
- J.M. Keynes

Friday, 9 December 2011

Restructure, reform, move on

Hapless Eurozone leaders are lurching from one nonsensical solution to the next as the world watches with a mixture of bewilderment, impatience and fear. The common theme in all the solutions put forth so far has been an attempt to tackle the debt crisis through creating more debt. If Greece or any other nation cannot borrow then let those who can, do, and transfer the money to Greece. This is akin to the crew of the Titanic assuming that scooping water from the flooded compartments to the dry ones will ensure survival.

Criticism and analysis of Eurozone failure is easy. More difficult is that task of developing a framework to arrive at viable and practical solutions. Most of the solutions being bandied around now such as monetisation, common Euro-bonds, fiscal union are based on flawed logic.

This flawed logic can be divided into two broad streams. The first is the logic of throwing money at the problem until it is solved. This is what EU leaders are attempting and it leads to monetisation being the end “solution”. It works but then so does dropping a one-ton atomic bomb to bring down a skyscraper. The unintended consequences can be slightly unpleasant. The second is the economist’s logic of propounding solutions for the long-term assuming away all short-term problems. From this springs the idea of fiscal union with a Germanic zeal for balancing budgets. Although it should eventually occur, if implemented immediately without addressing the underlying imbalances, it may make the situation worse in the short-term and jeopardise the union itself. Search for a solution requires some common sense, ability to accept unpleasant truths and the courage to forge a credible plan and move forward.

Three important common sense observations are required to proceed towards a solution. The first is the inherent contradiction in the European welfare state model. Generous benefits and pensions are incompatible with a greying demographic profile, limited immigration and inflexible labour markets. The welfare revolution could be supported post the second world war as European economies grew relatively rapidly and a large working age population supported a comparatively small base of dependents. Protectionism along with industrial backwardness of emerging economies further shielded economies with inflexible labour and product markets. For a time, debt provided short-term relief from the forces of globalisation, industrialisation of the third-world and continued inversion of the demographic pyramid. Now, the tipping point has been reached and the debt-drug can no longer mask the symptoms of the disease.

The second is the irrelevance of sunk cost. This operates both on the level of national policy and multilateral aid decisions. National fiscal policy must not consider debt which has been incurred in the past to determine future course of action. In a recession, fiscal policy needs to be expansionary. This appears counter-intuitive and is derided as the discredited Keynesian model[1] but debt can only be paid off if there is growth. Of course this is to guard against unthinking austerity and not a carte blanche to defer reforms until the economy starts growing again.

In case the level of debt has reached beyond redemption then it needs to be restructured. Any multilateral aid money which has been sunk in the mistaken belief of debt sustainability should be considered partially or wholly lost. It is difficult to follow this since it involves loss of face for the political elite. However they should take heed from history. Beyond a point inevitability sets in and the loss of face is invariably bigger. However, despite historical evidence to the contrary human hubris perennially assumes that it can always triumph over the forces of economics.

The third realisation is to recognise that public policy is aimed keeping the welfare of a country’s citizens in mind and not its financial markets. Starting from the credit crisis, nation after nation has adopted policies in the interests of the latter. Ostensibly the justification has been to protect the ordinary person from the collapse of the system. In reality policy has been demonstrably detrimental to the public interest and involved a large transfer from the public to private vested interests. Current European policy is constructed to target yields on existing debt. This is treating the symptom rather than the cause. The reason for this undue importance on secondary yields is the fact that they affect interest demanded on new debt. However, a few high interest new debt issues are immaterial in the grand scheme of things. Credible and coherent policy acts as a natural barrier to the market’s pessimism. If investors are convinced that the situation will improve in the future they will readily buy and yields will drift back lower. They may not revert to pre-crisis levels but they will certainly not explode exponentially creating a self-fulfilling insolvency. Conversely, short-term ad hoc measures to bring yields down and thus demonstrate “market confidence” are usually counterproductive. European leaders have consistently overpromised and under delivered. This has only served to destroy investor trust and confidence leading to the present unhappy situation.

