Home > News > The End Game for the Euro: German Rules and Bondholder Revolts
171 views 21 min 0 Comment

The End Game for the Euro: German Rules and Bondholder Revolts

- January 18, 2011

bq. _Things Continue, `Till they Don’t …_

The end game for the Germans, and the rest of Europe, in terms of resolving the current Eurozone crisis is pretty straightforward. There are four ways to deal with a financial crisis: devalue, default, inflate, or deflate. For any country in the Eurozone who transferred private debt from the banking sector to their public balance sheets, and thus blew a hole in their debts and deficits, neither inflation nor devaluation were options. That leaves default, which pushes the costs onto bondholders, or deflation, through domestic wages and prices via the public balance sheet, which places the costs onto taxpayers. For a host of reasons, as guardians of the Eurozone, as an inflation-averse savings-culture, we would expect the Germans to prefer austerity to expediency, and force deflation, but there are real and obvious limits to any such strategy, which is what I have found puzzling since the crisis began just over a year ago.

The first and most obvious limit is that currency unions should not be suicide pacts. There should be exit-clauses; otherwise the only way to adjust is through deflation. Unfortunately, as the 1920s demonstrated clearly, and as anti-austerity protests across Europe today continue to make plain, democracy and deflation do not mix well together. Hard money commitments such as the Stability and Growth Pact, the ECB’s inflation targeting regime, and the Maastricht criteria, were supposed to serve as a check on profligate governments. But what we have in this case, with the Greeks as a possible exception, is not state profligacy. Rather, the situation is akin to a giant ‘bait and switch’ operation where massively leveraged financial institutions wrote deep out of the money options on other financial institutions, and when it all went wrong tax receipts dried up at the same time as huge amounts of private debt were transferred to the public sector balance sheet to keep various national payments systems operating.

What was a crisis of banking became, in short order, a crisis of state-spending via a massive taxpayer put, and with sovereign bondholders’ interests being held sacrosanct while their investments were diluted (if not polluted), the taxpayer had to shoulder the costs twice: once through lost output and new debt issuance; and then twice through the austerity packages held necessary to placate the sovereign bondholders. But if the EU is at base a democracy then the problem is clear. Is it reasonable to expect mass publics to pay for the mistakes of private elites on a multi-billion dollar and multi-year scale? As the Irish example shows, publics may be able to take some of the pain, but eventually they can vote against it. The Germans must know this, so why insist on it?

Second, the preferred German policy to get us out of this mess, austerity for others and exports for them, cannot work even in its own terms. As the ECB’s much trumpeted June 2010 report admits, examples of successful ‘growth friendly fiscal consolidation’ are few and apply mainly to small export dependent states whose budgetary consolidation was cushioned by export led growth. Crucially, such states had their own currencies and could devalue as well as deflate, giving them more room to move. Poster child for this policy was Ireland in the late 1980s. Ireland today is discovering that not only is it much harder to do this when everyone else is not growing, and is therefore not importing, you can actually cut so much that the policy cannibalizes future growth via debt deflation.

The problem of exporting your way to success is, as Martin Wolf has ably demonstrated in his FT columns, essentially similar. We can’t all export at once. Someone has to be importing, and for that to happen a state needs to either be able to import capital to cover their current account deficit, as in the cases of the US and the UK, or blow a whole in their current accounts. Now, if I assume that there is no existential reason for Germans not to understand the notion of a fallacy of composition, why do they wish to follow a policy course that is so obviously flawed on both grounds of political sustainability as well as basic economic logic? It can’t work and it will not work, so why keep doing it?

_”Spain/Portugal/Italy/France is just another Greece/Ireland Waiting to Happen …” _

The joke doing the rounds a year ago was, “what’s the difference between Ireland and Iceland?” The answer was, “one letter and six months.” The unfunny and better answer should have been “not much.” Both of these countries are exceptions, not rules. Both of them turned their economies into Ponzi-schemes so highly levered that all it needed was a less than three percent turn against their biggest banks’ assets to make them insolvent. Both were far too small to absorb such losses. Icelandic and Irish bank indebtedness now hovers between $18,000 and $35,000 per person, depending on how you count it.

