The answer is yes. It matters considerably, we think. The risk-free nature of sovereign debt and its resulting safe haven status are in our view instrumental to the ability of governments to use fiscal policy counter-cyclically as a macroeconomic stabilisation tool. If government debt is deprived of its safe haven status, then this pushes us back towards a ‘pre-Keynesian' state of the world where fiscal policy is neutral at best (US), and more likely pro-cyclical (Europe). Against a backdrop of slowing growth in advanced economies, the consequences are likely to be serious.
In this note, we provide our interpretation of the ‘consequences of Greece', both in Europe and more globally. In Europe, we believe that the decision to resort to private sector involvement in Greece without having first put in place credible arrangements for the funding of governments set in motion a chain of events that extended the debt crisis to Italy, Spain and to a lesser but nonetheless significant extent France. We think that it also makes an acceleration of the process hinted at by Angela Merkel and Nicolas Sarkozy (fiscal integration accompanied by common bond issuance) the only genuinely stabilising outcome for Europe. If that does not happen, the most likely alternative is in our view sooner or later a ‘debt jubilee', by which we refer to a wave of public and private defaults, with all the economic and social consequences this entails.
Towards a world of fiscal dominance. More globally, we believe that the deterioration of government credit results in a form of fiscal dominance, whereby we mean that the fiscal situation constrains the course of monetary policy, possibly for a long time.
What happens in Greece does not stay in Greece. The relevance of what happened in Greece does not flow from the size of the country or its role in international trade and financial flows. Both are minimal. It does not flow either from the exposure of foreign institutions to the Greek government. That is manageable. Rather, the global relevance of what happened in Greece stems from the fact that it officially put an end to the notion that sovereign debt is risk-free.
‘Private sector involvement' in Greece is indeed effectively the first case of sovereign debt restructuring in advanced economies since the Second World War. Even though not all creditors will suffer losses, many will. The fact that private sector involvement is both partial and ‘voluntary' is relevant to the CDS market - avoiding default in a technical sense - but does not fundamentally alter the economic reality of the precedent set in Greece.
Sovereign debt is officially no longer risk-free. It is significant that this restructuring was not a unilateral decision of the Greek government, but was imposed by another European government (Germany) and endorsed by its peers. This makes it an official validation of the notion that sovereign debt is not, and in the view of some at least should not be, risk-free.
It would be tempting to believe that events in Athens are idiosyncratic in nature and carry little relevance for other governments, inside or outside Europe. This is the line taken by European heads of state and government, who stated on July 21, 2011 that:
"As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.
All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature (...)".
The credibility of this statement relies on three assumptions: first, that Greece was an idiosyncratic case because Greece was insolvent while other governments are not; Second, that other governments will be able to fulfill their obligations because they are not only solvent but liquid; And third, that the line drawn between Greece and other countries is credible because governments said so.
The market was not convinced. Neither were we, for the following reasons:
Government solvency is a blurred concept. For governments with high levels of debt, the concept of solvency is very sensitive to the government's cost of funding, and therefore to swings in market confidence. What makes a government solvent is its ability to stabilise its debt (as opposed to the level of debt in itself). This, in turn, depends on the ability of the government to generate a sufficient primary balance, which can be expressed as follows:
Primary balance / GDP ≥ ( i - g / 1 + g) x debt / GDP
Where i is the average interest rate paid on the debt and g is the nominal rate of growth of the economy.
What this relationship emphasises is the importance of the interest rate paid on the debt. All other things being equal, a higher cost of funding raises the ‘fiscal hurdle', i.e., the required primary balance, in proportion to the initial level of debt. The higher the interest rate, the higher the likelihood that the fiscal hurdle becomes politically insurmountable, which in turns justifies a higher risk premium in what becomes a vicious spiral. Conversely, a government with even a very large level of debt can appear entirely solvent if funded cheaply enough, a point to which we return below (for a longer discussion of this point, see Sovereign Subjects: Sense and Sustainability, November 5, 2010).
It is possible to be solvent yet illiquid. The second issue with the heads of states' position is that to guarantee that sovereign debt outside Greece remains risk-free, governments have to have unconstrained access to liquidity. Following the precedents set by Greece, Ireland and Portugal, this can no longer be taken for granted in the absence of sufficient contingency liquidity support by core governments and/or the ECB. The size of Europe's main inter-government liquidity support scheme (EFSF) has been calibrated in line with the requirements of Greece, Ireland and Portugal. It could be sufficient to absorb in addition the funding needs of Cyprus but not those of Spain and Italy in the event of a ‘run' on governments, such as that which was effectively starting to unfold until the ECB intervened. In its current state, therefore, it does not constitute an entirely credible liquidity backstop, especially given political opposition in several countries to an increase of its capacity. Meanwhile, the ECB provides indirect liquidity support to Spain and Italy through its bond purchases, but it appeared to take on this role reluctantly and under the assumption that it would only be temporary (until such point at which EFSF may take over). This does not provide much reassurance that solvent governments will always be kept liquid.