Common sense also leads to two unpleasant truths that need to be accepted in order to arrive at a solution. The first is the inherent contradiction between monetary union without fiscal union. An extremely conservative German monetary policy cannot coexist with profligate fiscal policy if periodic default is ruled out. Therefore either there is periodic debasement of the currency or an equally conservative fiscal union or members can be allowed to default periodically. This seems to have been realised by Merkel and German leaders who are trying to resolve this through a fiscal union. Unfortunately at this juncture this is not going to work without a few debt restructurings first.

The second unpleasant truth which is harder to accept is Western Europe’s decline. Ex-communist countries and the “third-world” are out-competing the sclerotic European nations in the globalised economy. The demographics are unfavourable and the debt too high. Banding together nation states with different languages and little labour mobility to mathematically achieve the world’s largest GDP does not confer superpower status. Only to manage this decline the welfare state needs to curtail its benevolence and enhance the pain of taxation. Not only that, the social compact may also need to be rewritten. The present working age population has to accept that they will never have it as good as their parents.

It takes courage to face up to these truths and even more to propose policies which have common sense but are unpalatable to the majority. Unfortunately in this day of instant opinion polls, it is rare to find a politician who can trust him/herself when opinion polls doubt him/her. However this is not an excuse to continue with the current blind ad-hoc policies. Policy prescriptions must still be made. These can be divided into the short, medium and long term based on their impact.

In the short term, the aim is to restore confidence and restart growth. At outset this requires debt restructuring in nations beyond the point of redemption. Futile attempts to pay back and reduce the excessive debt burden destroy confidence and choke growth. Restructuring should achieve a debt level which is sustainable in the long term taking into account the addition to debt which will occur in the near term. Then the government needs to run a fiscal policy guided by the level of economic activity and not by the level of existing debt. At this point critics will argue that debt restructuring will alienate creditors and make it impossible to run anything but a severely contractionary fiscal policy. This is where multilateral aid can make a real difference. Instead of creating ever larger bailout packages which only serve to bailout private creditors, EU and the IMF can lend to tide over governments in the initial emergency period. Vested interests who cry about this being an attack on capitalism[2] should be reminded that one of the precepts of capitalism is caveat emptor. And another is the failure of unintelligent businesses and business models. Taxpayers do not exist to enrich foolish investors. 

Along with these the standard list of reforms need to be pursued. Tax collection has to be more efficient through not only cracking down on evasion but also on closing legislative loopholes. Wasteful government spending has to be eliminated. Loss making public sector enterprises which are nothing more than sinecures should be either closed or sold. These will have an impact in the medium term to return government finances to a more sustainable footing.

Over the long term, the focus has to be to arrest and reverse the decline of Europe. This requires labour market reform and encouraging immigration. It also requires a fiscal and transfer union to complement the monetary union. Moreover there should be an allowance for defaults (equivalent to US Chapter 9 filing for municipalities) rather than a Germanic straitjacket on deficits. Governments like Houdini can wriggle out of rule-based straitjackets (Greece gave a masterly performance to get into the EU) but find it harder to hoodwink a sceptical financial market audience.

These are not novel or revolutionary ideas. Apart from opposition to immigration, which  is the only issue uniting Europe, all others are slowly being accepted. Labour market reform is grudgingly being pushed through against defiant unions. Partial fiscal union is being pushed by Germany in the form of stability union. And transfer union surprisingly actually exists in the form of EU subsidies to poorer EU nations. Lastly ESM (European Stability Mechanism) is nothing but a place to allow defaults/restructuring within the Eurozone. The need is to be bolder and integrate these elements into a single coherent policy. It is going to be the most contentious and difficult policy to pursue. However it will make the difference between realising the European ambition of a united global power and being forced to manage a decline into frustrated (and maybe penurious) old age.

[1] Those making the derisory remarks forget that Keynes suggested running surpluses during economic expansion precisely so that deficits could be generated during recession. Political failure to implement does not imply a flawed theory.
[2] Currently any policy which threatens status quo and inflicts losses on the financial sector is somehow construed as an “attack on capitalism”

Tuesday, 20 September 2011

Trading the European crisis

This is something I wrote before the EU summit meeting of 21st July for a private discussion. I thought I'd share it as the Greek drama continues to enthrall markets.