This is however, simply not true for any of the other Eurozone states, even the biggest of the problem cases – Spain and Italy. Italian debt is large but it is long term and mainly held domestically. Their banking system is notoriously closed and conservative. Spain certainly got hit hard despite having prudential banking regulations in place at the time of the crisis and being the Eurozone ‘best in class’ for debts and deficits in the years up to the crisis. However, having effectively deindustrialized, it turned its economy into a real estate and financial services hub. So when (external) demand dried up, the current account went awry, and the banking sector stopped paying taxes, and the ‘best in class’ became the last of the PIGS. Portugal did not have a financial crisis, it had an Eastern European-style current account crisis when exports collapsed and consumption came through imports.

For those outside the Eurozone, for example, the UK, whose public debt is still below the 60 percent Maastricht threshold, the claim makes even less sense. Yes, Greece and Ireland are in bad shape, but that’s no reason to start a continent wide austerity movement. It simply will not do anything for growth. But maybe that’s not the real problem.

_”The Real Problem is Avoiding the Mother of all Bank Runs”_

Another possible explanation for German behavior is more plausible. Putting regional elections and other such trivia to one side, there is a reasonable fear of a general run in the European bond market, similar to what we saw in the US repo-market crisis in 2008. The basic problem is twofold: institutional mismatches and portfolio correlations. First, on a macro level, the European political project was based around a deliberately incomplete contract that allowed agreements to change over time in accordance to circumstances since the final shape of the EU could not be established ex ante. The European financial project was, on the other hand, based on a complete contract that attempted to specify ex ante all possible states of the world via sets of rules and monitoring institutions on the assumption that behavior is a function of rules plus incentives and can be programmed as such.

Unfortunately, such a design does not consider the possibility that private sector actors might, for example, develop swap contracts with governments that allow said governments to perform fiscal prudence while practicing fiscal profligacy, a la Greece and Goldman. Consequently, the possibility that the European bond market might suddenly suffer widely divergent, rather than convergent prices, wasn’t considered at all likely. This contract-mismatch became a problem when bondholders, including some of the biggest European banks, dumped low yielding Northern bonds for higher yielding Southern bonds on the assumption that the risk premium priced in a credible commitment by the ECB to maintain the value of the bond via monitoring the fiscal policies of the member states.

Unfortunately, the ex ante mechanism designed to make this happen, fiscal rules and self-disciplined behavior, fell by the wayside during the last decade. So when the banking crisis hit and the true state of public finances became apparent, the risk premium for holding Southern bonds was revised upwards quite spectacularly. The political incomplete contract had flexibility built into it to deal with contingencies. The monetary complete contract denied contingencies could arise, until they did.

At this point the obvious thing to do would have been for the Germans to buy and hold the troubled bonds, thus denying the markets a piñata strategy, thereby limiting the possibility of a bank run through the bond market where attacks on weak currency leads to attacks against the next most weak currency in anticipation of a short sell. But the Germans did not do this. There were many reasons for not doing this: moral hazard vis-à-vis other countries, upcoming regional elections, schadenfreude. But there was also one very good reason for doing just this, which is the other side of the bank-run story.

_What the Germans Know and are Afraid to Admit_

You can get a run through a bond market in two ways. The first is to discover that the real price of the bond is not reflected in the risk premium and dump it or short it. The other lies through contagion mechanisms. If banks have essentially similar positions in similar assets, in this case Southern Bonds, the chances are that they also have similar hedges. If so, and these assets are in demand, Southern European bonds in this case, bond rates go down as demand goes up, leading to lower risk premiums as far as the bank is concerned. But if there is a shock that leads to a rapid revision of prices, as there was in 2008 and 2009, the temptation is to look to the hedge to take up the strain. Unfortunately however, by 2010 other available asset classes, real estate and equities are on the floor. So to avoid taking these losses banks will have to liquidate similar assets in an effort to cover their losses, if their hedges will not cover their losses. But it gets worse. If those losses are anticipated in advance, then the temptation is to ‘dump good to cover bad.’ But if my ‘good’ asset is also your ‘good’ asset, then I will try to dump them ahead of you doing the same. You can see where this story of asset correlation goes.

