April 12, 2010
In a crisis, what seems initially radical and impossible to contemplate can quickly become consensus and mainstream.
The sands are shifting so quickly under our feet, a thought that can seem fanciful at breakfast can be plausible by lunchtime and become government policy by night.
Think about the economy and how we have moved. A few years ago, suggesting house prices would crash violently was dismissed by the mainstream as radical – the currency of ‘‘self promoters’’ and ‘‘cranks’’.
Similarly, in 2007/06 anyone who questioned the banks and their robustness was slammed as unpatriotic or naive. In September 2007 in The Generation Game, I described Anglo Irish as ‘‘an out of control hedge fund’’ that would ‘‘go bust’’.
The mainstream guffawed and rubbished this notion. Even late last year, questioning the wisdom of the euro as constituted at present for Ireland and Greece was equally looked on as radical.
The Economist magazine described my suggestion that the euro was not appropriate for every European country, Ireland included, as ‘‘plain potty’’. Guess what? This same magazine has spent the past few months questioning the wisdom of the euro, the very article of faith that was supposed to be its doctrine last November.
Now we can all be wrong and only an eejit thinks that he has any monopoly on the truth, but time and again in a crisis, the only rule seems to be that there are no rules. And, if we adopt an almost childlike curiosity and flexibility to problem solving, we can sometimes get closer to the outcome than if we dismiss the unthinkable because our adult mind has told us that this is not possible.
Another way to look at this is – as the Prussian military genius Von Clausewitz stated – ‘‘the best laid military plans never survive the impact of the enemy’’.
Therefore, we would be wise to embrace the notion that everything is unpredictable and what is ‘‘outside the box’’ today can be ‘‘inside the tent’’ tomorrow.
Interestingly, once an idea gains credence the opposition to it falls away, which may have more to do with human nature and that thing about success having many fathers while failure is an orphan. As a result, there can be contagion in ideas as well as in financial markets.
New ideas, like new paradigms in markets, can spread rapidly to become conventional wisdom.
Armed with these few observations, let’s consider why banks or nations default on their obligations. Defaulting sounds off the wall, but it happens regularly. Until recently there was no real suggestion that Greece might do such a thing.
However, Greek bonds are now trading at an interest rate of above 7 per cent. This is higher than Icelandic bonds, implying that the financial markets believe a country in the euro, which has met every debt interest payment so far, is a greater risk than a country outside the euro, which has defaulted on everything. By the way, it is also higher than Colombia – a country with a history of defaulting.
A recent book called ‘This Time Is Different: Eight Centuries of Financial Crisis, by Ken Rogoff and Carmen Reinhardt, two famous US economic professors, evidences that since 1945, the average time between a serious financial crisis and the default is three years.
There is a pattern in all crises and defaults, which is more or less the same in every country.
In the immediate aftermath of the financial crisis, the government believes that the national bond market can be used as a giant skip into which the sins of the past can be thrown. Debt begins to rise and if there is a banking crisis, the debts of the banks are transferred to the taxpayer.
This pushes up the debt to income ratio rapidly. But for awhile there is calm.
However, bubbling under the surface are doubts and these doubts trigger changes in what the authors call the ‘‘tolerance of debt’’.
The authors argue that once the debt to income ratio goes above 60 per cent of GNP, both the citizens’ tolerance of more taxes to pay the interest and the markets’ tolerance of politicians’ soothing words, begins to atrophy.
Greece is in this position now. For the Greeks the two alternative routes are whether to default now or wait for the German and IMF led bailout and contemplate what is called ‘‘internal devaluation’’, which means letting rising unemployment and falling wages bear the brunt of the economic pain.
We face the same choice. For the political elite these are just words, but for ordinary people unemployment and wage cuts are real.
My suspicion is that Greece will default. By this, I mean it will repudiate debt by renegotiating the terms of the debt simply because the population won’t tolerate the hardship associated with unemployment and rising prices. Greece also realises that the financial markets are forgiving. They are forward-looking.
What happens if this occurs? Well, it changes the game. If Greece defaults in the euro, the precedent is set. Ireland is likely to be next because we are now firmly in the danger zone where debt to income is above 60 per cent and exploding. Examine these figures: In 2008 our debt cost â‚¬1.5 billion to service. This figure had jumped to â‚¬2.5 billion in 2009 – an increase of â‚¬1 billion, or 66 per cent.
But if you look at our debt servicing costs as a percentage of our tax revenues, the picture is much more worrying. In 2008 we spent 3.8 per cent of tax income on debt servicing. In 2009 that figure was 7.7 per cent, an increase of over 100 per cent year on year.
This trajectory gets worse. As a government’s income is reduced, it borrows more money to close the gap, which in turn, means a greater amount of tax will have to go on interest payments the following year, which will lead to a greater deficit.
Also, as the government is forced to use more and more of our money to pay off its debt, it becomes unable to invest in productive things that would increase the growth rate of the economy.
Today, our national debt stands at 57 per cent of our GNP. But after the bank bailout (â‚¬54 billion for Nama and â‚¬18 billion for Anglo) debt rises to 108 per cent of GNP. This is not counting the money for Bank of Ireland and AIB.
So quite apart from the deteriorating situation due to the gap between spending and revenues, 50 per cent of GNP is being spent on the banks.
The problem is that none of this spending increases the productive capacity of the nation. The government, by keeping the banks afloat with our money, is in fact investing in land. But land has no productive value. So all the money is spent and all the debt is amassed, but unlike other countries who have debts, we have no infrastructure to show in return. All we have is fields in Athlone, revamped golf courses and zombie hotels.
So are we headed for default?
I know this sounds like heresy now, just like property collapses, bank failures and problems in the euro sounded heretical in the recent past. But they happened. Again, events – once they move in a certain direction – tend to follow a similar path.
Take the following example, from my own experience in Russia in 1998. In June 1998, the IMF announced a bailout for Russia. At the time, the newspapers said that the crisis was over and the IMF had saved the day.
The main banks and brokers announced it was an opportunity to buy Russian bonds again.
However, a wily old investor called me and whispered: ‘‘Now is your last opportunity to sell’’. We did.
I sense that smart bond investors will use any putative EU bailout as the last opportunity to sell. The clumsy ones will buy, believing the government and brokers’ spin.
But as they realise that Greece’s problems haven’t gone away, the positive euphoria accompanying the EU bailout of Greece will dissipate.
When the bond market panic ensues, contagion will take hold and Ireland will be next.