Overview of trade strategy for the European crisis

The dream of European integration lies in tatters as the original sin of a pure monetary union without a fiscal union has been compounded by a series of policy errors. This has allowed the bond market vigilantes to reach the gates of Rome after the sack of Athens, Lisbon and Dublin. However the air of inevitability that hangs heavy over Europe at the moment can dangerously cloud trading judgement. Even if the eventual outcome is correctly envisaged at outset, path dependent price moves can wreck a portfolio. Also, the interconnectedness of variables and massive volatility generated by the crisis considerably worsens risk-reward of tactical trading based on a partial view. Therefore, trading in this environment requires not only knowledge of the destination but also an awareness of the path. Sun Tzu’s maxim encapsulates it best: “Strategy without tactics is the slowest road to victory. Tactics without strategy is the noise before defeat.”

Plausible scenario

At this juncture, it is the fate of Greece which will determine how the crisis proceeds.  The flow chart below lays out a broad overview of the plausible paths.

The likely path (in red) at this point in time appears to be a default[1] through a combination of bond buybacks and forced “voluntary” exchanges. The Greek template will then be assumed to apply to the other sovereigns in trouble, viz. Portugal and Ireland in the first instance and Italy and Spain after. This is the reason for the current bout of peripheral weakness as market participants engage in a desperate and ultimately futile attempt to reduce exposure. With core country voter opposition to further bailouts and political deadlock, the onus will be on the ECB to calm markets until a credible plan can be developed. Bundesbank capture of ECB ensures that a timely and forceful intervention in the form of monetisation along with a reversal of the tightening cycle[2] shall not be forthcoming. Contagion and disorderly defaults will take the EU to the brink of breakup. However Europe’s political elite will be helped by inertia and initial lack of overwhelming support for secession, in keeping the union together. At this point, ECB will have to abandon dogma and monetise to deal with economic and financial collapse wrought by sovereign defaults and mass bank failures. There is a risk that monetisation leads to inflation and complete loss of confidence in the Euro. This would severely test political will for the union as voters, especially in the periphery, tire of a recessionary existence. At that point in time, unless there is a change from the current dismal political leadership, a breakup into more homogenous groups or individual sovereigns is likely. Such a cataclysmic event would generate considerable antipathy between EU members and require exiting members to financially repress their economies to provide stability. Attempts at economic growth will lead to trade wars and competitive devaluations.

Enlightened political leadership along with financial repression and coercion can stabilise the situation preventing a breakup. And ultimately a fiscal union can take place with members facing a significant loss of financial autonomy. However, this is a lower probability outcome.

Wheels within wheels and reflexivity

The chart above is a helpful overview and each step can be magnified to create a similar chart. Also it is not static but changes with time. This is because feedback loops operate between economics, markets and politics where a change in one feeds through to the others and their responses generate another change. 

European leaders are working under the assumption that they have until September to work out a solution for Greece. This has caused uncertainty and fear in markets and led to spread widening. Over time, the toxic effect of austerity, rate rises and credit contraction in peripheral economies will be further revealed in economic data releases[3]. As budget deficits remain untamed, calls for further austerity and a halt to further aid will be made in core countries. Both will serve to enhance the market’s fears. At a certain spread and market dysfunction level, politicians will be forced into knee-jerk reactions such as placing restrictions on short-sellers of bonds and curbing CDS activity. This will exacerbate the problem and may lead to auction failures as participants shy away from European (Italian and Spanish) government bonds. With refinancing interrupted the question of default and monetisation will have to be immediately addressed.
As an example, the first arrow of the flowchart can be expanded as below.

Eurozone is not enough
In a market operating on “risk on/off” with cross-asset correlations at the highs, analysing Eurozone dynamics is not enough. Other systemic risk factors need to be considered such as:
  1. China (growth concerns and credit fuelled asset bubble)
  2. US (Debt ceiling and double dip concerns)
  3. Middle East (Oil price shock)
Detailed discussion on these is beyond the scope of this paper.

