Lender's Folly (Full Version - Part 2)

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Continued from here.

Third, it makes no sense to blame the recipients of the capital inflows for causing the crisis. If enough money is sloshing around willing to invest in any stupid idea, you shouldn’t be too surprised that a lot of stupid ideas get funded. When, for example, Wolfgang Schaeuble, Germany’s finance minister, says:

The reasons for Greece’s problems can be attributable only to Greece and not to actors outside the country, and certainly not in Germany.

As he did during the press conference following his meeting with Yanis Varoufakis, his Greek counterpart, we have to remember that Schaeuble is talking nonsense. It’s logically impossible for excess borrowing to occur unless there is someone sufficiently reckless (or stupid) to provide the financing.

The problem with Schaeuble’s assignment of blame is that it prevents optimal solutions that are best for the majority of Europeans, Greek, Spanish, and German alike. Pettis:

An awful lot of Europeans have understood the crisis primarily in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility. This interpretation is intuitively appealing but it is almost wholly incorrect, and because the cost of saving Europe is debt forgiveness, and Europe must decide if this is a cost worth paying (I think it is), to the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost.

In fact, Pettis thinks that, if anything, it was net lenders in Germany and the Netherlands who were responsible for what happened, rather than borrowers in Ireland or Greece or Spain:

It would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time. It would be even more remarkable, had they done so, that they could have all sucked money out of a reluctant Germany while driving interest rates down. It is very hard to believe, in other words, that the enormous shift in the internal European balance of payments was driven by anything other than a domestic shift in the German economy that suddenly saw total savings soar relative to total investment.

That shift, in turn, is connected to anaemic wage growth and even weaker domestic consumption in Germany.

Fourth, it matters how your obligations are structured. Many smart people, most notably Daniel Davies, have argued that the headline numbers surrounding Greece’s public debt burden are irrelevant to understanding the situation in Greece. As Davies puts it:

The total figure for “Greece’s Debt Burden” is an economically meaningless number. Everyone knows it is going to be restructured at some politically convenient time in the future; it simply can’t be paid back, and so it simply won’t be. So increasing the size of the debt outstanding by 2.5 now just means that you increase the size of the writeoff in the year two-thousand-and-something by the same amount. Concentrate on the flows and only on the flows — the stocks are no longer a useful quantity to think about.

But the focus on flows misses the impact of the structure of the debt stock on the incentives of private sector lenders and producers, writes Pettis (our emphasis):

The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value.

Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value (this rather obvious point is almost never implemented because economists have difficulty in conceptualizing and modelling reflexive behavior in dynamic systems).

Rather than let economists work out the arithmetic of the restructuring based on linear estimates of highly uncertain future cashflows, whose values are themselves affected by the way debt payments are indexed to these cashflows, Greece and her creditors may want to unleash a couple of options experts onto the repayment formulas and allow them to calculate how volatility affects the value of these payments and what impact this might have on incentives and economic behavior.

This is why Pettis thinks Varoufakis’s plan to swap existing Greek debts for obligations indexed to GDP is a good idea that ought to be expanded to other countries, including Spain and Italy. The appeal of these GDP-indexed obligations is that they give creditors an incentive to support investments in future growth.

That’s very different from the current setup, where the Troika has every incentive to tie its funding to the willingness to implement austerity programmes. Even if those programmes boosted productivity in the long term by shifting resources away from the state, the behaviour demanded by the euro area’s official sector creditors exacerbates the cyclical weakness.

The good news, though, is that a different liability structure that encourages additional investment could instantly lead to stronger growth given the reforms that have already occurred. Moreover, a large-scale restructuring should encourage lots of new investment even if it also wipes out many existing creditors, at least if they are done soon. As Pettis puts it:

There is overwhelming evidence — the US during the 19th Century most obviously — that trade and investment flow to countries with good future prospects, and not to countries with good track records. The main investment Spain is likely to see over the next few years is foreign purchases of existing apartments along the country’s beautiful beaches.
Once its growth prospects improve, however, with among other things a manageable debt burden, foreign businesses and investors will fall over each other to regain the Spanish market regardless of its debt repayment history. This is one of those things about which the historical track record is quite unambiguous.

That leads to the fifth point: euro area officials are running out of time. Patience may be a virtue in some situations, but not when it comes to crisis resolution and debt restructuring. That’s especially true when you appreciate the difference between “financial crises that occur within a globalization cycle and those that end a globalization cycle.”

The past few years have been a golden opportunity for even the dodgiest borrowers to raise capital at low spreads, because the rich world (where most foreign investment comes from) has been awash in savings searching for a decent return. Under current conditions, there would be plenty of investors eager to jump in and finance investment in Greece, Spain, Ireland, etc if they dramatically restructured their debts. Just think of all the “dry powder” burning holes in the pockets of the private equity firms (and their LPs!), or the bond investors searching, but not finding, decent rates of return in their home country. After all, if Ecuador can do it…

Pettis reminds us that it’s always been this way. Germany was surprised at how easy it was for France to raise the money necessary to pay its 1871 reparations — a bill worth more than 20 per cent of France’s annual GDP. In fact, “the French indemnity actually increased global liquidity by expanding the global supply of highly liquid ‘money-like’ assets.”

The Weimar government also had an easy time securing credit from American and other lenders to cover its own reparations half a century later once hyperinflation had wiped out its domestic debts.

But sometimes the timing is rough. The boom in lending to Latin America funded by petrodollars in the 1970s had a very unhappy ending because the 1980s were a period of relatively high rates in America and Europe, not to mention lower commodity prices. The combination was a disaster for the debtors who had borrowed in dollars.

We at Alphaville have no insight into the future of monetary policy or global liquidity here or in Europe. But we wouldn’t be surprised if it turned out that the optimal window for restructuring, even if you leave aside the political implications of persistently high unemployment, could soon close. Something for the can-kicking eurocrats to keep in mind.

Finally — and you should have figured this one out by now — nothing about the euro crisis is particularly new. All of this has happened before and all of it will (probably) happen again. There isn’t any need to understand radical new financial products or technological innovations or world-historical changes in politics to figure out why everything blew up. Historical literacy and/or a decent model of capital flows in a fixed exchange-rate system would have been more than sufficient.

In fact, one of our favourite books about finance and economics — Pettis’s The Volatility Machine — has basically everything you need to know about the euro crisis even though it was written before the euro had even launched. (The appendix on the relationship between option pricing and credit risk is worth the price of admission alone, in our view.)

No wonder he writes in his latest article that “the current European crisis is boringly similar to nearly every currency and sovereign debt crisis in modern history.”

The source.