The consequences of excess debt are now facing the leaders of Europe head on, and a monumental decision must be made whether explicitly or implicitly. Excess debt leads to a long chain of D words: Deleveraging in an attempt to retire debt results in a depressed economy and declining asset prices. The depressed economy breeds private debt defaults that in turn produce distressed banks. The chain then runs through depositor flight from the banks, producing a financial crisis and in turn a devaluation of the currency as capital flees. When foreign goods become more expensive there is a declining standard of living as import prices rise faster than wages. Then in an effort to stop the government debt trap, there is a default on promised entitlements under an austerity program leading to the swift defeat of the political leaders. But ultimately there is a sovereign restructuring or a default of the government debt. Most, if not all, the D words are visiting Europe at the moment and its leaders are falling by the wayside.
There is not a precise science that tells us when the debt trap begins the downward spiral that takes the ship down, but there are some rough guidelines. Reinhart and Rogoff (This Time is Different) have found to the extent one can generalize when a country’s debt-to-income ratio reaches the 90 percent level the ship of state begins to list and currently the OECD aggregate of 30-country gross debt-to-income ratio is 105 percent.
The sustainability of a country’s stock of debt is assessed by the market relative to the income flows that will be taxed in order to support the overhead cost of interest, even assuming an endless capability to rollover principal. The unraveling occurs when the financial markets lose confidence that the debt problem will be resolved successfully through income growth, austerity, or both and the refinanced debt carries the new higher market yield.
At that point, the overhead cost of the debt load is ever more depleting of the income stream that must be taxed to pay the higher interest carry. Now on a daily basis, there is a market panic attack if the market yield on Italian sovereigns rises above 7 percent. (Note the yield was close to 5 percent earlier this year so sovereign default is indeed being priced.)
After holders of Greek debt “voluntarily” accepted an arm-twisted 50-percent haircut, the market now believes that a sovereign default by a Western democracy is no longer a fairy tale. Furthermore, the default can’t be reliably hedged by CDS contracts, which proved to be voidable at the whim of the government, thus converting hedged risks into naked risks for the holders of distressed government debt. To make matters even dicier, the BIS regulators are backing away from continuing to award capital shields to the holders of sovereign debt, as explained in my last blog (The Dumpster for Toxic Euro Sovereign Debt). Also, the market has come to believe the world is without remaining Rich Uncles willing to rescue the Poor Uncles of Europe. All these factors cause investors to revert back to pricing sovereign debt based on risk fundamentals rather than government pledges of invincibility or confidence in financial insurance.
At this point, the remaining options to avoid reaching the tipping point to the D chain explained above are few, and the decisions to be made are momentous. The options are: submit to what the market is doing to you; take the lead and offer a debt restructure at a fractional payout; or run the printing presses to purchase enough sovereign debt necessary to contain the market yields. Halfway measures such as strengthening the EFSF no longer buys even a day’s worth of market forbearance.
It certainly must be crossing the minds of the Euro leaders that there are consequences for being at the helm when the ship goes down. The alternative is to orchestrate your own departure, which was cleverly done by Papandreou in Greece by calling for an austerity referendum. In Italy, Silvio Berlusconi’s departure was orchestrated quite literally, as reported by Reuters:
“Italians sang, danced and drank champagne in the streets to celebrate the resignation of scandal-plagued billionaire Silvio Berlusconi, and an impromptu orchestra near the presidential palace played the Hallelujah chorus from Handel’s Messiah”.
Not even in my most Machiavellian thoughts had I conceived of the possible value of being “scandal-plagued” as a means to a back-door retreat from an uncomfortable situation. Given its frequency among politicians it seems to be an undervalued asset in politics. But the strategy doesn’t seem to fit Ms. Merkel, so she is stuck at the helm of the ship of state and is looking for a life raft.
And the consequence of being at the helm when all the D words cascade is more chilling when one witnesses what has happened to the Icelandic captain when his country’s ship went down. Iceland’s ex-premier is facing a formal indictment charging him with criminal violations against the laws of ministerial responsibility and “serious malfeasance of his duties as prime minister in the face of major danger looming over Icelandic financial institutions and the state treasury.” (See: Ex-Premier Charged)
We have reached the point where government bluff, bluster and promises no longer control the markets, and criminal indictments for those at the helm are threatening. If it is not possible to orchestrate an early exit, it would seem the only remaining life raft is the printing press — but that would not be easy for a German government to do out in the open, given their Weimar inflation history, as shown in the chart to the right.
The monetization of government debt is undoubtedly being conceived of as only a bridge to buy time to form a tighter Euro fiscal union with strict budget discipline. Indeed, this is being counseled by Joseph Ackermann, who seems to be the influential behind-the-scenes advisor.
But to keep things together until then, the ECB is no doubt on the job, if not directly purchasing Italian and other sovereigns, but lending to others who will purchase the same. But running the printing press does not stop with the ECB. Once QEs start for whatever reason and a number of countries are engaged, the very act of one major central bank printing to save a government drives capital offshore to perceived safer ports from inflation and a declining economy. This in turn sets up another dynamic that is well underway as other countries are driven to become sellers of their own currency in order to prevent its appreciation and maintain export market share. Thus, using the printing press to save the Euro debt leads to a global money race of competitive devaluations.
Now there is a confrontation of expectations in the markets, a bi-modal distribution if you will, of those believing the deflationary forces of the D chain above will dominate and those believing, now with greater justification, that the monetary produced inflationary route will be the Euro outcome.
Expect some inconsistent pricing in the market by those being moved to bet on inflation hedges side by side with those willing to bet on deflation hedges. What must be most maddening to a deflation hawk is the asset of choice in that circumstance, long-term government bonds, are at the very heart of the credit problem and are not the solution to protecting one’s portfolio. Nor is it the solution to the inflation hawks either. So the questionable sovereigns go begging among private investors with only the central bank as a friend.