Policy credibility is a major casualty. The third issue has to do with the diminished credibility of policy statements, undermined as they have been by successive u-turns over the past year. This is perhaps best illustrated by putting in perspective the decision to resort to private sector involvement in Greece with the statement issued on November 12, 2010 by the governments of France, Germany, Italy, Spain and the UK. At the time, governments had formally ruled out private sector involvement, including in Greece, for at least two-and-a-half years in the following terms:
"Whatever the debate within the euro area about the future permanent crisis resolution mechanism and the potential private sector involvement in that mechanism, we are clear that this does not apply to any outstanding debt and any programme under current instruments.
Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements."
The entire government bond asset class could be tainted. We find it therefore rational that the first consequence of PSI in Greece is a re-assessment by the market of the credit risk of all euro area governments, as illustrated by the behaviour of CDS prices in the run up to and after the July 21 agreement. If it has been deemed necessary to sacrifice, in one instance, the property rights of private creditors to the interest of other government stakeholders (taxpayers, recipients of public expenditure and, incidentally, official creditors), then the risk that this happens again elsewhere - in a context where most governments have overstretched balance sheets - is no longer negligible.
What European governments have done for sovereign debt, therefore, is exactly what the ECB had painstakingly succeeded in avoiding in the case of bank debt (by disallowing default by Irish banks on their senior unsecured debt): creating a precedent that effectively damages the entire asset class.
This leads us to the central question we raised earlier: why does it matter? What matters is not so much that government debt is risk-free as that it is seen as a safe haven. In our view, this is a precondition for governments to be able to use fiscal policy as a macroeconomic stabilisation tool. Indeed, what allows governments to deploy their balance sheet defensively at a time of recession is two properties of public debt, both of which derive from this safe haven status:
The first is practically unlimited access to finance. This is the property that allowed, for instance, governments to support their banking systems in the winter of 2008/09 by guaranteeing bank deposits and bank debt. In essence, what governments were doing in that instance was to lend their superior access to funding to the banks.
The second property, perhaps even more important, is that in a recession or crisis, flight-to-quality flows towards the safe haven lower the relative cost of funding of the governments. As long as this holds true, governments can cost-effectively deploy their balance sheet, borrowing more to supplement a fall in private sector consumption and investment.
The consequences of disabling fiscal policy. Should public credit start behaving like private credit, then the ability of governments to run counter-cyclical fiscal policies (even merely by letting automatic stabilisers run their course) would in our view be impaired. At best, fiscal policy would become neutral. At worst, it would become pro-cyclical in a slowdown. It is in that sense that we see one of the consequences of the Greek precedent to be to push us towards a ‘pre-Keynesian' state, where fiscal policy is largely disabled.
At this stage, it is worth underlining that the notion that fiscal contractions can be expansionary finds little empirical support, at least in the near term, as evidenced by two recent studies published by the IMF and the BIS1. We live in a world that is not only becoming non-Keynesian, but is non-Ricardian too. We illustrated this by plotting the IMF's projections for discretionary fiscal tightening over 2010-12 against the level of real growth over the same period. Countries that tighten fiscal policy suffer an instant loss of economic output, while a number of countries that still experience(d) healthy rates of growth have done little by the way of fiscal consolidation so far, and will likely need to do much more eventually (the US being a case in point). Indeed, additional fiscal austerity is one of the reasons that led our Chief European Economist Elga Bartsch and her colleagues in our European Economics team to revise significantly downwards their growth forecasts for the euro area both this year and next (see European Economics: Growth Coming to a Standstill, August 17, 2011).
The consequences of disabling the fiscal backstop for banks. The loss of the risk-free status of government debt has in our view a second damaging consequence, which is that it weakens the quality of the fiscal backstop enjoyed by banks. Banks are by nature highly leveraged and cyclical institutions. Their debt should therefore be very risky. What makes it safe is prudential supervision, backed by systemic support from the fiscal authorities. There is a direct relationship between the credit quality of the government and the cost and availability of bank funding, as illustrated by the correlation between their CDS prices, or by the relationship of causality from sovereign credit rating to bank credit rating. We therefore regard the renewed tensions in the bank funding market in Europe as at least in part the consequence of the decision to use private sector involvement in the restructuring of Greece's sovereign debt.
The risk, if funding tensions continue, is that banks de-lever their balance sheets more rapidly from the bottom end of the balance sheet (debt reduction and therefore credit contraction) as opposed to more slowly from the top end of the balance sheet (recapitalisation over time through retained earnings). Tougher term funding markets is another of the factors identified by Elga Bartsch as responsible for a deterioration of the European growth outlook.
