One day after the Parliament in Berlin voted in favor of the Spanish bank aid package, and one week after the Spanish government announced a historically unprecedented package of austerity measures, Spanish 10 year bonds were rubbing up against the 7.3% mark while the spread with German bunds rose above the 600 point level for the first time. “Berlin, this is Madrid calling, we have lift off”. Evidently Spain will need, as I have been arguing for some weeks, a bailout in full order, so what are they waiting for? As I jokingly told the FT’s Miles Johnson, are they trying to prove they can get to 8% before asking? After all, the Olympics are about to start, and Spain has a strong team of athletes.
In a more serious vein I have been thinking this weekend about just what it is which is driving market sentiment at this point.
In the first place I think a major mistake was made following Friday’s Euro Group Finance Ministers conference call in not spelling out in clear and plain English that the Spanish MoU stipulated that the bank recapitalization would eventually become a direct one from the ESM to the banks. Reuters summarized the atmosphere as follows: “Even with euro-area finance ministers signing off on providing aid of as much as 100 billion euros to Spanish banks, the officials continue to squabble over whether the burden of the emergency loans will be assumed by the Spanish government or the banks”.
Uncertainty over this key issue was not lessened on Thursday when even as the Bundestag were voting the bailout TV screens across the globe showed images of one German politician after another informing their interviewers that there was no question whatsoever of the money not being ultimately the responsibility of the Spanish state. As Frank-Walter Steinmeier, parliamentary floor leader for the SPD, a party which is a likely coalition member following next year’s election, said ahead of the vote, “There will be no direct path from the Spanish aid to permanent recapitalization of banks, at least not with us.”
This is the heart of the issue that is stressing markets, and the question is really quite a simple one. If the Spanish sovereign is going to have to accept responsibility for ongoing bank losses (and the final total will surely end up being much more than the 100 billion euros currently envisaged) then debt restructuring in Spain (beyond that already contemplated for those long suffering preference share and subordinated debt holders) will become inevitable. It may not arrive till 2015, but the markets will be able to see it coming today, so the roadmap has to be provided now. Unless it is a direct bank recap, Spain’s sovereign debt will simply become unsustainable, which is why it is now un-financeable.
On the other hand, take bank debt out of the equation and the whole picture changes. Spain still has plenty of problems, but medium term sovereign insolvency may not be one of them. The cost of Spanish CDS can come down, even if that of the German equivalent goes up.
Now everyone will agree there is no substantial problem here once everything is agreed in principle, and we have a road map and time scale for banking union. But despite the small print in the MoU everything still isn’t agreed in principal in crystal clear fashion – people are still arguing about whether it is state debt or bank debt – and there is no roadmap. Indeed, to accept that Spain will eventually get direct bank aid you have to believe that a large number of German politicians are systematically lying to their population, and will only let them know the harsh truth after the constitutional court ruling.
Indeed, according to the Austrian newspaper Handellsblat, German Parliamentarians are becoming aware of the tight corner they are putting themselves in in front of their electors, and are instigating a Parliamentary investigation to see whether Finance Minister Schaüble has given them all the necessary information. It reminds me of marital infidelity – many of those being cheated on pretend to themselves they don’t know they are being lied to.
I’m not sure whether markets prefer to believe the former argument (only state aid) or the latter (they’re all lying), since if it is the latter, and Germany is being held up as an example to the rest, well………….
Even before I read the news that the IMF may stop funding Greece in September I was thinking we had a long complicated summer ahead of us. Now I’m sure we do.
The 4th World Congress of the Game Theory Society is taking place at Bilgi University in Istanbul this week. Today’s appropriately-named Nobel Panel, which will feature four laureates, including John Nash, reminded me of a research note that grabbed a lot of attention a couple of weeks ago.
Bank of America Merrill Lynch strategists David Woo and Athanasios Vamvakidis devise the canonical Prisoner’s Dilemma between Germany and Greece, where the former’s options being Eurobonds and No Eurobonds, and the latter’s Austerity and No Austerity. In the Nash equilibrium of this game, the two countries do not cooperate, meaning that Greece will not undertake austerity and Germany will not OK Eurobonds.
