[THS] John Mauldin: The Risks from Fiscal Imbalances

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Thoughts from the Frontline Weekly Newsletter
The Center Cannot Hold
by John Mauldin
May 7, 2010

In this issue:
The Risks from Fiscal Imbalances
The Challenge for Central Banks
Bang, Indeed!
The Center Cannot Hold
A Decent Employment Report
Montreal and New York and Italy


Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the center cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

- William Butler Yeats

Last week we focused on the first half of a paper by the Bank of International
Settlements, discussing what they characterized as the need for "Drastic measures ...
to check the rapid growth of current and future liabilities of governments and reduce
their adverse consequences for long-term growth and monetary stability." As I noted,
you don't often see the term drastic measures in a staid economic paper from the
BIS. This week we will look at the conclusion of that paper, and then turn our
discussion to the fallout from the problems they discuss, initially in Europe but coming
soon to a country near you.

But first, what a week in the markets! I'm sure more than a few investors felt like
they had a severe case of whiplash. We will discuss the volatility a little more below.

...

The Risks from Fiscal Imbalances

Today we are going to return to a paper from the Bank of International Settlements,
often thought of as the central bankers' central bank. This paper was written by
Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli. (
http://www.bis.org/publ/work300.pdf?noframes=1 )

The paper looks at fiscal policy in a number of countries and, when combined with
the implications of age-related spending (public pensions and health care),
determines where levels of debt in terms of GDP are going. The authors don't mince
words. They write at the beginning:

"Our projections of public debt ratios lead us to conclude that the path pursued by
fiscal authorities in a number of industrial countries is unsustainable. Drastic
measures are necessary to check the rapid growth of current and future liabilities of
governments and reduce their adverse consequences for long-term growth and
monetary stability."

Let me briefly sum up last week's letter. They wrote: "Today, interest rates are
exceptionally low and the growth outlook for advanced economies is modest at best.
This leads us to conclude that the question is when markets will start putting
pressure on governments, not if.

"When, in the absence of fiscal actions, will investors start demanding a much higher
compensation for the risk of holding the increasingly large amounts of public debt
that authorities are going to issue to finance their extravagant ways?"

I reproduced graphs that projected interest-rate payments as a percentage of GDP
rising rather dramatically over the next 30 years, to levels that, quite frankly, cannot
be tolerated by the markets. Long before we get to the place where we in the US are
paying 20% of our GDP in interest (which would be about 80% of our tax collections,
even with much higher tax rates) the bond market, not to mention taxpayers, will
revolt.

The paper's authors clearly show that the current course is not sustainable. And to
get back to a level of debt-to-GDP that countries "enjoyed" as recently as 2007
requires such massive structural surpluses as to boggle the mind. And that is with
rather optimistic growth assumptions that, as I will show in a few pages, are not very
likely.

You can read last week's letter at
http://www.2000wave.com/article.asp?id=mwo043010. The discussion of the BIX
paper is in the last half of the letter.

Now, we come to the section where they talk about the risks associated with the fiscal
deficits. And by the way, we should note that 25 of 27 European countries are
running deficits in excess of 3% of GDP. Ireland has a deficit of 14.3%. Portugal is at
almost 10%. Greece is almost 14%.

Here is a table from my friends at Variant Perception in London, from data from The
Economist. Notice that France is over 8%. Germany is almost 6%. Wow. We'll look at
the implications of this later.

image001

The first risk is of course, higher interest rates brought about by what they term
increased risk premia. In essence, investors want to get paid more for their increased
risk. Interest on Greek debt for 5-year bonds is now 15%. There is no way for them
to grow their way out of the problem if interest rates are at 15%, up almost fourfold
in less than a year. Rates are rising for other European peripheral countries as well.

The second risk "... associated with high levels of public debt comes from potentially
lower long-term growth. A higher level of public debt implies that a larger share of
society's resources is permanently being spent servicing the debt. This means that a
government intent on maintaining a given level of public services and transfers must
raise taxes as debt increases. Taxes distort resource allocation, and can lead to lower
levels of growth. Given the level of taxes in some countries, one has to wonder if
further increases will actually raise revenue.

"The distortionary impact of taxes is normally further compounded by the crowding-
out of productive private capital. In a closed economy, a higher level of public debt
will eventually absorb a larger share of national wealth, pushing up real interest rates
and causing an offsetting fall in the stock of private capital.

