The pigs, the Titanic, and Noah’s Ark

P.I.G.S. is the notorious acronym that was coined, in some Anglo-Saxon circles, at the time of the launch of the euro to denote the countries with worse public finances which would deserve to be shut out of the door (i.e Portugal, Italy, Greece, Spain).

In these days, the zoological characterization of  EMU members has been revived since sizeable spreads have appeared between the long-term interest rates on government bonds of those countries and the benchmark rate of the German Bund (for more details see E. Hugh in this site). A new “I” has joind the party, namely Ireland, breaking the coincidence between zoology and geography that originally made the P.I.G.S. game such an easy game to play. Latest news say in fact that the Irish spread is growing dramatically (see this site).  Rumours have also mounted that for this and some other countries, perhaps Greece – if not Italy – the burden charged by these spreads may bo so large that opting-out the euro and devalue the re-birth national currency may be more than a temptation. Some observers attribute the current dollar revaluation to markets attaching a non-zero chance to the whole euro-system collapse.

Other economists have noticed (e.g. W. Buiter) that, in principle, non-negligible spreads within the EMU are a sign of correct working of markets, given the non-negligible differences in sovereign debt stocks. As Buiter, with Corsetti and Roubini claimed at the very beginning of the euro enterprise, spreads may be a more effective way of imposing market discipline onto governments than formal rules and controls[1]. Much ado about nothing?

Yes and no. The problem is that the present time is not the right time to let markets alone impose discipline onto governments’ spending capacity. If spreads are part of the physiology of markets, markets now are not in a physiological state

Market spreads are efficient as long as market makers share realiable standards of value and operate in normal conditions of liquidity. None of these prerequisites hold at present. Standards of value are generally set by rating agencies. Standard & Poor’s has recently downgraded the sovereign debt of Greece, Portugal and Spain, thus fuelling the P.I.G.S. rally. But, Paul De Grauwe asks, “Is S&P still in the business of producing risk analysis? Should the rating agencies not have gone out of business after they told us for years that the risk associated with ballooning debt of banks and large companies was nothing to worry about? How can these agencies, which were systematically wrong in the past, have any credibility in whatever risk analysis they make?” (Financial Times, January 22.)”. Various considerations suggest that rating agencies and markets may be just over-reacting to past errors.

First, it is generally believed that it is now the time for a worldwide coordinated fiscal support to the real economy. The dramatic sequel of stock market crashes of  September and October has only come to a stop after consistent fiscal plans have been presented and approved in the US and Europe. Now everyone in the world seems to subscribe to the view that the problem is not the budget, the problem is the slump.

Second, starting from the US core of the hurricane, there should, and will, certainly take place an enormous take over of private debt with public debt. Both for quantitative and qualitative reasons. On the quantitative side, the private sector spending capacity is on retreat all over the world. Either because households and firms are seeking to recover their vanished wealth stocks or because they are unable to find lenders. On the qualitative side, lenders will not return to their usual buisness as long as they will not be able to get rid of toxic private debt, and good public debt is a means to clean their balance sheets. It is clear that markets need and want more public debt.

Third, as regards the EMU, there is no evidence that the public finances in the area as a whole may pose any serious problem – at least in comparison with say the US or other major economy-wide threats. a) Their pre-crisis condition was much healthier than in the US. b) This largely holds true at the country level as well, even among the P.I.G.S. The usual exceptions are Italy, because of her high debt, and Greece, but only for reasons of political instability. c) Approved fiscal plans so far in the EMU are almost everywhere well below the targets given by the 1.5% GDP plan approved by the Commission in October (see my previous post in this site).  d) Increasing spreads notwithstanding, since the anti-inflationary peaks of early 2008 all EMU governments are paying less interests at all maturities (though the yield curve is steep all over the world).

Fourth, fears about chains of euro sovereign  defaults and an EMU collapse are totally irrational,  because there is no economic fundamental reason, and because it cannot happen politically (e.g. A. Maccario in this site).

However, the long history of financial crises, incluiding the present one, warns that fundamentals may do very little against market psychology or, indeed, market psychiatry. Loosers may become systematic risk-seekers according to Kahneman and Tversky’s Prospect Theory. As is well known, risk-seeking as a reaction to losses is the psycological drive that leads gamblers to ruin. Hence, what is going on in the EMU public debt market, may not be ordinary risk coverage, or excess risk coverage as suggested by De Grauwe, but exactly the opposite, with operators lacking any credible standard of value and thirsty of short-term gains,  who bet large sums on the remote, though lucrative, chance of national or even systemic defaults.  Typically, risk-seeking gambling strategies are self-defeating and bound to fail. From this point of view, however, the key difference between true gambling casinos and financial markets is that the latter bring with themselves crucial public interests.

For the time being, the gambles against a few euro sovereign debts may just hinder the development of  a sustained and coordinated fiscal stimulus in the EMU. If the market is caught by the idea that only Germany and Luxemburg can afford a fiscal expansion, then there will be no fiscal expansion at all, bettors on euro defaults will be defeated, but meanwhile the EMU economy will sink in the sea of recession, and all those who have a stake in a bank or a company will see their wealth disappear.

