TheEconomist: Old maid
THE Spanish debt deal may relieve the short-term pressure on the country's financial system but one thing it doesn't do is reduce the country's debt burden. And that is a persistent theme of the crisis; in most countries, there has been no deleveraging at all. Rather than destroy the debt, we have reshuffled it; initially from struggling homeowners to banks, then from banks to governments, and then from weak governments to stronger ones.
It is rather like the game of Old Maid, where the loser is the player who ends up with the Queen of Spades; we all try to pass on the card to someone else. Why not write off the debt entirely? That has happened in the past; for example there was the Hoover moratorium on war reparations in the early 1930s and, more recently, there has been the forgiveness of what used to be called third world debt.
But it is easiest to forgive the debt if it is concentrated in a few small countries or if there is one strong country (like America in the mid-20th century) which can afford to take the hit. What we have now is a debt crisis in much of the rich world; what Jerome Booth of Ashmore dubs HIDCs (highly indebted developed countries). We can afford the default of Greece but not Spain or Italy. Or to go back to the analogy, we have a pack with a dozen Old Maids rather than just one.
And if we do write off the debt, who takes the hit? Not, by and large, top-hatted capitalists but the taxpayers of other nations, explicitly or implicitly. States clearly stand behind the ECB, the various bailout funds and the IMF. And if most of the rest of the debt is held by banks, insurance companies or pension funds, then any hit to their balance sheets may end up being replenished by the taxpayer.
This is why this is such a pernicious problem. There is no "solution" to the debt crisis that is pain-free; we are merely arguing about how the pain is distributed. Who ends up with the Old Maid?
The problem of subordination
THE Spanish debt deal has pleased the equity markets this morning although a lot of the details are yet to be known. One issue that has cropped up elsewhere is what happens to private sector creditors when official creditors get involved; what usually happens is that the official bodies get seniority. that creates a problem of subordination; official help may make it clear that the private sector won't get paid back. That can cause capital flight.
The loan is being made, it seems, to the Fund for Orderly Bank Restructuring (FROB) and will be added to Spanish government debt. If it comes via the European Stability Mechanism, as has been suggested, such a loan would get seniority (as IMF loans are presumed to have). So normal bondholders would be subordinated. And we have seen from Greece what happens when government debt gets restructured; the private sector takes the first hit.
Meanwhile here is Rabobank on the potential effect on Spanish bank bondholders.
This bailout is a step in the right direction in terms of the bigger picture. However, it looks unlikely that bondholders can walk away from this in one piece. At the very least, as has been the custom since 2008, any bank in the EU that accepts state aid has to submit a restructuring plan to the EC, and has to impose losses on bondholders, via coupon deferral (Upper Tier 2 and Tier 1), and not calling debt (all subordinated debt). This would be the minimum, and yet have very limited impact.We would expect increased focus/pressure on subordinated bondholders to accept principal losses as a consequence of this bailout, as we saw at the Irish banks. This could be done by a (semi-coercive) liability management exercise. There are a few problems with this, not least: (a) the quantum of subordinated debt in the small Spanish banks is not significant, and was recently reduced by the trend of liability management exercises; (b) a not insignificant amount of this subordinated was sold to retail investors. In the good old days before Basel III, the mutual cajas could raise their capital ratios by selling junior subordinated debt to their retail clients. Spanish politicians might not be so keen on burdening these ‘taxpayers’, some of whom would also face losses on their shareholdings in banks, such as those who participated in Bankia’s IPO last year.Such is the limited size of subordinated debt at the banks in Spain, however, we fear that the government or the IMF (who are tasked with overseeing the process) may look further up the capital structure, to unsecured creditors and uninsured depositors. This is precisely how the bail-in Directive proposes banks that receive state aid should be treated. The crucial difference is that the EC bail-in plan is drafted to be enacted as a European-level regime, imposed by a central European authority, and backed by a Eurozone deposit guarantee fund, and presumably a EU-wide bank tax. Such centrality would mean that the political elements of bailing-out a bank, and bailing-in its creditors are neutralised. In this instance, however, such conditions could be the cause of conflict between Spain and its Euro partners, without the benefit of the mutuality of fiscal burden sharing, or Euro deposit guarantees.