"This not only lowers the level of output but, since new capital is invariably more
productive than old capital, a reduced rate of capital accumulation can also lead to a
persistent slowdown in the rate of economic growth. In an open economy,
international financial markets can moderate these effects so long as investors remain
confident in a country's ability to repay. But, even when private capital is not
crowded out, larger borrowing from abroad means that domestic income is reduced
by interest paid to foreigners, increasing the gap between GDP and GNP."

This squares solidly with the work done by Rogoff and Reinhart, showing that when
the debt of a country reaches about 100% of GDP, there is a reduction in potential
GDP growth of about 1%. As I have written elsewhere, government debt and
spending do not increase productivity. That takes private investment. And if
government debt crowds out private investment, then there is lower growth. And
that is what the Rogoff and Reinhart study clearly shows.

And finally, the BIS authors note the risk that a government cannot run deficits in
times of crisis to offset the affects of the crisis, if they already are running large
deficits and have a large debt. In effect, fiscal policy is hamstrung.

The Challenge for Central Banks

Interestingly, the authors worry that one of the real problems central banks may face
is that inflation expectations may become unanchored in the absence of a willingness
on the part of the government to show fiscal constraint. Without some evidence of
that willingness, monetary policy could lose any ability of be effective.

In other words, no matter how much the people at the Fed might like to help in a
crisis, they may not be able to do anything effective if the US government does not
deal with its deficits.

"A second mechanism by which public debt can lead to inflation focuses on the
political and economic pressures that a monetary policymaker may face to inflate
away the real value of debt. The payoff to doing this rises the bigger the debt, the
longer its average maturity, the larger the fraction denominated in domestic
currency, and the bigger the fraction held by foreigners. Moreover, the incentives to
tolerate temporarily high inflation rise if the tax and transfer system is mainly based
on nominal cash flows and if policymakers see a social benefit to helping households
and firms to reduce their leverage in real terms. It is, however, worth emphasising
that the costs of creating an unexpected inflation would almost surely be very high in
the form of permanently high future real interest rates (and any other distortions
caused by persistently higher inflation)."

The head of the European Central Bank, Jean-Claude Trichet, made it very clear this
week that the ECB is not going to be buying Greek bonds. In my recent discussion
with Richard Fisher, president of the Dallas Fed, it was also made clear that the
current leadership of the Fed knows it cannot print money. So who is the BIS looking
at when they talk about the temptation to inflate?

The Bank of England comes to mind. Also Japan. And a number of smaller European
central banks. Countries that would not mind their currencies falling, especially if the
euro continues to slide. As the BIS notes, the temptation is going to be large. But
there is no free lunch. Such things can spiral out of control and either end in tears or
in a Paul Volker wrenching the economy into serious recession. I think the final
sentence of the paragraph quoted above serves as a warning that such a policy
dooms a country to even worse nightmares.

Now we come to the conclusion of the paper. Normally, I do not like to quote at
length, but these next six paragraphs deserve it (again, all emphasis mine):

"Our examination of the future of public debt leads us to several important
conclusions. First, fiscal problems confronting industrial economies are bigger than
suggested by official debt figures that show the implications of the financial crisis and
recession for fiscal balances. As frightening as it is to consider public debt increasing
to more than 100% of GDP, an even greater danger arises from a rapidly ageing
population. The related unfunded liabilities are large and growing, and should be a
central part of today's long-term fiscal planning.

"It is essential that governments not be lulled into complacency by the ease with
which they have financed their deficits thus far. In the aftermath of the financial
crisis, the path of future output is likely to be permanently below where we thought it
would be just several years ago. As a result, government revenues will be lower and
expenditures higher, making consolidation even more difficult. But, unless action is
taken to place fiscal policy on a sustainable footing, these costs could easily rise
sharply and suddenly.

"Second, large public debts have significant financial and real consequences. The
recent sharp rise in risk premia on long-term bonds issued by several industrial
countries suggests that markets no longer consider sovereign debt low-risk. The
limited evidence we have suggests default risk premia move up with debt levels and
down with the revenue share of GDP as well as the availability of private saving.
Countries with a relatively weak fiscal system and a high degree of dependence on
foreign investors to finance their deficits generally face larger spreads on their debts.
This market differentiation is a positive feature of the financial system, but it could
force governments with weak fiscal systems to return to fiscal rectitude sooner than
they might like or hope.

"Third, we note the risk that persistently high levels of public debt will drive down
capital accumulation, productivity growth and long-term potential growth. Although
we do not provide direct evidence of this, a recent study suggests that there may be
non-linear effects of public debt on growth, with adverse output effects tending to
rise as the debt/GDP ratio approaches the 100% limit (Reinhart and Rogoff (2009b)).

