Mehtinks this one deserves extra attention , , ,
http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10554The Sovereign Debt Crisis Learning Curve:
During the second-half of his reign, Alan Greenspan became fond of trumpeting the U.S. economy’s newfound resiliency. This was a theme peppered throughout his “Age of Turbulence” memoir, published in the pre-crisis year 2007. Greenspan cited computer and telecommunications technologies; monumental productivity advancements; a flexible workforce; the financial system’s superior capacity to effectively invest limited savings; and, of course, enlightened policymaking.
Back when I wrote more colorfully, I was fond of saying, “Financial crisis is like Christmas.” In hindsight, it would have been more accurate to write “private-sector financial crisis is…” Whether it was banking system debt problems from the early-90s; the series of “emerging” market Credit collapses; the unwinding of LTCM leverage; the bursting of the tech Bubble; the 2002 corporate debt crisis; or the spectacular collapse of the mortgage/Wall Street finance Bubble - the Fed would reliably respond to each and every crisis with the “gift” of reflationary policymaking.
And, no doubt about it, “inflationism” was the market gift that kept on giving. Crisis, in the Age of Activist Central Banking, created momentous opportunities to harvest speculative returns. Those that best understood and exploited these dynamics (our era’s “titans of industry”) accumulated incredible fortunes – and vast AUM (assets under management).
It’s becoming increasingly apparent these days that public (government) debt problems are a whole different kettle of fish. Rather than a “gift”, they instead present extraordinary challenges for both policy making and the markets. European policymakers are today at a complete loss. In Washington, politicians are making a sad mockery out of responsible debt management – and the markets have yet to even lower the boom.
From my analytical vantage point, the U.S. economy’s “resilience” was always more about New Age Finance than it was some New Paradigm economy coupled with sagacious economic management. The Fed’s pegging of short-term interest rates, along with timely market interventions, created powerful incentives for private-sector Credit expansion - in the real economy and throughout the financial sphere. System Credit, resilient as never before, was at the heart of it all. Over years evolved a most powerful dynamic encompassing a historic private-sector Credit boom and speculative financial Bubble - both backstopped by the GSEs and aggressive fiscal and monetary management.
Wall Street finance provided the nucleus of the private sector Credit boom: asset-backed securities, mortgage-backed securities, “repos,” derivatives, CDOs, CLOs, etc. New Age risk intermediation - “Wall Street alchemy” – created seemingly endless “safe” higher-yielding and liquid securities, the perfect fodder for the mushrooming “leveraged speculating community.” The structures both of the financial architecture and policymaking incentivized aggressive leveraging by the hedge funds and proprietary trading desks. And when the markets occasionally caught the leveraged players overextended and vulnerable, Washington was quick with market bailouts. These dynamics nurtured history’s greatest expansions of “private” sector debt and system leverage.
Of course, Fed rate cuts played a pivotal role in prolonging the Credit Bubble. Greenspan’s asymmetrical approach – transparent little “baby-step” tightening moves and aggressive rate-slashing in the event of mounting systemic stress – was a godsend for leveraged speculation. The critical role played by the GSEs has never received the Credit it deserves. Beginning with the faltering bond Bubble in 1994, the GSE’s became aggressive (non-price sensitive) buyers of MBS, mortgages and miscellaneous debt instruments anytime market liquidity became an issue (when the speculators needed to deleverage). GSE assets expanded $151bn (24%) in 1994, $305bn in 1998, $317bn in 1999, $242bn in 2000, $344bn in 2001, $240bn in 2002, and another $245bn in 2003. With effectively parallel “activist” central banks backstopping the markets – the Federal Reserve and the GSEs down the road - the mortgage finance Bubble inflated to historic proportions. This dynamic will not be repeated in our lifetimes.
Sovereign debt crises are altogether different in nature to those “private” affairs that we’ve become rather comfortable with over the years. Keep in mind that crises of confidence in private debt securities are quite amenable to rate cuts, the public sector’s explicit or implicit assumption/guarantee of private obligations, and system Credit reflation through public debt issuance and central bank monetization. If sufficiently determined to do so, policymakers have the capacity to resolve about any private debt issue. And, of course, the short-term benefits can be irresistible: i.e. buoyant asset markets, reduced unemployment, bolstered confidence, economic expansion, inflating tax receipts and reelection (or, in the case of central bank chairmen, hero status).
The great longer-term costs – which can remain “long-term” as long as policymakers perpetuate Credit Bubble excess – include mispriced finance, dysfunctional markets, the misallocation of resources, increasingly fragile financial and economic structures, social disquiet, geopolitical risks, and an unmanageable accumulation of public-sector debt and obligations. Importantly, the mechanisms that work all too well in dealing with private debt crisis are not readily available come that fateful day when the markets question the creditworthiness of the government’s debt load.
There is more attention paid these days to sovereign debt ratios and such. At about 150% of GDP, Greece finances were (belatedly) recognized as an unmitigated disaster. At 120%, Italy is too vulnerable. Here at home, the National Debt Clock shows federal debt surpassing $14.3 TN. Federal borrowings have expanded at a double-digit to GDP rate for the past three years, with total debt increasing more than $5.0 TN in short order. There is today no realistic prospect for meaningful fiscal reform.
