The Maastricht Treaty of 1992, which created the Eurozone and the European Central Bank (ECB), requires fiscal responsibility of its members. Annual fiscal deficits relative to GDP were not to exceed 3 percent, and cumulative debt was supposed to be limited to 60 percent of GDP. Efforts to police members to these standards were ignored or dropped in the last decade, with only moral suasion left as a regulator.
Almost 20 years later we now know the value of moral suasion, as first Greece then Ireland and now Portugal, among other members, are not only well beyond those pledged debt ceilings but also to the point where the government bond market is no longer willing to hold their debt securities without support from other governments or government entities. Hence the Eurozone has split into what I have previously called Poor Uncles and Rich Uncles. The Poor Uncles are trying to corral Rich Uncles to either guarantee their debt or out-and-out purchase their debt (On the Ratio of Rich to Poor Uncles).
The situation has now become dire for Greece, and both the Poor and Rich Uncles of Europe once again must face the issue that will not go away. It was only a year ago that a bailout fund was put in place to purchase Euro government debt, if the market would no longer have any part of it. Since then, the number of governments that are stepping up to the trough for assistance has increased. There are clearly too many Poor Uncles for the few remaining Rich Uncles to assist without themselves being put into the poorhouse. Nonetheless, the Rich Uncles are at least making noise that they could once again provide assistance. Given the uncertainty of the Rich Uncles’ pledges, just two months ago, the original three-year bailout fund had to be made permanent to placate the bond market with a new, higher amount being pledged to fund the Poor Uncles.
While a permanent fund sounds reassuring — and did reassure a naïve bond market for a few months —trouble arose when the Rich Uncles decided they would only provide funding for the permanent fund over a five-year period. Then when it became time to put their money where their mouth was and the first Rich Uncle installment came due, Germany indicated it would only put up half of its first installment and that it would take six years to complete its share of the funding. Understandably, the market’s confidence in the willingness of the Rich Uncles to step up to the plate plunged, along with the market value of Greek bonds. The market yield on two-year Greek bonds rose from 16 percent to beyond a respectable junk bond rate of 24.5 percent.
Just to do the back-of-the-envelope math, Greek government debt is currently equal to 143 percent of Greece’s GDP —and rising by another 10.5 percent relative to GDP this year, with no end in sight. Also, much of the Greek debt is short term, under four years. If the debt is refinanced over the next four years, when due at the present market cost of funds, a tax bite of more than one-third of ALL Greek income would be required just to pay interest on its government’s debt.
If that doesn’t bring the county to its knees, 61 percent of Greek debt is owned by foreigners, so a majority of the interest payments is then shipped abroad, widening the country’s current account deficit (see the April 2011 IMF Global Financial Stability Report for more details). The interest payments alone would reduce the annual GDP flow rate by about 20 percent. This means Greek debt service on current market terms unravels the economy and hemorrhages the fiscal imbalance. Denial might be an option when debt is accumulating, but is no longer an option when income systemically deteriorates.
The Rich Uncles of Europe are quickly running out of time and options to further paper over the fiscal sinkhole. With the unthinkable happening, their minds are frozen by the totality of the issues at hand with various parties walking out of meetings if the subject comes up. Government dysfunction is not merely a U.S. problem. The issues and decisions are so far-reaching that consensus among the Rich and Poor Uncles and the ECB and the IMF doesn’t seem possible. The options include changing the charter of the ECB to allow it to monetize distressed sovereign debt to provide an inflation deterioration in the real value of all Euro debt at the cost of a capital flight from the Euro; saving the Euro and expelling Greece from the currency union, (leaving the wealthier countries to wonder whether the currency union will still have viability as a reserve currency if more of the Poor Uncles are expelled); and offering further aid to Greece on the condition that the Rich Uncles take control of the taxing and spending of the Poor Uncles, meaning the Poor Uncles give up their sovereignty on fiscal matters.
Given the stakes in these decisions and the difficulty of reaching a consensus, there is no doubt that there will be one last attempt to save Greece by doing what governments do best: postponing the inevitable. In one effort to buy time, French Finance Minister Christine Lagarde is aggressively marketing her bid to become president of the IMF to further tap IMF bailout funds. Another option to buy time (but not settle the problem) would be to sell off Greece’s national assets in order to balance budgets and retire debt. Someone call Donald Trump and let him know that the Parthenon and some beautiful Mediterranean coastline are available for a fabulous golf resort. Or call China to offer up an island in the Mediterranean as a wonderful site for a naval base. Or call the investment bankers, as Greek nationalized companies are for sale to anyone at distressed prices.
