Monday, March 28, 2011

Fiscal sanity: Time to end special treatment of government debt!

Greek financial minister George Papaconstantinou's recent diatribe against rating agencies illustrates the pernicious mentality that got Greece into deep financial problems and national bankruptcy. He wants to avoid the discipline of the market place, getting special loan pricing with rates that do not reflect true credit risk. He cannot live with objective transparency in Greek public finance. Market priced sovereign credit is critical to fiscal sanity and proper allocation of resources.

Since governments make the laws and appoint the regulators, there is substantial political moral hazard to abuse credit allocation, create financial pyramids and bubbles rewarding political constituencies and buying votes to assure re-election at expense of the future. Greece is case in point.

The country was middle income and emerging market, but 'baptized' within the Eurozone as a 'developed country' with a mispriced credit rating. The trade imbalances worsened severely, people lived beyond their means - many in bloated state sector jobs with salaries far in excess of the private sector - and the public debt levels became out of control, rising to Ponzi levels. The political system encouraged the consumption priding itself on the rise in living standards that was largely financed by "cheap" debt with a shrinking productive base.

There was the EU stability agreement designed to impose fiscal discipline and avoid 'free-loading' the system, but politics got in the way of serious enforcement. Core countries like France and Germany were the first to set a bad example by flaunting the rules. The ongoing Greek statistics blame game is superfluous when Greek accession to the Euro was fudged from the beginning with the blessing of the European Commission because the currency union was seen a political unification project and they wanted the widest participation possible.

The Eurozone is now moving to fried ice cream where core countries like Germany are overheating but periphery laggards like Greece are insolvent and in deep recession.  ECB's President Trichet even suggests some topping syrup in the form of higher interest rates that might help price stability in Germany but send Greece to outright default with losses on core country banks.  Even the ECB balance sheet carries toxic Greek sovereign debt securities which the CDO market prices with deep discounts for longer maturities.

The IMF-ESM backstop facility to Greece adds to Greek debt along with the short-term debt market where the ECB buys Greek securities from the Greek banks. The Greek crisis is treated as a liquidity problem but in the immediate future, the public debt levels continue to increase to even more alarming levels whilst the tax base is imploding with the deep recession. The theory that Greece is a rich country with lots of tax evaders is largely a euphemistic illusion in self denial to support this kind of thinking. At the current rates of VAT including substantial increase on food and fuel taxes, everyone in Greece effectively pays already substantial taxes and these taxes are a huge drag on the private economy together with the government using the Greek banks for short term funding.

The Greek banks themselves are deteriorating financially with growing loan losses from the recession and the toxic Greek debt securities. Just recently the IMF has asked the Greek government to implement a Euro 30 billion guarantee to backstop the banks. So contingent liabilities are also on the rise. In short, the EU is creating an ever growing mountain of debt.

In the same spirit, many would like to increase this mountain of debt with the introduction of Eurobonds, a subterfuge for more mispriced credit to EU laggards based on cross guarantees from the core countries. Woe to any rating agency that might eventually downgrade Eurozone core countries for the rising contingent liabilities from such a system!!! The Eurocrats would be tempted to send them to the guillotine!!!

Whilst the fear of debt deflation is understandable, getting out this Ponzi debt pyramid situation depends on a miracle of unexpected growth that just does not seem realistic. In the case of Greece, the required economic growth rates to pare down its 125-130% GDP (still rising) debt levels would be sustained double digit levels that exceed China!!! The EZ is rapidly moving to a situation between a rock and a hard place.

It is time that that governments end their games of voter deception with mispriced credit and subsidies on sovereign debt. They should revise the Basel Accords to include loan reserves on sovereign debt, insist on stringent sovereign debt credit rating and avoid the temptation of Eurobonds that would add to the contagion risk and credit mispricing that already plagues the system.

The only road to fiscal sanity in the EU is market priced sovereign credit and a period of painful loan restructuring and credit writedowns, with possibly (suggested by Nouriel Roubini) some monetization through quantitative easing and lower exchange rate to temper the shock of the debt deflation.

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