And while Europe is briskly moving up The Sovereign Debt Crisis Learning Curve, complacency still abounds here at home. And the more hideous things appear in Europe and Washington, the more confident our markets become that policymakers will soon come to their senses and resolve the ugliness. Such wishful thinking is a holdover from the good old private debt crisis days.
Avoid thinking in terms of sovereign debt in isolation. The massive accumulation of public-sector debt is almost without exception symptomatic of deep systemic problems. Whether we’re discussing Greece, Spain, Italy, the U.S. or Japan, enormous deficits and public debt loads are reflective of a post-private-sector Credit Bubble environment. This is a critical issue. Not only are governments running up huge debts, the underlying economic structure has already been heavily impaired from years of Credit abuse. And as much as policymakers hope and intend for their borrowing, spending and monetizing programs to promote sound economic and financial recoveries, the reality is that expansionary policies exacerbate deleterious Credit Bubble effects. It’s a case of aggressive monetary stimulus thrown at systems already way out of kilter.
The empirical work of Carmen Reinhart and Kenneth Rogoff demonstrates conclusively that heavy debt loads negatively impact growth dynamics (they have found 90% of GDP an important threshold). This is no earth-shaking revelation, especially if one comes from the analytical perspective that huge accumulations of public debt are generally associated with an extended period of private and public sector Credit excess. And years of Credit-related excesses will almost certainly foment acute financial fragilities and economic impairment.
It’s no coincidence that the greatest expansion of public debt comes late in the cycle when the economy’s response to additional layers of debt becomes both muted and uneven. Indeed, a precarious dynamic evolves where enormous amounts of (non-productive) government debt are required just to stabilize increasingly fragile economic structures. In the meantime, late-cycle stimulus will most certainly distort and dangerously inflate highly speculative securities markets – especially when higher market prices are the direct aim of policy.
There was a Financial Times column today that posited that Italy’s problem was that it was stuck with the ECB rather than the Federal Reserve! If only the Fed were purchasing Italian sovereign debt as it does Treasurys, Italian debt service costs and deficits would be much lower. Crisis resolved. Well, monetary policy certainly does play a critical role in sovereign debt Bubbles and crises.
Back in the autumn of 2009, Greece could finance its massive deficit spending program for two-years at less than 2%. Portuguese yields were about 125 bps and Ireland 175 bps. Spanish and Italian 2-year yields were around 1.5%. The Fed’s, ECB’s and global central bankers’ moves to slash interest rates to near zero were instrumental in the marketplace’s accommodation of unprecedented government debt issuance at artificially low yields. The European “periphery” markets were part of the expansive Global Government Finance Bubble. And the market perception that monetary policy would ensure ongoing low sovereign debt service costs was instrumental in the market disregarding – and mispricing - Credit risk throughout the eurozone. Even last spring, after the Greek crisis’ initial eruption, markets held to the assumption that policymakers would sustain low sovereign borrowing costs and insulate bondholders from significant losses.
Not only has monetary policy fostered the rapid expansion of government debt at artificially low rates, it has also set the stage for a very destabilizing change in market perceptions. Particularly after many years of interventionist policymaking (throughout the protracted private Credit boom), the markets naturally turn complacent when it comes debt crisis risks. Yet as Europe is confronting these days, there are limited available options when crisis finally arrives at sovereign debt’s doorstep. At some point, fiscal and monetary stimulus comes to the inevitable end of the road. At some point, markets say “no mas.”
Piling on additional government debt is then no longer a solution, inaugurating the debilitating and depressing “austerity” cycle. And, as we continue to witness here at home, having the central bank monetize federal debt only worsens market distortions and delays desperately-needed fiscal (and economic) reform. As much as there was an element of certainty in the marketplace with regard to the mechanics of private-sector debt crisis resolution, sovereign debt Bubbles and crises just seem to foment uncertainty. Policymakers are destined to look incompetent, while markets will appear fickle and unstable. Meanwhile, fragile recoveries will turn increasingly vulnerable. And throughout, there will be a growing disconnect between what the markets have come to expect from policymakers and what they can now realistically deliver.
As witnessed in Greece, Ireland, and Portugal, there comes a point where the market recognizes debt trap dynamics and begins to price in sovereign risk. And it is not long into this process of risk re-pricing that the marketplace comes to view huge debt loads as unmanageable albatrosses. This destabilizing process has now commenced with Spain and Italy. Once unleashed, sovereign debt crisis momentum can prove difficult to contain.
To be sure, the debt situation in these economies remains manageable only as long as the markets are content to finance sovereign borrowings at monetary policy-induced low rates. Or, stated differently, Italy’s (and others’) debt load is viable only if the marketplace disregards risk. Well, the market is today rather keen to risk and debt dynamics - and has been determined to push borrowing costs significantly higher. This not only imperils the government debt and Credit default swap (CDS) markets, but casts an immediate pall on the Italian and European banking sector with their huge exposures to increasingly problematic sovereign debt. As an analyst quoted in the Financial Times put it, “A banking sector is only as strong as its sovereign.”
European Credit and inter-bank lending markets are faltering. The resulting de-leveraging and de-risking – and tightened general finance - will likely further pressure markets, overall confidence and economic activity – adding further pressure to the unfolding debt crisis. And as China and Asian central bankers witness the spectacle of an unraveling Italy, they must view the unfolding U.S. debt debacle with heightened trepidation. Perhaps this was on ECB President Trichet’s mind this past weekend when he referred to “the global debt crisis.”
