another break as capital surges inward, the Dollar rises and US Treasury rate declines and hence puts off the day of reckoning here.
Another major impact is the announced intent by the ECB to “sterilize” its purchases of wayward country debt. This means that the central bank will raise interest bearing debt to substitute for its currency outstanding to appease the monetarists who would automatically assume more inflation and flee the country. If the crisis permanently reduces confidence of the market to hold wayward country debt, the EBC becomes the buyer of last resort financed by its own debt issuance. In this case the new money issuance is then limited to the interest spread between its assets and its own debt which is a slower growth rate of currency as currency doesn’t cover principal but only the part of the interest not covered by its interest income from the government debt it holds.
In this case, be prepared to donate all your money and banking books to the history of economic thought section of the library. The market will likely be more satisfied to hold the ECB interest bearing debt than government debt as the ECB has the printing press and doesn’t need to rely on taxes as does the government to service debt. Thus the monetization of interest instead of principal probably gives this expansion of central bank debt some elasticity. Perhaps it buys a few years and allows a greater ability to stretch the limits of government debt issuance relative to its income.
In essence, the Great Recession caused private debt to be refinanced by the government. In this leg of the Great Recession the added government debt is being refinanced by the central bank Hence the omnipotence of governments to finance itself is being challenged but this type of bailout likely defines the is the outer limit as all the Rich Uncle have been rounded up to sign up for the added credit support and soon the market will see through the smoke and mirrors.
The Wikipedia definition of smoke and mirrors: Smoke and mirrors is a metaphor for a deceptive, fraudulent or insubstantial explanation or description. The source of the name is based on magicians‘ illusions, where magicians make objects appear or disappear by extending or retracting mirrors amid a confusing burst of smoke. The expression may have a connotation of virtuosity or cleverness in carrying out such a deception.
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