"Finally, looming long-term fiscal imbalances pose significant risk to the prospects for
future monetary stability. We describe two channels through which unstable debt
dynamics could lead to higher inflation: direct debt monetisation, and the temptation
to reduce the real value of government debt through higher inflation. Given the
current institutional setting of monetary policy, both risks are clearly limited, at least
for now.

"How to tackle these fiscal dangers without seriously jeopardising the incipient
recovery is the key challenge facing policymakers today. Although we do not offer
advice on how to go about this, we believe that any fiscal consolidation plan should
include credible measures to reduce future unfunded liabilities. Announcements of
changes in these programmes would allow authorities to wait until the recovery from
the crisis is assured before reducing discretionary spending and improving the short-
term fiscal position. An important aspect of measures to tackle future liabilities is that
any potential adverse impact on today's saving behaviour be minimised. From this
point of view, a decision to raise the retirement age appears a better measure than a
future cut in benefits or an increase in taxes. Indeed, it may even lead to an increase
in consumption (see eg Barrell et al [2009] for an analysis applied to the United
Kingdom)."

Bang, Indeed!

I had a discussion today with Jonathan Tepper of Variant Perception in London. We
agree that the risk that no one talks about is the level of foreign investment in some
of these countries and the consequent rollover risk. By this we mean that when a
bond comes due, you have to roll over that bond into another bond. If the party that
bought the original bond wants cash to invest in something else, or just does not
want your bond risk anymore, you have to find someone to buy the new bond.
Greece has a large number of bonds coming due this year. It is not just the new
debt; they have to find someone to buy the old debt. And that is why they need so
much money.

But it is not just a Greek problem. About 45% of Spain's debt is owned by non-
Spanish, and they need to roll over old debt and new debt of 225 billion euros this
year alone. That is bigger than the entire GDP of Portugal. Spain cannot finance this
internally. But will foreigners buy 100 billion euros and, if so, at what price if they are
not convinced that Spain will enact serious austerity measures?

Listen to ECB Governing Council President Jean-Claude Trichet (hat tip to Greg
Weldon):

†"As regards fiscal policies, we call for decisive actions by governments to achieve a
lasting and credible consolidation of public finances. The latest information shows
that the correction of the large fiscal imbalances will, in general, require a stepping-
up of current efforts. Fiscal consolidation will need to exceed substantially the annual
structural adjustment of 0.5% of GDP set as a minimum requirement by the Stability
and Growth Pact....

"The longer the fiscal correction is postponed, the greater the adjustment needs
become and the higher the risk of reputational and confidence losses. Instead, the
swift implementation of frontloaded and comprehensive consolidation plans, focusing
on the expenditure side and combined with structural reforms, will strengthen public
confidence in the capacity of governments to regain sustainability of public finances,
reduce risk premium in interest rates and thus support sustainable growth."

This is a man who wants some serious austerity. No garden-variety cuts here and
there. And that brings us to the heart of the problem. That chart a few pages above
showed the large fiscal deficits involved. If those are tackled seriously, it will put
many countries into outright recessions and reduce the growth in others. Some, like
Greece, will be in what can only be called a depression.

The entire eurozone †is in for a double-dip recession, if it is not there already. And
one country after another is going to have to convince foreigners to buy its debt. But
if they make the cuts, their GDP will fall, ironically increasing their debt-to-GDP ratio
and making investors demand even higher rates, which becomes a very vicious
spiral.

And the banks that do own that debt will suffer liquidity problems unless the ECB
steps forward with a new program in a massive way - which Trichet is currently
resisting.

As Reinhart and Rogoff wrote: "Highly indebted governments, banks, or corporations
can seem to be merrily rolling along for an extended period, when bang! ñ
confidence collapses, lenders disappear, and a crisis hits."

Bang is the right word. It is the nature of human beings to assume that the current
trend will work out, that things can't really be that bad. The trend is your friend until
it ends. Look at the bond markets just a few months before World War I. There was
no sign of an impending war. Everyone "knew" that cooler heads would prevail.

We can look back now and see where we made mistakes in the current crisis. We
actually believed that this time was different, that we had better financial
instruments, smarter regulators, and were so, well, modern. Times were different.
We knew how to deal with leverage. Borrowing against your home was a good thing.
Housing values would always go up. Etc.

The Center Cannot Hold

Sovereign debt was a good idea only a little while ago. Take cheap money, lever up,
and make a nice spread. And now, not so much a good idea. Credit spreads are
widening all over Europe. Interest rates are rising for the European periphery.