Putting it all together

Given the likely scenario is of disorderly defaults across the periphery followed by monetisation, a broad strategy of being short EUR, short bonds and long CDS suggests itself. Using Table 1 (appendix) and idiosyncratic factors, this can be refined to provide a broad trading view for each sovereign. This is given in table below.

Risk position
Rationale and risks
·     Growth, Debt/GDP, deficit are better than average
·     Fiscally prudent
·     Bank exposure to CEE is a concern in case of wider contagion
·     Political stalemate is a source of uncertainty
·     High debt/GDP and interest servicing cost
·     Low debt/GDP, interest servicing cost and nominal growth higher than average interest cost
·     Protecting sovereign credit by allowing banks to fail
·     Widening on bank fears is a buying opportunity
·     However, current low spreads are unattractive
·     High debt/GDP, deficit along with low growth due to structural factors
·     Large bank exposure to periphery with likely government bailout in an adverse scenario
·     Debt burden growing as nominal growth lags average interest rate due to loss of competitiveness versus Germany
·     A fiscal union will lead to convergence at wider spreads
Short (CDS)
·     Large bank exposure to periphery with likely government recapitalisation in an adverse scenario
·     A fiscal union will lead to convergence at wider spreads
·     Short at current spread level provides attractive risk-reward (in CDS only)
·     Default is inevitable. However impossible to trade as there is no liquidity
·     No growth due to austerity and ECB rate hikes
·     High interest cost, debt/GDP (due to bank guarantees)
·     High misery index leading to political pressure to renege on bank guarantees
·     Can still survive outside Eurozone as 50% of trade is with US, UK and labour markets are flexible
·     Moribund growth being outpaced by average interest costs
·     Increasing high debt burden
·     Poor demographics
·     Poor market technicals with most investors overweight
·     Relatively opaque banking sector balance sheets
·     Low debt/GDP, interest costs; Historically fiscally prudent
·     Reasonable economic growth
·     Lower banking exposure to periphery
·     Oil wealth with no debt problem
·     However spreads too low to be attractive
·     Low growth, uncompetitive and least skilled
·     High debt/GDP, interest costs
·     Austerity and ECB rate hikes will lead to economic deterioration
·     Undercapitalised and wholesale funded banks
·      High deficit regions counteracting most of the improvement by the central government
·      Unrecognised bank losses post housing bust (Cajas responsible for €1trn of lending on CRE/RRE/Land, an Irish style loss implies €500bn of losses)
·      Government support for banking sector has potential to destroy relatively low debt/GDP
·      Very high unemployment with rigid labour market
·      Similar to other Nordics in low debt/GDP, interest costs
United Kingdom
Long (CDS)
·      High debt/GDP and poor growth but BoE policy implies debt reduction through inflation. This can be seen in nominal growth being higher than average interest rate
·      Long through CDS only to take pure credit view

[1] For ease of use, “default” shall refer to all scenarios which lead to a loss for the bondholder compared to the cash-flows envisaged at the time of bond issue. Therefore cases of restructuring such as maturity extension, coupon reduction are also labelled as default. Additionally, bond buybacks below par are included as they represent a loss to the bondholder even if it has already been taken by marking to market.
[2] Raising rates is a repeat of the policy mistake made in 2008 and likely to have worse consequences
[3] This is clearly seen in Greece where unemployment has been consistently rising and government revenue falling

Monday, 30 May 2011

Defunct economics

‘Don’t fix it if it ain’t broke’ is a maxim that neatly encapsulates human tendency to stick to a strategy which has proved successful in the past and to apply it to new situations. The problem is not that it isn’t true but when it’s finally ‘broke’ the failure can be catastrophic.

Individuals develop heuristics to succeed in an environment. The more time they spend in that environment, more efficient do the heuristics become. Hence achieving success becomes easier. However, when the environment changes these heuristics may need to be modified and new ones adopted for success. Similar to individuals, society and its institutions also develop such heuristics. These are the theories which become dominant and induce societal institutions to act according to their precepts. The dominance of a particular theory is not permanent. There is a cycle wherein a previously accepted theory is shown to be false and a new one takes its place only to be replaced by another. Usually a vigourous debate on the dominant theory constantly takes place within narrow academic confines. However, acceptance by the masses provides continuing dominance and democratic sanction to the proponents of the theory. When changed circumstances show the shortcomings of a prevailing theory its opponents are strengthened. And if the failure is serious enough, they supplant it with their own theory.