Governments are now more vulnerable to ‘runs'. Our conclusion at this stage is that the decision to resort to private sector involvement in Greece without having first put in place credible arrangements for the funding of governments (and banks) was a major policy error that has destabilised economies and financial markets. It has effectively increased the probability of a run on governments, a run which was in fact in our view in the process of developing until the ECB put a (temporary) end to it.
From this point, we think it is very unlikely that government bond markets will stabilise by themselves, at least not in the foreseeable future, not against a background of near or outright economic recession and not until the damage caused by private sector involvement in Greece is corrected.
So where does this lead us? To a critical bifurcation point. In our view, this means that we are getting ever closer to a bifurcation point, where either of two outcomes must unfold. Either the aforementioned run must resume and eventually lead to a wave of defaults for (even solvent) governments and banks - a scenario we labelled in the past a ‘debt jubilee'; or, governments must reverse the effects of the use of private sector involvement in Greece by ensuring that they - and banks - benefit again from unimpaired access to funding at affordable costs. Intermediate scenarios (such as the ECB buying time by acting as a de facto lender of last resort) are in our view both transitional and costly.
In this context, we do not believe that the implementation of all the measures agreed by European governments on July 21, 2011, in particular as regards the enhanced capability of EFSF, will be fully stabilising.
Why EFSF cannot bring about lasting stability. The main issue here is the size of EFSF. As mentioned above, its lending capacity is sufficient to provide a fully credible liquidity backstop - effectively a function of lender of last resort - to Greece, Ireland and Portugal. Its current size provides ample reassurance that these three governments can remain funded ad vitam aeternam, providing of course they continue to fully comply with the conditions of their respective adjustment programmes. It does not have the capacity to act as a credible lender of last resort for Spain and Italy and other governments. To the extent that the problem generated by the use of PSI in Greece has been a broadening of contagion towards governments outside the periphery strictly speaking, and a material risk of a run on these governments, then EFSF as it currently stands is effectively obsolete.
Size does not matter (unless unlimited). With this in mind, it might seem paradoxical that we do not believe that increasing the size of EFSF would have much effect. The business model of EFSF is to borrow the superior market access of those governments that have retained safe haven status (the AAA rated sovereigns or increasingly, in the light of the discussion above, Germany, the only true residual safe haven) and lend this market access to their peers that have lost (affordable) market access. To be fully credible as a lender of last resort for the whole euro area, EFSF would need to have the capacity to finance any European government facing a run (in the same way that a central bank has the capacity to keep any solvent bank liquid in the event of a run). The size of EFSF would not merely need to be increased. It would have to be made open-ended. In essence, this would imply that European governments are willing to help financing each other without limitation, providing they all abide by fiscal and macroeconomic adjustment policies dictated by the strongest among them (in practice, Germany). This would be tantamount to what we have called in the past a shift from peer pressure to peer control in the fiscal governance framework, with abandonment of national sovereignty over the conduct of fiscal policy (at least as regards the overall level of the deficit) and centralised bond issuance.
We believe that only fiscal integration will provide lasting stability. What we have described here is not an increase in the size of the EFSF. It is a quantum leap towards enhanced integration of economic and fiscal policy, in which case - as indicated by Angela Merkel and Nicolas Sarkozy themselves in Paris on August 16, 2011 - centralised government funding through the issuance of common bonds becomes both possible and, in our view, desirable. Such fiscal integration is in fact, as we have argued for a long time, the only fully stabilising resolution of the European sovereign debt crisis, in our view (see Sovereign Subjects: Curing Demotion Sickness, December 6, 2010).
Why the ECB's protective action can only bring about temporary stability. If we assume that this quantum leap remains unlikely in the view of deep-rooted political tensions across Europe, then the only barrier that stands in the way of a debt jubilee is the ECB. By acting as a buyer of last resort of government debt (at an affordable price), and as a lender of last resort (at an affordable rate) for banks, the Eurosystem is effectively stemming a run on governments and banks.
Yet, we do not believe that ECB intervention can be fully stabilising. Rather, we believe that it can be temporarily stabilising, but can only postpone for some time the bifurcation choice described above. The reasons stem from the fact that the ability and credibility of the Eurosystem's intervention to stem a run rely on: i) unlimited capacity; ii) centralised and flexible decision-making; and iii) unwavering commitment.
With this in mind, a first observation is that the ratification of the new powers of EFSF may be a double-edged sword. While it would be positive in the sense that governments follow through with their commitment, it would inevitably raise the question as to whether the ECB would hand over its market stabilisation role to the EFSF, in our view. If that were the case, given that the EFSF does not have the quasi-unlimited financial resources that the ECB has, the risk is that it undermines market confidence rather than enhances it.