This simple construct ignores many real-life complications. Besides, I have argued beforethat fiscal austerity is the problem rather than the solution. But it does capture the main problem that neither side is able to pre-commit credibly to the solution that would make both better off (Austerity, Eurobonds). Note that fiscal union would be the enforcement mechanism that would ensure each country lived up to its promises.
Woo and Anthanasios then calculate the costs and benefits of a voluntary exit from the Eurozone for the major core and periphery countries. They try to estimate the chances for an orderly exit as well as the impact on growth, borrowing costs and the country’s balance sheet following an exit.
Their analysis is only a simplification, but the results are striking. First, while everyone is expecting Greece to exit first, Italy and Ireland have the highest incentives to leave. Italy has a good chance of an orderly exit and stands to benefit from competitiveness, growth and even balance sheet gains. On the other hand, while it is the country most likely to achieve an orderly exit, Germany has the lowest incentive to leave, as it would suffer from lower growth, higher borrowing costs and a negative balance sheet effect.
Using these payoffs, the strategists then devise a three-period game, where Italy first decides whether or not to exit. If it doesn’t, Germany could pay her to stay and then Italy again decides to stay or leave. The Nash equilibrium of this game is for Italy to exit in the first period.
It seems, therefore, that game theory does not predict a bright future for the Eurozone.
Interest Group Politics and the Decline of Nations
Sometimes you read one thing in isolation and it doesn’t make much impression, but then you read something else and the pieces click together. That was the case for me this week with two disparate articles on how nations select leaders.
The first was written by Jon Huntsman, former Governor of Utah, Ambassador to China, and Republican presidential candidate. During the GOP primaries, Huntsman’s candidacy was distinguished by two things: An unusually high ratio of sense to nonsense during the debates, and an unusually low number of votes at the polls. Now he is free to speak out. In a Financial Times comment this week entitled “True Conservatives Despise America’s Crony Capitalism,” he wrote that Republicans should do the following:
- Protect America’s economic dynamism by rolling back the power of incumbent business and political interests
- Reform the tax code by closing loopholes and flattening individual rates
- Open markets to allow clean fuels to compete with gasoline and diesel
- Reform the financial system so that the country is not held hostage by banks that are too big to fail
- Instead of pointlessly ranting against “Obamacare,” start slogging toward alternative healthcare solutions, with an emphasis on cost control measures like ending fee-for-service medicine
- Make sure defense budgets are driven by long-term strategic threats, not lobbyists
- Endorse term limits for Congress, campaign finance reform, and an end to the revolving door that blurs the distinction between regulators and regulated
Great ideas, all of them, but in the unlikely event Huntsman had won the nomination, how many of these points would he have dared to hammer away at in his campaign speeches? How much money would his Super PACs have brought in if he had openly backed all of them?
China, like the United States, needs structural reforms. It has a housing bubble that is proving hard to deflate in an orderly manner, a fragile financial system, and a distribution of income that is becoming ever more unequal. Pei doubts that the leadership is up to dealing with these issues.
Of course, China’s political system is different from that of the United States in many ways. Where China has a one-party, authoritarian government with scheduled changes of leadership, the United States has a two-party, democratic government with scheduled changes of leadership. Beneath these obvious differences, though, there are similarities.
Pei thinks China’s problem lies in the fact that it does not select leaders on the basis of demonstrated abilities, but rather, on the basis of political patronage and ties to powerful interest groups. He writes that the most damaging effect of this Byzantine system is a “leadership prone to factional compromise, even policy paralysis.” That is why China has failed to undertake much-needed economic reforms to rebalance its economy.
The problem that afflicts both countries is one that Mancur Olson wrote about in The Rise and Decline of Nations. As economies grow strong and political systems mature, leadership becomes more and more beholden to coalitions of special interests that are more interested in dividing up the pie than in enlarging it or improving the quality of the stuff it is filled with. Once interest group politics becomes entrenched, nations decline.
It has been a quarter of a century now since Olson wrote that book. In the United States, factionalism has hardened and policy paralysis has become the norm. Over the same period, China has had a run of success that Olson could hardly have imagined, but it, too, is showing signs of the same factionalism and paralysis. In both countries, very different but equally flawed systems for selecting leaders exacerbate the problem.