THE BRADY BUNCH

DERICKOO

THE BRADY BUNCH
With Portugal, with its poor growth prospects and insufficient domestic savings to fund the public-sector deficit, looks like Greece. And Spain clearly has to grapple with its own Irish problem, namely a huge housing over-hang – and probably large losses in the banking sector – following the collapse of an out sized real-estate bubble. The problems of Portugal and Spain might be less severe than those of Greece and Ireland, but this apparently is not enough to induce investors to buy their government debt.A danger these countries share is thus the acute danger of large-scale runs on their banking systems.

Investors trying to exit first have been made whole. Holders of Greek debt maturing now are repaid courtesy of the €110 billion bailout program, and holders of Irish bank bonds have been given a guarantee by the Irish government, whose promises have in turn been underwritten by the EFSF. With The EFSF will also provide funds to ensure that Irish banks’ depositors can get their money back today.For example, the Spanish banking sector alone has short-term liabilities of several hundred billion Euro. To return to the cinema analogy: investors know that the exit is not large enough to allow them all to squeeze through at the same time. So each one want to be among the first to get out.

Official line so far has been “no default,” meaning no sovereign default or that of any bank can be considered. If this line is to be maintained, the exit door must immediately be made much wider, and huge fire extinguishers must be brandished. The International Monetary Fund and the European Central Bank must show investors that they have enough funding to finance the simultaneous exit of all short-term investors.

It could work. A show of overwhelming force might restore calm to the markets. But it is a risky proposition: if investors exit nonetheless, the required funds might be so large that creditor countries’ taxpayers’ revolt.

The problem with this approach is that it creates the wrong incentives. Investors have now learned that the first to sell will avoid losses. The situation resembles that of a crowded cinema with only one exit. Everyone knows that in case of fire, only the first to leave will be safe. So, if the exit is small, even the faintest whiff of smoke can trigger a stampede. But if the exit looks comfortably large, the public will be much more likely to remain calm, even if parts of the room are already filling with smoke.

For the financial market, the size of the exit depends on the funds available to make short-term investors whole. Unfortunately, the size of the EFSF looks inadequate to finance a collective exit by short-term investors.

When the EFSF was created, it was assumed that the only problem was to ensure financing for the government deficits of the four prospective problem countries (Portugal, Ireland, Greece, and Spain). From this perspective, the headline figure of €750 billion allocated to the EFSF looked adequate.

A danger these countries share is thus the acute danger of large-scale runs on their banking systems. So far, investors trying to exit first have been made whole. Holders of Greek debt maturing now are repaid courtesy of the €110 billion bailout program, and holders of Irish bank bonds have been given a guarantee by the Irish government, whose promises have in turn been underwritten by the EFSF. The EFSF will also provide funds to ensure that Irish banks’ depositors can get their money back today.

Already facing sluggish growth before fiscal austerity set in, the so-called “PIGS” (Portugal,
ireland, Greece, and Spain) face the prospect of a “lost decade” much as Latin America experienced in the 1980’s. Latin America’s rebirth and modern growth dynamic really only began to unfold after the 1987 “Brady plan” orchestrated massive debt write-downs across the region. Surely, a similar restructuring is the most plausible scenario in Europe as well.It sometimes seems that the only eurozone leader who is willing to face the likely prospect of future debt restructuring is German Chancellor Angela Merkel.The Greek and Irish bailouts are only temporary palliatives: they do nothing to curtail indebtedness, and they have not stopped contagion. Moreover, the fiscal austerity they prescribe delays economic recovery.
The idea that structural and labour-market reforms can deliver quick growth is nothing but a mirage. So the need for debt restructuring is an unavoidable reality.

Even if the Germans and other creditors acquiesce in a restructuring – not from 2013 on, as German Chancellor Angel Merkel has asked for, but now – there is the further problem of restoring competitiveness. This problem is shared by all deficit countries, but is acute in Southern Europe. Membership in the same monetary zone as Germany will condemn these countries to years of deflation, high unemployment, and domestic political turmoil. An exit from the European may be at this point the only realistic option for recovery.

First, governments should not be pushed into insolvency just to save all banks. This means that the Irish government (maybe the next one) should demand that holders of bank bonds share the losses, perhaps by offering them a simple debt-equity swap.

Doubts about the Irish government’s solvency would then disappear quickly, and its guarantee of bank deposits would no longer look so shaky. Something similar might have to be done for the Spanish banking system’s exposure to the local housing market.

The second component of a permanent anti-crisis mechanism is a floor for bond prices – and thus a ceiling for losses. The yields and volatility of longer-term bonds should then fall relative to short-term securities, allowing peripheral governments to finance themselves reliably and at reasonable cost.

None of this would resolve Europe’s fundamental problems, namely weak fiscal positions, poorly functioning financial sectors, and lack of competitiveness. But all of them would be easier to manage with calmer financial markets.

To put it into simple form
With huge private debts, falling house prices, and external claims on Ireland amounting to more than 10 times national income there was never going to be an easy way out. Allowing European debt problems to fester and grow by sweeping them under the carpet through dubious theatrics can only make those problems worse.

Here is where the latest Irish bailout is particularly disconcerting. What Europe and the IMF have essentially done is to convert a private-debt problem into a sovereign-debt problem. Private bondholders, people and entities who lent money to banks, are being allowed to pull out their money en masses and have it replaced by public debt. Have the Europeans decided that sovereign default is easier, or are they just dreaming that it won’t happen?

The European policy-makers seek to move from one stage of denial to another, perhaps it is time to start looking ahead more realistically. As any recovering alcoholic could tell them, the first step is admitting, with Merkel, that Europe has a problem????

oscarBravo

Not political theory material, and doesn't meet the standards for a thread starter anyway.