We once again find ourselves on a Minsky Journey to a rather fraught Minsky
Moment. Hyman Minsky famously taught us that stability breeds instability. The more
things stay the same, the more complacent we get, until Bang! We always seem to
think this time is different, and it never is.

The Minsky Journey is where investment goes from what Minsky called a hedge unit,
where the investment is its own source of repayment; to a speculative unit, where
the investment only pays the interest; to a Ponzi unit, where the only way to repay
the debt is for the value of the investment to rise.

Greece is now at its Ponzi moment of financing. As John Hussman pointed out this
week, if interest rates are at 15% when you roll over debt, and your country is not
growing, you have no way to actually service the debt. And thus, the Minsky Moment
when the markets walk away. Bang! †From Hussman's letter:

"The basic problem is that Greece has insufficient economic growth, enormous
deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP
(over 120%), accruing at high interest rates (about 8%), payable in a currency that it
is unable to devalue. This creates a violation of what economists call the
"transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt
has to have a well-defined present value (technically, the present value of the future
debt should vanish if you look far enough into the future).

"Without the transversality condition, the price of a security can be anything investors
like. However arbitrary that price is, investors may be able to keep the asset on an
upward path for some period of time, but the price will gradually bear less and less
relation to the actual cash flows that will be delivered. At some point, the only reason
to hold the asset will be the expectation of selling it to somebody else, even though it
won't be delivering enough payments to justify the price.

"Unless Greece implements enormous fiscal austerity, its debt will grow faster than
the rate that investors use to discount it back to present value. Moreover, to bail out
Greece for anything more than a short period of time, the rules of the game would
have to be changed to allow for much larger budget deficits than those originally
agreed upon in the Maastricht Treaty."

And if Greece has further problems, the market will look at Spain (and Portugal and
Ireland). In order for Spain to continue to get financing, the market must believe
they are going to make a credible effort at austerity measures. And because they
need so much foreign financing, that moment may be sooner than we now think, as
their rollover risk is massive. If Spain gets slapped, then who will be next?

There are examples of countries that have worked their way out of even worse
problems and have done so without default. But those examples always came with
currency devaluation and higher inflation. The eurozone countries cannot devalue
their currencies. The risk in Europe is that the austerity measures bring about
deflation, which makes the debt an even greater burden.

Look, I want the eurozone to succeed. I love Europe and look forward to my family
vacation in Italy this June. But I think we have to be realistic and acknowledge that
the European leadership has a very tough set of problems. As does Japan, as does
Great Britain, as does the US, etc.

To argue that the US can decouple from Europe's problems doesn't hold water with
me. We are clearly in recovery, but we are going to need all the help we can get.
And a Europe falling into what could be a serious recession is not a Europe that buys
our goods. And with the euro on the way to parity (along with the pound) we will
have to compete with their exporters. The latter half of this year, I think the US slows
down. Then the 2011 tax hikes kick in.

I still think there is at least a 50-50 chance of renewed recession, and with it a serious
bear market and rising unemployment. I hope I am wrong but, as I have been
writing for some time, you should see this as a trader's market and, with a few
exceptions, be wary of being long only.

Montreal and New York and Italy

I am home for most of May. I have a 24-hour trip to Montreal to be with Tony Boeckh
for his private Club X conference. Tony will be the author of next Monday's Outside
the Box, where he will discuss the themes of his new (and should-be bestseller) book,
The Great Reflation. I also get to go out and party when I land there with David
Rosenberg. That should be fun!

The following week I am back in New York for a day, then two nights in Stamford,
Connecticut, speaking to Pitney Bowes execs, and then home, where I will stay until
June 3, when the whole family (seven kids and spouses, grand-babys) takes a
vacation to Italy for two weeks.

I am going to stay over and speak at the Global Interdependence Center Conference
in Paris June 17th and 18th, with my good friend David Kotok and other luminaries.
There will be a lot of central banker types, and if you want to get a feel for what's
happening in Europe you should come. Information is at www.interdependence.org.

We have been planning (or Tiffani has) for the Italy trip. I really can't wait, as it's
going to be a ton of fun. It has been over 25 years since I was in Italy, and that was
just a few days in Rome and Venice. This time it's two full weeks, with a week in
Rome and Venice and then a week in Tuscany, then to Paris, and then back to
Tuscany and Milan.

Your ready for a vacation analyst,

John Mauldin
John at FrontLineThoughts.com

Copyright 2010 John Mauldin. All Rights Reserved