If I know you want to dump Greece, I will dump Ireland, and you will dump Italy to cover the anticipated losses, and I will dump Spain to get ahead of you, and as we all try to cover the bad with good, we all try to find liquidity, when in fact it is a community property, thus creating illiquidity in the bond market, just as happened in the repo market in the US in September 2008. This is why any talk of exiting the Eurozone has to be quashed and austerity is the only game in town. With billions of dollars of risk held in a myriad of banks in dozens of EU countries no one is immune from contagion effects. So if anyone gets wind of someone printing a new currency, for example, the whole thing unravels at light speed as investors try to liquidate ahead of the pack. Investors don’t want to do this in the main. Speculators aside, most bondholders want to ‘be made whole’ rather than blow up their portfolio. But if someone is going to shout fire in a crowded theater, then it pays to be close to the door, the signal for which is the increasing pressure on spreads that we see today.

So if the Germans are smart enough to see this bank run coming, and that they know austerity politics cannot work as advertised, and if the ‘rescue’ vehicle of choice is a $750 billion SPV with no actual cash in it supported by new ‘restructuring mechanisms’ that are seen as less-than-credible by bondholders, and if we can assume that at some point mass publics will vote against austerity, then what is the end game? I think that it might be the case that the Germans are ‘performing austerity’ to buy some time for the inevitable bank run that lies ahead.

_Passing the Put Around: Eventually Someone has to Pay Up_

Go back to the macro story laid out above for a moment. About two and a half years ago highly levered companies trading deep out of the money options with massive amounts of leverage blew up. For heavily financialized economies (UK, Ireland, Iceland) this ended up on the public sector balance sheet via lost tax revenues, higher interest payments, deficits and debt increases. Globally, two trillion dollars was lost and someone has to pay for it. For those countries that didn’t have a banking crisis, the true extent of their budgetary imbalances (Greece), structural current account deficits (Portugal) or export dependence (Germany, Austria) was revealed in short order. When this happens the way out is, again as noted above, devaluation, default, inflation or deflation, and the EU chose deflation of wages and prices, and the Germans at least talked a good game concerning austerity politics. What they practice was something else entirely; but if other states really did it then its all the better. But why do so if its only performative, and it cannot ‘do what it says on the tin,’ as the Brits like to say?

If the Germans read the game as I do, then they only hope is delaying the bank-run that is coming with promises of SPVs filled with magic Euros and bailouts for the Irish and the Greeks as they slash themselves senseless. But if you know that it’s coming, then so must the bondholders. And if they do, their interests are clear. They bought sovereign debt, not the crappy corporate debt that is now bloating the balance sheets of their sovereigns and increasing their risks, so they really don’t want to take the hit for finance’s `put’ on the state.

So the state put that ‘put’ on the taxpayer. But in a democracy there is only so much you can put on the taxpayer before they throw out the rascals and vote for someone that promises to put that ‘put’ elsewhere, and the only place left is back on the bondholders. So if the bondholders know that the haircut is coming, they can try and put the put back on the banks, but given the state of the bank’s balance sheets and overall business model (it’s bust – and its not coming back), that’s not going to happen. So bondholders have only one out. They pressure the EU, and the Germans in particular, by squeezing peripheral bonds to make sure that taxpayers there take the hit that they don’t want to. But this of course, has a limit. That limit is called Spain. When you put $750 billion in a bag and say ‘bailout funds’ that tells everyone how much you are really willing to lose. It’s a chunk of change and it will take care of Ireland and Greece. But if everyone is, metaphorically speaking, trying to get towards the door in case someone shouts ‘fire’ in the crowded theater, then there is no guarantee it will stop there as contagion mechanisms take hold. In which case Spain’s liabilities, dotted across the bond portfolios of major Eurozone banks, blow through the bag of cash and the limit is reached. When that limit is reached, the mother of all bank runs will begin and the endgame for not just the Euro, but also the EU, will enter its final act.