The PIIGS "Extend And Pretend" Period Is Winding Down

The near financial failure of Greece in April 2010 nearly caused a global panic.  Fortunately (depending on your point of view) the European Central Bank stepped in with a systemic bailout of the entire banking sector.  A rescue was put forth for Greek debt, and the crisis was nearly forgotten.

The intention of the Greek bailout, as well as the Irish and soon to be Portuguese, was never about fixing the structural problems.  Greece and the other PIIGS (Portugal, Ireland, Italy, Greece, Spain) simply have too much debt compared to post-recession revenue potential.  The entitlements that were created on the back of cheap common-currency financing were/are unsustainable.

So the bailout was simply a mechanism to allow Greece to continue to pay some of its bills while it began to unwind parts of those entitlement liabilities.  This was absolutely necessary because, as the thinking goes, any credit restructuring and bondholder losses would lock Greece out of the financial markets.  That would be the end of this attempt at crisis avoidance since Greece, and the other PIIGS, continues to have massive structural deficits that can only be sustained by outside lenders.

So, to summarize, the PIIGS have to have time to unwind financial commitments in an orderly fashion, i.e., austerity.  At the bailout maturity (only two years left for Greece) it is expected that Greece will have its fiscal house in order.  But no one in their right mind believes that expense cuts will be enough on their own.  It is fully expected that economic growth will have returned to enhance revenue, and reduce the burden of austerity.  The Greek plan was sold to the public with extremely rosy assumptions, to put it mildly.

We find this simple assumption in every single government/central bank plan.  There is this implicit assumption that economic growth will return and it will take the burden off of some really tough decisions. 

The infection of these “extend and pretend” plans is so widespread that should there not be enough global growth, the downside is almost unfathomable.

First and foremost, look no further than the expectations for the United States federal government.  At the end of 2009 the CBO projected federal revenues to be $2.67 trillion in 2011.  That would have been a 23% increase over 2010, but miracles do occur.  The government was counting on a robust recovery to alleviate fiscal stress and a growing backlash to “stimulus”.  It never came.

By the end of 2010 the CBO reduced its revenue projection for 2011 to $2.23 trillion – 17% short of its original estimate.  The effect on the projected deficit was obscene:  the 2009 estimate allowed federal budget officials to proclaim a fiscal deficit under $1 trillion for 2011.  With the updated estimates, the deficit for 2011 grew to $1.48 trillion, or 51% more than first claimed.  This is not a small mistaken assumption (nor was it unintentional).

But we shouldn’t worry too much since federal revenue is still projected to grow at robust rates in 2012 and 2013.  The government just needs a little more time until the real recovery finally arrives.

Unfortunately, investors are no longer buying this recovery story.  Portugal’s debt prices have imploded as bond investors have finally had enough of the “wait and see” game.  It has infected Belgium, Spain and even the US (were it not for the Federal Reserve’s bond purchases who knows where interest rates would be).

What we are really talking about here is time.  The policymakers keep trying to fight against the clock to create more space while investors are losing patience with a weak “recovery”.  As more and more marginal investors shift assets toward more productive and profitable alternatives (commodities) existing bondholders get hit with price declines.  Those existing bondholders are really just banks.

That is what the entire global “extend and pretend” policies are designed for:  the global banking system. 

Remember whom it was that was buying all of this PIIGS debt after the Greek inflammation:  European and American banks.

They believed that the ECB would backstop any potential losses since the ECB (and now the Fed) would buy the sovereigns back from them if the situation got worse.  This is nothing more than moral hazard in action, brought on by the “stimulative” low interest rate policies the world over.

Banks engaged in classic risk-seeking behaviour because they needed an alternative to mortgage bonds to rebuild profit margins.  Once mortgage bonds (European banks were heavily into US structured finance) got shut out of the repo market (they were no longer viewed as good collateral) banks needed a leveraged alternative.  Sovereign debt was the logical choice, especially with a central bank backstop.

So any flare up in the sovereign crisis has the potential to re-ignite the credit crunch of 2007/08.  We have already seen Ireland and Portugal get shut out as repo collateral without much effect.  But should Spain or Italy go down that path the banking system would be in jeopardy, again.

However, time is no longer a luxury in the face of a growing backlash to bailouts on both sides of the equation.  Germany is actively resisting unlimited funding, even going so far as to mention an end to the funding revolving door.  Meanwhile Irish, Greek and Portuguese populations have begun to resist bailout terms.  In other words, these parties are beginning to erode the time component of “extend and pretend”.

Is the financial system really better equipped to handle a paradigm shift in collateral structure?  If Greece, Ireland and Portugal are early examples, then the answer is a resounding “no”.  A world awash in liquidity is no safeguard from fear (see 1937).  Excess money will simply find other uses, leaving the source of trouble gasping for funds.  Just look at the US housing market today.

Market discipline is brutal and unforgiving.  Central banks and world governments keep trying to circumvent it, but that discipline may yet prove to be the only real foundation for long-term, productive economic expansion.  Without it we may simply experience one crisis after another, in an endless string of fear and anger.

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