A second observation is that if the ECB continues to perform its stabilisation role by purchasing as necessary the bonds of challenged governments, this will likely increase, not decrease, political tensions across Europe. When the ECB buys, in the secondary market and for the purpose of stabilising yields, the bonds of governments that still fund themselves in the market, this is not meaningfully different from extending direct lending to governments. The ECB is effectively the marginal buyer, clearing demand and (government) supply at a quasi-fixed price. This may not be a violation of the letter of the Treaties, but it is certainly in contravention to their spirit. The political backlash this is causing in some countries, Germany in particular, does not only make it less likely that the only truly stabilising solution is agreed upon. It also fuels market expectations that the euro area may eventually break up from the core, itself a destabilising factor (see The Global Monetary Analyst: Euro Wreckage Reloaded, April 14, 2010).
Can the ECB unilaterally withdraw its support to governments? Probably not. We believe that it will be very difficult for the ECB to withdraw its liquidity (and indirectly solvency) support to governments and banks. Doing so would likely precipitate the ‘debt jubilee' outcome we described earlier, which could move Europe from a near recession to an outright depression. Faced with a choice between two undesirable outcomes, we expect that the ECB, as any other central bank, would still prefer the admittedly unpalatable outcome of debt monetisation/inflation to the potentially disastrous outcome of debt default/depression and deflation (for a discussion of this point, see The Global Monetary Analyst: Better the Devil You Know, August 18, 2010).
Fiscal dominance emerges in Europe. It is in this sense that we referred in the introduction to the emergence of a form of fiscal dominance. By this we mean a situation where the deterioration of government credit forces central banks to alter the course of monetary policy in a way that they might deem distinctively suboptimal, but that is necessary to prevent an even more undesirable outcome.
Fiscal dominance exists in fact across advanced economies. This form of fiscal dominance, we believe, is not a European but a more global phenomenon, illustrated by the situation of the US. It is indeed in our view only the dominance of fiscal authorities over monetary authorities which guarantees that - unlike what happened in Europe - the US government remains entirely (credit) risk-free.
To illustrate this point, it suffices to consider the debt ratio that we consider much more relevant than debt/GDP, the ratio of a government's debt to a government's revenues. This ratio approximates 360% in Greece and 315% in Ireland. It stands at approximately 325% for the general government in the US, much higher for the sole federal government (for the sake of comparison, it stands at around 170% for France, 190% in Germany and 220% in the UK). What, then, makes the US government entirely solvent, while those of Greece or Ireland may not be? The answer, in our view, lies less in the revenue-raising capability of the US government and more in its low cost of financing, engineered by a very loose monetary policy. For a government with short-dated debt (especially when taking into account the effect of past quantitative easing operations), there exists a relationship of causality from the monetary policy stance to sovereign debt dynamics that results directly from the formula presented earlier.
We believe that this relationship will make it difficult for the Fed to fully ‘normalise' monetary policy, if and when inflation requires it, because doing so would quickly build up pressure on fiscal dynamics. In this sense, the fiscal situation, in the US and in Europe, constrains the course of monetary policy, probably for a very long time. This is good news for the nominal return on bonds but bad news for their real return.
For full details, see Sovereign Subjects: The Economic Consequences of Greece, August 31, 2011.
A big medium-term uncertainty for DM equity investors is the sustainability of earnings. A decade ago, the big uncertainty was whether valuations could be sustained. They weren't. The de-rating may have further to go, but clearly valuation is less of a headwind now than at the TMT-inspired peak.
Earnings, on the other hand, are very high. Profits are now near an all-time high as a share of global GDP, and the real return on equity has followed. What's notable, however, is not the cycle rebound, but the elevated level of earnings (and real returns) over the past decade. The forward-looking issue is whether those elevated returns can be sustained.
At a global level, the answer may be ‘yes' - for the simple reason that it's now possible to make profits in places where previously it was not. What's not clear is the sustainability of high earnings in the developed world.
DM profits have rebounded from the ‘great recession'. For example, the profit share of GDP in the US is now at an all-time high. (Reported EPS is not. The gap between earnings and EPS is in part due to equity raises diluting earnings over the past 2-3 years.) As with global earnings, DM earnings have been in an elevated range through the past decade. In short, high earnings are not just a cycle story.
I did, however, get the cycle wrong. I was too bearish on DM earnings over the past couple of years, assuming (wrongly) that a lackluster macro revival would translate into a lackluster profit revival. As it turned out, everything went right for business, particularly in the non-financial sectors.
The first thing to emphasize is that this was not just a matter of riding growth in emerging markets. Profits made within the US have increased by 5.8% of business GDP from the low, while total profits of US corporates increased by 6.3%. (The profits within the US include profits made by foreign firms.)
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