European Policy Makers Don’t Understand But Markets Do
European Policy Makers Don’t Understand But Markets Do
So here we are: the Italian yield curve is flat at above 7%; the government institution is in question; and the ECB is using its SMP purchase program as a carrot to drive austerity implementation in and Berlusconi out. Some would argue that the ‘market is irrational’ – Italy faces a liquidity not solvency crisis. That’s the IMF’s line, and I don’t buy it.
See Italy’s situation is simple: given the Italian debt profile and initial conditions, the Italian sovereign should be able to stabilize its debt levels – even at 8% interest rate (borrowing costs) – PROVIDED (1) it grows, and (2) the sovereign increases its primary surplus (Italy is 1 of just 2 G7 countries expected to run a primary surplus in 2011, according to the IMF). The problem is, that (1) Italy’s contracting, and (2) a higher primary surplus is more likely than not going to aggravate the recession. Something has to change to break the link – this is where I encourage you to read Nouriel Roubini’s latest.
In my view, the market is behaving very rationally. The Troika (ECB+EU+IMF) adapted the standard IMF model to the European sovereign debt crisis as a means to regain market confidence amid a sovereign liquidity crisis. The plan is to enhance fiscal discipline and become more ‘competitive’ (usually that means coincident with currency devaluation).
So fiscal discipline + new competitiveness = market confidence. Right? Wrong.
Italy’s solvency is now under question amid current IMF-style bureaucratic policy in Europe. Why they haven’t figured out the following is beyond me: austerity and competitiveness gains only works if monetary policy is easy and/or the global economy is expanding, and that’s with nominal devaluation.
Either the IMF model will fail or the Euro area will
Here’s the problem with the IMF model:
1. None of the program countries are unequivocally more competitive. Devaluation would help here, but no Euro area (EA) economy can devalue unless they exit the EA.
The table below illustrates the gains in competitiveness by key EA markets since the beginning of the peak of the last cycle, Q1 2008. Competitiveness here is broadly measured by shifts in the real exchange rate, as calculated by relative prices, relative unit labor costs, and relative GDP deflators. The red cells highlight country real exchange rate gains/losses that undercut Germany.
Broadly speaking, no country except Ireland trumps Germany in two out of three measures of real depreciation. At best, the results on which country has indeed gained competitiveness against the 6th most competitive country in the world, Germany, is mixed. Furthermore, Europe as a whole is cutting labor costs, not just the program countries, and dragging domestic demand of the EA as a whole.
Ireland is the only country to have experienced broad depreciation across all three measures and against Germany. But I would argue this: they had further to go. The chart below illustrates the CPI-based real effective exchange rate. Spanning the period January 2007 to April 2008 (the peak), the Irish real exchange rate appreciated 10% against its major trading partners. As such, the 13.6% real depreciation since April 2008 is more reflective of mean reversion rather than competitiveness gains.
2. The second part of any IMF program (first, really) is controlling fiscal balances through ‘austerity’; but this is not possible if the private sector is simultaneously deleveraging and external demand is not sufficient. Spain and Ireland seem to be on track at this point – but they won’t be for long. The inevitable EA recession will increase the required ‘cuts’ to facilitate the reduced revenues; this is both logistically and nationalistically difficult. Global monetary easing is likely to help, but it’s too late for Europe.
Eventually the population will appeal to the economic malaise that is the disintegrating labor markets in program countries and fight against reform.
The divergence in economic performance is quickly turning into convergence, as the sovereign debt crisis inflicts the core economic performance. Shoot, even the ECB has acquiesced and is now calling for a ‘mild recession’.
Markets understand what policy makers in Europe do not: the European IMF-style model is not and cannot work under these conditions. Monetary policy is too tight, the global rebound has dissipated, and fiscal austerity is killing aggregate demand.
And here I get to my favorite quote of the day. From Bank of America’s Athanasios Vamvakidis (no link), a former IMF economist:
“In our view, there are two ways for a country to bolster market confidence in its economic policy: either through the intervention and support of an international institution, or through effective commitment to reform.”
Italy doesn’t need foreign capital, nor does it need effective commitment to reform. It needs a credible path of adjustment. And this involves all EA members, not just Italy. See Martin Wolf’s FT article from October 5, and Nouriel Roubini’s article today on EconoMonitor.
originally published at The Wilder View…Economonitors
Private investors got the shaft on Greek debt, and are now dumping Italian debt driving their rates up. Who wants to be left holding that hot potato. Italy has a lot of debt to roll over, which will be at high rates, and nobody wants to lend (at least not at low rates). So the ECB stepped in today, but that only kicks the can down the road a tad.
MtM (e.g. Jeffires, MF Global) is causing others to now have to ditch debt, since the Greek haircut triggered revaluation of bonds downward.
“and nobody wants to lend (at least not at low rates).” Mcwop
True enough, but doesn’t this raise a question regarding the relationship between “quality” of the debt and interest rates? Does the higher rate actually reflect the buyer’s assumptions regarding possible default of discounted value of such debt? It’s a little perplexing. Think of it this way. Your credit stinks and no one wants to hold onto your existing debt. You may default on it or pay only some portion of that debt. So you need to pay an increased rate of interest on the new debt required to pay the existing debt, but that only means that you will be less able to pay the nes debt because of the higher cost of that debt. Yet the result of the new debt is full payment of the old debt. So who won and who lost? The old debt was sold off (in a panic?) because of some kind of market fear, but the new, higher cost debt has been provided so the buyers of the old debt (at some discounted price) have made a quick profit now that the old debt is refinanced. At the same time the issuers of the new debt, probably the same groups that was buying the old discounted debt, are receiving a higher rate of interest because the old debt had to be discounted because the holders had some sears about the ability of the debtor to raise new debt in order to pay off that old debt. Hmm, its beginning to sound like a vicious cyclic phenomenon.
Who are these sellers of old debt that should be aware that new debt at higher rates of return will be issued in order to preserve the value of the old debt. Why the fear? Why does a financial organization (remember we’re not likely to be talking about mom and pop digging up their sovereign debt holdings and selling before its too late) sell off debt at a discounted rate thereby setting off a process that guarantees that their debtor will then have to pay higher rates of interest on the newe debt that is requjired in order to pay off that old debt. Why take that kind of discounted loss if it seems evident that the likely result is that the new debt will be issued, but at a higher rate of interest? What’s going on?
Jack,
Old debt defaults 50%, debtor gets breathing room, and better Debt/GDP ratios.
Banks holding debt go bust or need caopital infusions (they hold a lot).
But, the debtor nation still needs to borrow.
They must issue new debt at high rates. While they have some breathing room, as time goes by, and assuming their economy is stagnant, their debt service simply becomes an even worse problem.
Oh did I mention bank runs.
The Rogoff Reinhart paper “Its Different This Time” Outlines this very scenario well.
http://www.nber.org/~wbuiter/cr1.pdf
But that’s my point Mcwop. What rate of default is the reality on sovereign debt, in this case pick either Italy or Greece. If I recall correctly Ireland got into deep debt trouble by guaranteeing the debt of its private banking industry. Who’s responsible for what in such cases?
But when a country must be save? We already saved Greece and they do not want to be saved, they wanted to make a referendum to accept the measures, they lie about its debt and they also lie about their financial statements to get into the euro, and now, after rescueing Greece we have to money to rescue any other country of the European Union because is to big to be saved.
I hope that with these technocrats governments we could start getting out of the crisis and doing things a bit different and better than we were doing…