Tuesday, April 23, 2013

Bridegwater Daily Observations

Bridgewater Daily Observations

What Europe's Lost Decade Will Look Like


At the recent IMF meeting, disappointment with the economic conditions and austerity in Southern Europe was palpable and suggestions to "do something different" were rampant. While there was considerable debate about how to move the levers, unfortunately the quality of the discussion was rather shallow. This is unfortunate as 1) such issues have been faced repeatedly by other countries, 2) the linkages are obvious and 3) the IMF has had a wealth of analogous experiences to draw upon to' convey the real picture.


The real picture is that "Southern Europe" is now going through a classic deleveraging that is analogous to all of those faced by overly indebted countries that have their debts denominated in a currency that they can't print - e.g., the Latin American deleveraging of the 1980s is a great example though many examples that reflect the typical dynamic can be tracked by looking at the IMF records. We are now at the stage that a) we are past the financial crisis, yet b) we are in the early days of the economic crisis. We are past the financial crisis because policy makers have moved from having no viable plan to having a viable plan (Le., a Plan B-1 sort of plan in which only the systemically important entities will be saved). We are in the early days of the economic crisis because that B-1 type of plan, which is quite similar to the IMF's usual plan, implies a long, painful deleveraging process.


Expectations that the economy will "normalize" and surprises that economic conditions are now so bad reflect a lack of understanding of how the economic machine works. Those who understand how it works in deleveragings recognize that debtors and creditors will go through several long, hard years of grinding brinkmanship in which they learn to hate each other and coexist at the same time. While classic, the terms of their relationship are now becoming clear. In other words, protocols that make clear who will do what in these deleveragings are now being established. Cyprus was important in helping make a couple of them clear. Slovenia will probably help further. It is better to have these new protocols be established in small, non-systemically risky cases in order "to kill the chicken to scare the monkey".


The overriding protocol is that "entities that are not systemically important probably won't be protected." Whether this pertains to larger entities in smaller countries (Cypriot banks) or smaller entities in larger countries (Spanish Cajas), those who can bear losses will, and in as orderly and

predictable a way as possible. Bank equity holders will take losses or be diluted before junior creditors take losses, who will take them before senior debtors, who will take losses before the sovereign. For countries that cannot get the amount of money they require from the private sector,

they will agree to a program that will be a troika type program with austerity terms that will allow the troika's supplies of capital to most likely get paid back. Debtors who are squeezed will have to sell their assets. These are basically the same protocols that have been typically used by the IMF in

other sovereign debt crises and essentially the same as we have learned from playing the game of Monopoly.


Naturally, social and political tensions ensue as debtors who have to cut back blame creditors rather than blaming themselves for their problems. The current popular picture of the troika being cruel and exploitative in forcing debtors to endure terrible conditions is both classic and backwards. Debtors had the freedom to make their own decisions and still have the freedom to choose how to manage the consequences of their actions. And they still have the choice of going it alone or entering into a program in which the troika will help them manage the deleveraging process. These programs will not include large wealth transfers to help debtors to continue to spend above their means, though they probably will include loans that are expected to be paid back. The reluctance of countries that can provide assistance to tax their citizens to support debt financed consumption that can't be paid back is well established. So those are the terms that are typically offered.


If those who run the debtor countries don't want to go into a program and sell assets, they have the right not to. They can choose not to sell their assets and to go it alone. However, if they go it alone, they will have to have even greater austerities, which produce even greater domestic economic pain, which will be even more threatening to the government in power. If history and common sense are to be guides, they won't choose to go it alone even though going into a program will cause lots of screaming by those who are hurting and by opposition political parties trying to use popular discontent to gain power.


The troika has neither the inclinations nor the resources to do more than that. The fiscal resources of the ESM, IMF and ECB are limited. As a result, those who have debt problems will have to cut their spending and sell their assets. We are now in the asset sale, spending cutting phase of the process. Since asset sales will contribute relatively small amounts, cutting spending is the implied inevitable path.


The picture ahead is obvious since it is not complex. It is also bleak. It is not openly talked about because optimism rather than bleakness is key to having debtors go down this path, and because most people don't understand how the economic machine works. To make sure that this simple

picture is clear, we will reiterate it.


Because "Southern European" households, banks and sovereigns have too much debt, their debt-to-income ratios can't rise. They can't rise because the free market will not finance increases in them because a) private sector lenders (most importantly banks) don't have the capacities to lend in those amounts and b) everyone understands that lending in amounts that raise debtors' debt-to-income ratios is probably going to lead to bigger problems down the road. Given that a) debt-to-Income ratios can't rise and b) interest rates are higher than income growth rates (which they justifiably are because of the risks of default and currency breakup that exist from high debt levels and social and political

challenges), there must be c) contractions in debt and spending and d) the selling of assets - i.e., a classic deleveraging. It's just that simple.


In our opinion, those who talk about solutions other than material changes in ECB monetary policies are more optimistic than realistic. The bad economic conditions of debtors are a function of the previously described dynamic and cannot be materially changed without a material change in the ECB's policies. Loosening fiscal policy means increasing governments' debts and these increased debts have to be sold to lenders who would have to redirect funds from alternative investments. Who will buy that extra debt and at what rate? Changes in productivity and competitiveness will help some, but they will occur only because they are forced by the strains resulting from the deleveraging, they will painful (e.g., getting people to work harder and to receive less transfer payments) and they' will be relatively slow coming and marginal in impact.


Going down the existing path will produce a long, steady grinding away of spending, and social and political changes. That's just the way things work. There's no sense in being surprised or upset by it.






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