In contrast to individuals, it takes society longer to adapt and embrace a new theory. Not only do a majority of people need to be convinced that the old theory is failing, which in itself takes time as events unfold, but also the opposition by vested interests needs to be successfully countered. This delay added to the fact that a dominant theory is usually elevated to the level of dogma with blind following by practitioners leads to the consequences of failure being amplified. Such amplification has the unwarranted effect of the theory being rejected lock, stock and barrel for another supposedly superior theory assumed to be truly universally applicable. The nuance that a theory has limits and only operates under a certain set of circumstances is lost.

This is the situation that we find ourselves at present in economics. Keynesianism was rejected due egregious government excesses and its failure to counter stagflation in 1970s. Monetarism gained ascendancy along with supply-side policies. Under Alan Greenspan, it morphed into the dogma that monetary policy alone is sufficient to counter economic cycles and fiscal policy should operate in a narrow region of automatic stabilisers. The belief of government incompetence in fiscal policy but supreme ability in monetary policy is Orwellian doublethink.

This dogma led to asset price bubbles, most recently the housing bubble. It also led to over-indebtedness of governments. Freed from the responsibility to build fiscal reserves to use during recessions and confident in the ability of central bankers to smooth booms and busts, politicians did what is rational for them – spend to make their constituents happy.

As the housing bubble collapsed, many governments found that they had no fiscal room to manoeuvre. Also the Keynesian liquidity trap bit with a vengeance. When banks are unwilling to lend, monetary policy is useless. However, the orthodoxy still holds sway. Greenspan, the high priest, and others are back professing their faith after flirting with apostasy at the bottom of the crash. The dogmatic remedy for present ills is for fiscal policy to be contractionary and monetary policy to be super-expansionary. In an environment where unemployment is high and private spending by individuals and corporates subdued, the government is being asked to lay-off people and spend less. This travesty is supposed to be more than countered by central banks offering almost unlimited amounts of cheap money. The rationale being that cheap money will make it easier for debtors to pay their loans and thus prevent economic chaos which widespread bankruptcies cause. It will also induce people to borrow and invest. The first objective has only been achieved partially. If debtors are out of work or demand for their goods has disappeared then they cannot pay however low the interest rate. The second objective has failed miserably. Investment is inherently risky and in a recessionary environment, risk appetite is low amongst both lenders (banks) and borrowers (companies and individuals). Also no one is going to borrow to consume as perceived risk of loss of job increases.

The perverse effect that cheap money has achieved is asset hyperinflation. The few who have access to central bank largesse have used it to speculate on everything from equities to government bonds and foodgrains to metals. The prevailing economic dogma is not only causing serious hardship amongst the general public but also choking off the very recovery that it is supposed to induce. High commodity prices lead to higher inflation, hitting everyone and increasing the proportion of income spent on necessities. It hits the poorest the hardest and leads to a disproportionate impact on aggregate demand. For example, a lower quartile income earner might postpone the purchase of the latest iPad in order to meet his increased fuel and grocery bills. This is not going to be made up by the upper quartile income earner who is unlikely to buy an additional iPad even if the price falls somewhat.

The swamping of financial markets with speculative money distorts price signals and leads to the pursuit of speculative gains taking precedence over investing. With money almost free, wealth preservation becomes more important than wealth creation. Everyone rushes to lock in their wealth by buying ‘real’ assets such as farmland, commodities, companies, anything which can store value. This is vicious cycle where asset price rises lead to inflation induced demand squeeze leading to more cheap money provided by dogmatic central bankers causing another round of asset purchases. In cases where this money trickles to the masses, one sees the familiar textbook hyperinflation when any good is preferable to paper money and the economy breaks down into a barter system.

The longer this dogma is followed, the more catastrophic the eventual denouement. High unemployment and inflation is a recipe for social upheaval. Throw in a privileged elite seemingly reaping the rewards from this dogmatic policy and we have a chapter being written for future high-school history texts.