The Political Economy of the European Sovereign Debt Crisis

Includes: ERO, EU, EUO, FXE, IEV
by: Edward Harrison

With austerity implementation measures likely to pass the Greek parliament today, the move toward a French bailout plan is likely. Yesterday I was on BNN talking about the Greek bailout. Let me provide more extensive commentary here in the context of today’s European political economy.

The Framework

The framework I use when thinking about political economic systems is oriented around my belief that the status quo is relatively stable in large hierarchical societies. By that I mean, a number of human psychological traits have evolved to maintain an existing order until its utility has completely disintegrated. Deference to authority, the inertia of commitment, compulsion for consistency, the allure of confirmation bias, the norm of reciprocity, social proof, deference to authority – these are all psychological norms that aid the maintenance of order and the status quo.

When I started this blog three years ago I hypothesised about this in populist terms in a post about kleptocracy in large hierarchical societies. I am not that fond of ‘populism’ or class-based paradigms, so I looked at this as a pure hypothetical. Since I wrote that post, however, much of what has occurred in response to the credit crisis has confirmed the basic framework from it.

I wrote:

The problem is: these more stratified, more complex societies are in essence Kleptocracies, where those in power re-distribute societal wealth to themselves. Those at the bottom of the society's pyramid accept this unequal, non-egalitarian state of affairs because they too benefit from their society's relative advancement. It's a case of a rising tide lifting all boats.

[Jared] Diamond says the Kleptocrats maintain power using 4 different methods:

"1. Disarm the populace, and arm the elite."

"2. Make the masses happy by redistributing much of the tribute received, in popular ways."

"3. Use the monopoly of force to promote happiness, by maintaining public order and curbing violence. This is potentially a big and underappreciated advantage of centralized societies over noncentralized ones."

"4. The remaining way for kleptocrats to gain public support is to construct an ideology or religion justifying kleptocracy."

…The key is to use the four methods to gain popular support in order to re-distribute as much wealth to the ruling class as the populace will support. If the ruling class takes too much, it will be overthrown and replaced by a new ruling class (which in turn will re-distribute wealth to itself using the same four methods).

What I believe has happened is that the credit crisis has made plain how much re-distribution of wealth to economic elites has occurred and people are up in arms about this. Rather than dialling back the income distribution to more tolerable levels, the ‘elites’ have attempted to address this by making use of Diamond’s four methods to varying degrees. But this has been ineffective.

I see a certain inevitability about this due to the self-reinforcing norms that support the status quo. I expect the same dynamic to continue to play out in North America and Europe until the existing order is stabilised or we have some sort of economic collapse like the Great Depression which ushers in a ‘new order.’

Now obviously, there are the issues of economic efficiency and fairness to think about. However, I want to sidestep those and look at this from a pure forecasting perspective. I am sticking to the tack I began in October 2010 with “Less Policy Advocacy and More Policy Forecasting at Credit Writedowns”.

Framework applied in Europe

At the end of the day, what people want to know is who is insolvent and who isn’t. Once they know, they can fight over who takes the losses. And those creditors that cannot take the losses will have to be recapitalised or resolved. Everyone else gets to live another day.

-Stuffing bondholders in Greece and Ireland

If I had to simplify the sovereign debt crisis to one sentence I would say this: As some euro zone sovereign debtors are near insolvency, a liquidity crisis has begun in which various ‘creditors’, the various national taxpayers and bondholders, must fight to determine how to apportion the losses.

This is not a zero sum game, however, because the magnitude of the losses also depends on how various actors play their hands. For example, austerity decreases output and the likely losses. A unilateral default followed by panic and contagion would so as well. The players know this and are trying to play their hand in order to maximize their own narrow interests.

The question is whether some sort of Nash equilibrium exists where everybody is made better off. I am sceptical because banks enjoy the advantages elites always have in greater access to political power. Likely they will get policy makers to push for a lesser share of losses for banks until the system heals or breaks apart. For example, this is why you hear the ECB and the banks predicting a European Lehman if Greece is allowed to default. The goal is to make the present bailout path more palatable.

As I indicated on BNN, Nicolas Sarkozy has been deft in getting a French person installed at the ECB as a quid pro quo for allowing Mario Draghi to become its head. And he has been equally effective in getting Christine Lagarde, his finance minister installed at the head of the IMF. In that sense, France now has greater input throughout the Troika institutions, the ECB, the EU, and the IMF, now dictating terms on bailouts, restructurings and defaults in Europe. And clearly, as the French banks are very exposed to potential defaults in the periphery, there will be enormous pressure on the Troika through their French representation to accede to the interests of the French banks. Again, I am not advocating a position here. I am trying to forecast likely scenarios.

The bottom line is that the Troika is likely to shade policy responses toward the interests of the French banks, allowing them to delay a default and extract as much in principal and interest as they can before that default occurs.

The French proposal

I see the French proposal in line with this. When I first heard the outlines of that proposal I wrote:

I like this deal because it transfers some of the credit risk to the core banks and also sees some maturity extension and interest rate reduction. And it is in line with my expectations. "I expect a soft restructuring sometime in 2011 followed by a certain degree of dithering and a hard restructuring down the line in part to avoid a credit default event. This also gives more time for planning and recapitalization since many EU banks are expected to fail the stress tests."

-My Thoughts on the French Restructuring Plan for Greece

The banks are still on the hook for a large percentage of the money and for a longer period at a relatively low interest rate. Yet, while this is a soft restructuring, the details are definitely more favourable to the banks than the headline. A recent guest post at Zero Hedge on the Greek debt rollover has the details. Here are the main points I took away from that post:

  • Banks will be able to get 30% of their invested money upfront as only 70% of the funds committed to existing Greek bonds will be rolled over.
  • Greece will only receive 71% of the funds rolled over as a large percentage of the monies will be used to enhance the credit of the special purpose vehicle used to emit the bonds that replace the existing Greek debt.
  • Greece will therefore have a funding gap which then falls onto the Troika and the taxpayers which support them.

The bottom line is that the banks will still be exposed to losses on Greece but their loss risk is lessened by this deal. Meanwhile, Greece still must deliver on an austerity package, which is not credible or likely to be politically acceptable for long.

My conclusions

The French plan is another example of Europe’s extend and pretend strategy. And while Marshall and Warren Mosler have a plan, which is qualitatively different, I am sure they would readily admit there is little chance that this plan will be implemented. I would go further and say that the extend and pretend strategy is inevitable because that’s how large hierarchical systems respond to crisis. Seeing this, I also understand this is the template we are likely to see going forward for Ireland and Portugal as well.

Eventually, the extend and pretend approach will fail after successive rounds of the same policy response in Greece, Ireland and Portugal. Eventually, a combination of four things will occur:

  • the people in the periphery countries will rise up and overthrow the existing order forcing a default;
  • the poor economy that austerity entails will force leaders to move to the hard restructuring route as fiscal consolidation fails
  • markets become skittish about Spain or Italy, which cannot be bailed out. So EU leaders will cut Greece loose
  • popular unrest in core countries against bailouts grows so severe that they force a hard restructuring or default

The point for policy makers is to socialise enough of the bank losses onto taxpayers in order to recapitalise the banks, survive the crisis and maintain the status quo. Taxpayers will accept this if the economy is robust enough. As an investor, you should see this as an uncertain political situation. More than most. That means avoiding periphery sovereign debt until the situation stabilizes.

So, with that as background, here is the link to the BNN appearance where I don’t go to anywhere near the detail I provided here. But I still think it was a good show. See: Headline : June 29, 2011 : Greek Austerity Vote & Bank of America Settlement