When all these options are exhausted, the final nail in the coffin will be a default on Greek debt that will be spun as an adjustment rather than a default. When you hear talk of restructuring (paying 30 cents on the Euro) or rescheduling (pushing the maturity of the existing bonds out to infinity), these are defaults by another name. For example, debt due on June 30, 2011, could arbitrarily be rescheduled to be due on June 30, 3011, to give all politicians involved adequate time to expire and adequate time for history books to be lost, so as not to be able to pin the responsibility on anyone in particular. That will not work, since Greece can’t cover the interest, let alone the principal; but interest can also be adjusted downward arbitrarily. All those things can happen, but the bond market will go on furlough, and that will be the end of deficit spending for Greece for the foreseeable future. In the end, the bond market rules, as James Carville famously exclaimed: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody”.
One might wonder what’s in it for the Rich Uncles to anguish at the thought of a Poor Uncle default. That is, why are Germany and France so stressed with a Greek problem? The reason is that there are linkages between a Greek default and potential Rich Uncle defaults, triggered by banking system guarantees made by governments. Here is how it works:
In order to sell government debt at a low interest cost to Greece, other Euro governments have enticed banks and other financial institutions to purchase government bonds by waiving the need for banks to be fully capitalized to be in business. That is, with the housing/mortgage meltdown putting such a large dent into the market value of bank assets and hence to their capital (net worth), banks can prevent a government seizure or nationalization if they hold what the government has defined as low-risk assets. Yes, you’ve guessed it: According to bank regulations, government bonds of the Eurozone are considered low-risk as per their ratings; so by stocking up on those toxic assets, banks can operate with little capital. This pattern is illustrated clearly in IMF data, which shows that the Eurozone members’ banks hold between 16 and 27 percent of their assets in bank claims on the public sector (as compared to 10 percent for U.S. banks). At the same time, their banks are short of capital as the inducement to hold “high-quality” government debt.
Take the Rich Uncle Germany for example, where 25 percent of banks’ assets are claims on the public sector (government bonds of unspecified governments) and their banks are leveraged 32 times their own equity capital. The inverse of 32 is an equity capital ratio of about 3 percent, so if Greek bonds are defaulted and contagion occurs — Moody’s recently indicated a Euro sovereign default would lead to all Euro sovereign rating downgrades — the market value of other Euro Sovereigns would be hit and the banks’ capital requirements would increase. It would take only a 12 percent decline in the market value of the banks’ government bond portfolio to drive German banks to zero equity capital. GaveKal estimates the market value of the Greek and other Olive Belt sovereign debt to be already 45 percent below face value, before any default or further credit rating downgrade has occurred. This means many banks will require additional equity capital, as banks will not pass future stress tests requiring government recapitalizations of the banks in very large amounts. This is not uniquely a German problem but a problem for all the Rich Uncles.
Seeing this possibility, in the last year many banks have sold their Greek debt to the ECB, which was willing to pay the full face amount as part of their Rich Uncle support role. To the extent the ECB cleared the Greek debt from commercial bank balance sheets, it now holds the most toxic of the toxics — but the commercial banks still have a diversified portfolio of the less-toxic assets that will still be subject to contagion meltdown and require government assistance. For that matter, a Greek default would require the ECB to be recapitalized.
To give you some idea of the implications, Switzerland, as an extreme example, recently recapitalized two of its very large banks to the tune of $1 trillion, while the Swiss GDP is only $500 billion! The figures are almost as dire in Ireland, where the combination of the recession and bank undercapitalization pushed the government debt load to 98 percent of GDP from 22 percent in the last three years. Hence, Germany must care if the Poor Uncle’s government debt is marked down, as that would cause it to ramp up its own public sector debt to make its banks whole. This is the government insolvency multiplier, in which one government’s insolvency triggers contingent financial obligations on other governments. Hence the meltdown dynamic runs from the Poor Uncles to the Rich Uncles via the Rich Uncles’ financial guarantees. In the end, the meltdown in Greece is also a high powered Rich Uncle problem.
Given government commitments for bank survivability, when government bonds go down, banks go down, and governments that in turn honor their financial guarantees to banks also go down. Those are the links in the chain that leads to the unthinkable. No wonder gold and silver and Swiss Francs are bouncing upward, and even the U.S. dollar looks good in comparison to the Euro.
There is still room to redefine laws, bank regulations (such as capital requirements), accounting rules, rating criteria, or the ECB’s rules for bailouts. It’s still possible to walk away from previously made government commitments to banks. However, this is just containing the government insolvency multiplier of past debt, and it doesn’t provide private funding for future baby-boomer entitlements. We are nearing the endgame when the bond market shuts down governments’ ability to spend beyond their individual means, as well as their collective means.