European Leaders Look for a Lifeboat

 

Takeaway

  • European governments have few remaining options to avoid default
  • To purchase enough sovereign debt, Germany could soon have to start running the printing presses

The consequences of excess debt are now facing the leaders of Europe head on. Excess debt leads to a long chain of D-words: Deleveraging in an attempt to retire debt results in a depressed economy and declining asset prices. The depressed economy breeds private debt defaults that in turn produce distressed banks. The chain then runs through depositor flight from the banks, producing a financial crisis and in turn a devaluation of the currency as capital flees. When foreign goods become more expensive there is a declining standard of living as import prices rise faster than wages. Then in an effort to stop the government debt trap, there is a default on promised entitlements under an austerity program leading to the swift defeat of the political leaders. But ultimately there is a sovereign default or a restructuring of the government debt. Most, if not all, the D-words are visiting Europe at the moment and its leaders are falling by the wayside.

At this point, the remaining options to avoid reaching the tipping point to the D chain are few, and the decisions to be made are momentous. The options are: submit to what the market is doing to you; take the lead and offer a debt restructure at a fractional payout; or run the printing presses to purchase enough sovereign debt necessary to contain the market yields. Halfway measures such as the European Financial Stability Facility (EFSF) no longer buy even a day’s worth of market forbearance.

It certainly must be crossing the minds of the Euro leaders that there are consequences for being at the helm when the ship goes down. The alternative is to orchestrate your own departure, which was cleverly done by Papandreou in Greece by calling for an austerity referendum. In Italy, Silvio Berlusconi’s departure was orchestrated quite literally, as reported by Reuters

“Italians sang, danced and drank champagne in the streets to celebrate the resignation of scandal-plagued billionaire Silvio Berlusconi, and an impromptu orchestra near the presidential palace played the Hallelujah chorus from Handel's Messiah”.

Not even in my most Machiavellian thoughts had I conceived of the possible value of being “scandal-plagued” as a means to a back-door retreat from an uncomfortable situation. Given its frequency among politicians it seems to be an undervalued asset in politics. But the strategy doesn’t seem to fit Ms. Merkel, so she is stuck at the helm of the ship of state and is looking for a life raft.

We have reached the point where government bluff, bluster and promises no longer control the markets, and criminal indictments for those at the helm are no longer theoretical. If it is not possible to orchestrate an early exit, it would seem the only remaining life raft is the printing press — but that would not be easy for the German government to do out in the open.

The monetization of government debt is undoubtedly being conceived of as only a bridge to buy time to form a tighter Euro fiscal union with strict budget discipline.

Expect some inconsistent pricing in the market by those willing to bet on inflation hedges and those simultaneously willing to bet on deflation hedges. What must be most maddening to a deflationary hawk is the assets of choice in that circumstance, long-term government bonds, are at the very heart of the problem and are not the solution to protecting one’s portfolio. Nor is it the solution to the inflation hawks either. So the questionable sovereigns go begging among private investors with only the central bank as a friend.

Read the full version of this article, as well as other economic insights, at Professor Lew Spellman’s blog, The Spellman Report.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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