July 19th, 2012
in Op Ed
by Michael Pettis
Last night I arrived at my family’s home in Spain just in time to catch Spain play Italy. The whole family and lots of friends watched it, while feeding on great seafood and lots of wine, at a neighboring chiringuito on the beach, and I guess if you weren’t there you can only imagine the excitement. I suppose this spectacular win by Spain means that Spain will be able to stay in the euro a little longer than I otherwise expected, although I am not so sure about Italy.
It would make sense for me to start off with some foot-ball related comments, but instead most of the this issue of the newsletter will attempt to describe the way pro-cyclical behavior can be embedded into balance sheets, and how this can create significant risk for developing countries especially. Because most analysts do not seem to understand balance sheet dynamics, it is worth pointing out that the more pro-cyclical the balance sheet, the much more widely off-the-mark projections are going to be – both on the way up and on the way down.
To start off, in mid-June, just a couple of days before the Spanish treasury raised €2.2 billion in an auction – one in which the cost of borrowing surged, with 10-year bonds breaking 7% – France’s new president complained about the unfairness of the financial markets. According to an article two weeks ago the Financial Times,
“It’s not acceptable that Spain, which just got a promise for support, has interest rates around 7 per cent,” Mr Hollande said. “It’s not acceptable that countries that are making efforts, like Italy, to improve their public finances,” were paying high interest rates on their bonds.
It would be useful if policymakers (and not just in France) had an understanding of how markets actually work. Hollande is effectively complaining that markets are reacting not to what policymakers propose they will do but rather to something else, and he believes that this is unfair, even unacceptable.
But clearly it isn’t. Since that “something else” to which the market is responding is the underlying process of balance sheet unraveling, and this is happening no matter what policymakers might say in the G20 meetings or elsewhere, it actually makes a lot of sense that markets overall continue to deteriorate.
Last Friday, continuing I think the confusion between the politics and economics of the crisis, Reuters had the following:
Yet though the obstacles facing the euro are daunting, the main lesson of the debt crisis so far is that markets underestimate at their peril the political commitment of Europe’s leaders to do what is necessary to preserve the single currency.
“The euro crisis is in some ways mind-bogglingly simple to solve … because it isn’t economics, it’s politics,” Jim O’Neill, chairman of Goldman Sachs Asset Management, told Reuters. ”If Angela Merkel and her colleagues stood there together with the rest of the euro area … and if they behaved as a true union this crisis would be finished this weekend,” he added.
I am not sure what O’Neill means by Europe’s behaving like a “true union”, but if he means Europe’s immediately becoming the United States of Europe overnight, which is certainly not a mind-bogglingly simple policy to implement, then the euro part of the euro crisis will certainly end. What won’t end, however, is the need to write down a staggeringly large amount of bad loans and to cover the banking losses with transfers from the housing sector, nor the rapid slowdown in growth even in countries like Germany.
This, I would argue, is more than just about politics, and that while “the political commitment of Europe’s leaders to do what is necessary to preserve the single currency” may indeed be quite high, in disagreement with the author of the article I would suggest that overestimating the impact of this commitment is at least as perilous as underestimating it. The market reaction is no longer, nor should it be, about the lack of trust or confidence.
Why? Because yet another agreement for a temporary bailout of Spain will do little to address Spain’s real problems, which are its massively insolvent banks, its uncompetitive economy, and the fact that the country is caught in the downward spiral typical of debt crises in which every sector of the economy, not least its political elite, are acting in ways that systematically undermine growth and creditworthiness. The continued deterioration in Spain and elsewhere is now part of a fairly mechanical process that operates under its own dynamic, and it will take a lot more than exhortations to reverse the process (and it was noteworthy that a lot of comments and advertising during last night’s game explicitly tried to tie a Spanish victory with a boost in confidence sufficient to turn the corner of the crisis).
We need more than trust
But what the market needs is not for investors to start trusting policymakers more. Rather it needs actions that reverse the downward spiral in which countries like Spain find themselves, in which each sector of the economy – from workers to creditors to businessmen to middle class savers to policymakers themselves – are rationally and in self-defense acting in ways that increase the country’s debt, reduce growth, and exacerbate balance sheet fragility.
Unfortunately there isn’t much that can be done in a big enough or credible enough way to reverse the downward spiral, and this is why I don’t pay too much attention any more to the proposals and counterproposals that are on offer in Europe. I think it is probably too late for that, but certainly by continuing to behave as if this is all about trust, or lack of trust (or, for the more conspiratorially minded, about underhanded actions by speculators hoping to bring the system down), policymakers are building in their own disappointment and extending the crisis.
At this point the only thing that can save the euro is a combination of moves in which the European banks are guaranteed by a credible institution and in which Germany takes steps to stimulate its economy quickly and dramatically. Until Germany is willing to boost domestic spending enough to run a deficit that allows Spain to run a surplus, it is impossible for Spain to repay its debt. This is just basic balance-of-payments arithmetic.
Of course within days of Hollande’s complaint that the market didn’t trust policymakers, events showed just why the markets would have been anyway wrong to grant policymakers their trust. Here is the Financial Times just four days later:
Leaders of the eurozone’s four largest economies pledged on Friday to back a €130bn growth package and defend the common currency but remained divided over the credit crisis as Germany continued to resist proposals to issue common debt and use bailout funds to stabilise financial markets.
The meeting in Rome was intended to demonstrate a coming together ahead of next week’s EU summit, but ended in disagreement over the need for short-term intervention in the markets and how to achieve political and financial union.
At a joint press conference Angela Merkel, German chancellor, declined to endorse affirmations by all three of her co-heads of government – Italy’s Mario Monti, François Hollande of France and Spain’s Mariano Rajoy – of the need to use the eurozone’s bailout funds to “stabilise financial markets”.
I don’t want to be too glib here. I recognize that policymakers are in an extremely difficult position and that there is no longer any easy solution, but railing at the markets rather than trying to understand why they are doing what they do (which anyway makes them far more rational than if they responded to the pronouncements coming out of Brussels) is counterproductive. In fact this kind of pouting is just a part of the self-reinforcing downward spiral that I have described many times before. Policymakers are complaining that economic agents are behaving in ways that reinforce the crisis, even as they do the very same thing.
Given all the excitement over the speed of the deterioration in European markets, I suppose we are going to see urgent new measures announced and a temporary respite in the crisis, but ultimately I think this will be little more than a blip on the way to sovereign debt restructuring and the break-up of the euro. Nothing has changed fundamentally in Europe in the past few weeks and there is no reason to assume that the crisis is on its way to being resolved.
About the Author
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Shenyin Wanguo Securities (HK). Pettis has an impressive work history on Wall Street, Latin America, Europe and Asia (see his blog China Financial Markets for a complete bio).