Of course, bondholders would have suffered anyway if the Spanish banking system had collapsed; the Irish case also indicates that it seems unconscionable for the public to suffer massive cuts so that bondholders get bailed out. Nevertheless, the reason why they bailed out the Irish bondholders was because of the fear of contagion; bondholders in other countries may panic when they see what happens elsewhere.
And while we are on the subject of contagion, Greek voters may see the unconditional nature of the Spanish loan as a sign, either of favouritism, or that the Germans will blink in the face of financial catastrophe. That may encourage them to support the anti-bailout parties. This would be an irony as the signs are that the Spanish deal was rushed through to reassure the markets before the Greek vote.
The scorecard, part three
A WEAK economy causes government finances to deteriorate, but then as a government goes into deficit, automatic stabilisers (eg, unemployment benefits) are supposed to kick in to support output. Governments may add deliberate stimulus measures on top. So I thought it would be interesting to have an (unscientific) look at how the two relate, using the OECD figures.
Here are the cumulative GDP changes from 2008 through 2012 (using the OECD estimate for this year) and the change in the government financial balance over the same period.
Cuml GDP ch (%) Cuml deficit (% of GDP)
Germany + 3.4 9.5
US + 3.2 46.9
France + 0.6 27.8
Spain - 3.8 38.9
Portugal - 6.2 32.5
Italy - 6.1 18.1
Greece - 17.8 52.8
Ireland - 9.0 73.9
Euro area - 1.0 21.8
Britain - 2.0 42.1
Japan - 1.1 38.5
OECD ave + 2.8 30.6
At the extremes, we see what we might have expected. The second biggest rise in deficit was in Greece, which has also seen the biggest fall in GDP; Germany has had the smallest deficit, and the best GDP performance. But it is a far from uniform picture in the middle. The US has seen the second biggest cumulative deficit but the second best GDP growth. Italy has the fourth worst decline in GDP, but the second smallest rise in deficits.
We can attempt to disentangle the effect of deliberate government policy by looking at the cyclically-adjusted financial balances (ie, numbers that allow for the recessionary effects on spending and taxes). So here are data for the same countries on that basis. A caveat here - the figures are as a proportion of potential GDP, not actual GDP (so don't necessarily square with the numbers in the above table) and are taken from the IMF.
Cuml GDP ch (%) Cum cycl def (% of GDP)
Germany + 3.4 7.8
US + 3.2 33.4
France + 0.6 20.8
Spain - 3.8 33.4
Portugal - 6.2 26.3
Italy - 6.1 12.4
Greece - 17.8 51.1
Ireland - 9.0 46.8
Euro area - 1.0 17.5
Britain - 2.0 35.7
Japan - 1.1 35.7
OECD ave + 2.8 25.9
The US deficit numbers look less extreme on this basis, and have delivered, you could say, a lot more bang for the buck than similar deficits in Britain or Japan. But this is still a very rough-and-ready calculation; fiscal stimulus depends on the change in the balance from one year to another, and may only work with a lag. So here is one further scorecard. There are 12 countries, or groups of countries, above; we can rank them in quartiles by the change in the cyclically-adjusted balance and then the change in GDP in the same or following year. (ie what effect did have a bigger/smaller deficit in 2010 have on output in 2010 or 2011?) Did stimulus or austerity have the predictable effect?
Same year GDP % Next year %
Loosest policy 0.0 -1.1
Second quartile -0.4 0
Third quartile -0.8 -0.3
Tightest policy -1.5 -2.1
Now there is a bit of double-counting in here (because we have individual countries, as well as Euro area and OECD averages) so this is not to be taken too seriously. But in the same year numbers, you can definitely see the effect Keynesians would predict. The picture is not quite as clear for the subsequent year (oddly, because I would have expected the lagged effect to be greater) but the tightest policy stances did result in the worst outcomes.
