Tito's Blog

Euro Government Bonds Monthly Redemption Calendar 2012

Now you can scare your friends at dinner hinting at the hundreds of billion euros of government debt coming due every month in Europe in 2012. Happy new year!

Source: Goldman Sachs via ZeroHedge.

Two Scary Thoughts On #itadefault

At 500bps, CDS on Italian public debt implies an annual probability of default of 6.8%. Compounded over 5 years, that would be a 30% chance of default in the next 5 years.

We all know what the track record of the market is in predicting large defaults (Lehman, Iceland, Dubai, MF Global, Greece).

If the Italian government decided to suddenly appropriate from its citizens bank accounts (something that was done in 1992, and is now officially denied) for example an average €1000 per person, infants included, that would bring €60 billion.

That would be enough to cover 8-10 weeks of public debt refinancing, or to reduce debt/GDP ratio from 120% to 116%. You tell me if that’s enough to calm the markets.

MF Global Dies of Italian Bond Indigestion

Now we know that the sucker buying up Italian bonds was MF Global.

Italy can offer much tastier and healthier things to eat up rather than its government debt.

Deflation, or?

In the same week a received a 10%+ increase in my monthly rent for a spot in a parking silos in downtown Milan and a 7% fee hike from my cleaning service.

My deflationista stance is shaking.

Calling ECB’s Bluff

Nearly €70 billion of coupon and principal payments on Italian bonds are due in September 2011. I doubt that there is enough market appetite to meet this substantial supply at reasonable rates without the intervention of the ECB.

The Italian government doesn’t have the strength to craft a credible austerity cum structural reform package in the next few days (after not delivering it for 20 years). Confronted with market panic, the ECB will buy nevertheless.

First came excessive debt in the private sector. Then governments took over the private sector debt. Being the alternative so painful (disorderly default, banking system collapse, …), it is now the turn of the last balance sheet left (central banks).

Game Theory On The Eurozone Crisis

I’ve been thinking about the European debt crisis in game theory terms. Let’s assume for simplicity that there are only two players: a European core country (solvent government and banking system, current account surplus) “Germanland” and a European periphery country (insolvent government and banking system, current account deficit) “Greetaly”.

I think that the strategy matrix of this 2-player game would be the following:

Greetaly will be able to stay in the Eurozone and avoid major economic shocks (i.e. banking system collapse or adoption of a new devalued national currency) only if Germanland is willing to assume its debt and if Greetaly accepts to give up its sovereignty by implementing a fiscal policy imposed by its northern neighbor.

Even then, I believe that in order to have a stable economic scenario, Germanland would need to “double down” and agree to fiscal transfers (or a “Marshall Plan”) benefiting Greetaly, otherwise the depression in the periphery would create social tensions and increase the likelihood of Greetaly eventually choosing to exit the Eurozone.

The only real choice left to Greetaly is to either accept foreign-imposed austerity or to “press the red button”, i.e. choose to default and/or leave the Eurozone now.

Below is a possible payoff matrix for Germanland and Greetaly. What makes it interesting is that short-term and long-term payoffs are different.

Germanland might have a hard time to politically justify another round of bailouts and even more so to launch a “Marshall plan” (with negative short-term effects), but that would be the best choice in the long-term. The bailouts today represent the necessary cost of a solid export-driven economy at nearly full employment.

Similarly, Greetaly would suffer significant shocks in the short term if it decided to default and exit the Eurozone, but on average as a country it would probably enjoy a faster recovery thanks to suddenly higher competitiveness, growing exports, lower debt overhang (as Argentina did).

Given that political decisions tend to optimize short-term outcomes and because of the high short-term cost of the Eurozone exit decision by Greetaly, the most likely outcome is the suboptimal box highlighted in yellow. Both Greetaly and Germanland are worse off in the long-term than in the optimal box highlighted in green.

There is a dominant strategy in the long-term, which would be a decision by Greetaly to exit the Eurozone, although at an extremely high short-term cost.

How I Lost My Sovereignty

The European sovereign debt crisis seems to be developing along a path leading to accelerated political union of Eurozone nations. In part because it’s the relatively more benign option and in part because, at least initially, it offers the least-resistance, inertial option.

As a first step, key economic and fiscal policy decisions in debtor nations (Greece, Ireland, Portugal, Spain, Italy) are being made centrally by the European Central Bank and/or the European Commission under the direction of creditor nations (Germany, The Netherlands, Finland). In a surprisingly silent and passive loss of sovereignty, debtor nations are enacting substantial austerity measures as requested by their creditors.

In part, this development is positive because measures imposed on the European periphery also include important economic reforms that local politicians were too incompetent, shortsighted or corrupt to implement. Greece will finally improve its tax collection processes under the expert “technical guidance” of the troika. Italy will finally liberalize its labor/service markets and limit unfair economic rents extracted by heavily regulated guilds and professions. To paraphrase a famous quote by Winston Churchill quote, it appears that ClubMed governments will do the right thing, after having exhausted all possible alternatives.

On the other hand, such enormous fiscal tightening packages will represent a formidable drag to the periphery’s already modest growth. More austerity may reduce government spending, but will slow the economy and consequently tax receipts, possibly making the debt burden less manageable.

Creditor nations have driven monetary policy since the birth of the ECB, and are now driving fiscal policy as well. As Germany was struggling with a long recession, stagnating consumption and the difficulties of unification in the early noughties, Frankfurt-set monetary policy was too loose to contain inflation, real estate bubbles and loss of competitiveness in the European periphery. Economic policies in creditor nations pushed current account deficits onto debtor nations, bolstered exports and reduced unemployment at home. As the German export powerhouse is back above 2008 peak GDP levels with unemployment at a relatively healthy 7%, Frankfurt-set monetary policy is now tightening while Greece, Portugal, Spain and Italy have never grown back to their peak economy size, still have sluggish or non-existent growth and have high and increasing unemployment rates. To make things worse, Frankfurt-set fiscal policy will at the same time reduce government spending and tip the periphery back to recession.

With an 80% overall public debt over GDP ratio, the Eurozone as a whole would be in a better position than the US or Japan to manage its debt burden, if it completes its political integration at the expense of loss of sovereignty at the national level. Only if creditor nations agree on a framework of fiscal transfers to debtor nations and a full fiscal union through centrally-issued Eurobonds, can a depression in the European periphery be avoided. Although it is difficult to explain it to their local electorates, fiscal transfers would actually increase the likelihood of periphery public debt ever being paid back, though at the high political cost of higher unemployment in creditor nations (as the current account rebalances within Europe with higher inflation/lower exports/lower production in the core, and lower inflation/higher imports/higher production in the periphery).

The alternative to fiscal transfers is a depression in the European periphery, with (i) unbearably high unemployment leading to social tensions and (ii) higher risk of a self-fulfilling national banking system collapse due to rising bad debt, deposit withdrawal or financial panics. The combination of these two points increase the risk of the periphery “pulling an Argentina”, defaulting on its debt and abandoning the common currency, either because it eventually becomes the better alternative or because of national politics drifting to populistic or nationalistic excesses.