Yet the pathology of financial crises indicates that if the mass of  gamblers reaches some critical value, then the systemic euro collapse will enter the critical zone of self-fulfilling prophecies (see also Roubini, this site) . As it happened with the EMS crisis of 1992 triggered by a totally exogenous event like the Danish “No” to the Treaty, speculators may attack supposedly weak countries one after the other forcing them to default on debt or to opt-out the euro. At that point, being on the first class or on the third class deck of the Titanic will make no difference. We should never forget, however, that the ultimate cause of the tragedy of Titanic was not the irrational behaviour of passengers but of the commander and the sailing company.

Warnings and complaints about the weak design of EMU institutions on the grounds of macroeconomic stabilization are being sadly vindicated by ongoing events. A lonely, self-referential, autistic, monetary Whitesnow surrounded by many impotent fiscal Dwarfs was not the best conceivable design to manage system-wide shocks[2]. High and tight protections have been erected around public finances, whereas the turmoil has exploded in the largely unattended and unprotected playground of private finances, and is now propagating with little or no obstacles. Public finances across the EMU are now required to take care of the private finances of transnational banking corporations that often exceed  in value the GDP of a single country, and of those of unemployed and impoverished taxpayers. As explained above, a massive shift from private to public debt cannot be escaped from. This is simply not possible within the present institutional framework.

It is already clear that the message that governments are allowed to trespass the SGP limits, “for a few points and temporarily”, has turned out to be ridicolously insufficient, if not plainy wrong as it is now paving the way to selective speculative attacks. While a bypass of the no-bail-out clause is being frantically sought for Ireland (see this site), an entirely new approach is needed, and it is mainly a responsibility of EMU institutions to elaborate and to transmit it to the financial markets before they fall victims of destructive mass behaviour. The core of this new approach need not be that single governments are allowed to spend as much as they want as long as they want, but that a systemic private finance crisis calls for a systemic public finance response. The euro is a public good and hence it needs a line of defence of EMU public institutions. Ideas are not lacking, from the creation of a true European budget to the launch of  true euro bonds. However, these ideas seem to take too a long gestation time.

What should and can be done immediately is that the ECB steps in and sends bond markets a clear and credible message that any government engaged in the fiscal operations agreed upon at the Union level will face zero default risk. Yes, this means that the ECB stands ready to monetize sovereign debt, if the relevant circumstances occur. Of all the emergency solutions that are being put forward (see this site) this seems the most straightforward, clear, and honest. To those who are upset by this perspective, it is apt to remind that the ECB has already broken all possible taboos of orthodox central banking by easing collateral requirements of loans to banks, by accepting dubious assets in exchange for true euros, and even by buying trash assets. All this, albeit dictated by dramatic emergency, has been done in total absence of transparency and with full discretionality in relation with private entities of uncertain creditworthiness or public interest. As a result, we now face the serious risk of having both a central bank transformed into a garbage can of private banks as well as bankrupt governments.

The proposal advanced here has at least the merit to avoid both these gloomy outcomes by exchanging the roles in the drama. Governments will be allowed to pursue all the necessary cleaning-up interventions in the banking sector (possibly with more transparency and less discretion with regard to their taxpayers) without facing a trade-off against the fiscal measures to sustain their economies. Moral hazard by governments should be limited by explicit restriction to the menu of interventions and measures in the Recovery Programme approved by the Commission. And, let me say as a taxpayer, a little risk of moral hazard on the ground of public finance in this moment seems quite acceptable in comparison with those created by the incommensurable immoral hazards committed by the champions of the unfettered private finance.  The ECB, if necessary, will have to buy some public bonds that, even in the case of the P.I.G.S., will make its balance sheet and institutional role look more respectable than they are now.


[1] Buiter W., Corsetti G., Roubini N. (1993), “Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht”, Economic Policy, vol.16, pp.58-87.
[2] Tamborini R. (2004) “One monetary giant with many fiscal dwarfs: The efficiency of macroeconomic stabilization policies in the European Monetary Union”, in Deardorff A. V. The past, present and future of the European Union,  London, Palgrave Macmillan

7 Responses to "The pigs, the Titanic, and Noah’s Ark"

  1. Luis Montes   February 18, 2009 at 6:12 am

    A very good article. I remember in the late 90s when the term PIGS was coined by a Dutch journalist and inmediately adopted by the angloamerican press plus some german newspapers. The assumption was that the Catholic south was unfit to join the virtuos protestant nordics. In Spain that attempt at preventing the PIGS from joining the holy grail of the euro was overcome by the firm determination to demostratate that there is not such a thing as a predetermined monetary heaven where only nordics, germans and anglos ( if they want) can enter ( because God apparently says so). As a result, history has demostrated that a country like Spain was able to be more virtuous than Germany. For years Germany was stagnant and in its public finances were in the red while Spain was running budget surpluses and growing at a hectic pace. You can say now that it was an artificial and unbalanced growth fuelled by low interest rates. Fine. But the reality is that growth in Spain at that period amounted to a large percentage of overall growth in the euro zone. Now it happens that the irrational markets still controlled by the very same people who led the world to the current mess are trying to tell us that the PIGS are back and that the euro is at risk because of them. You can even sense a feeling of revenge in all those nordic and anglo journalists who are resurrecting the term: ” let them pigs eat mud”, ” those southerners deserve it, who the hell they think they were?”. This, and not market fundamentals, is the kind of thinking that is propelling the credit spread. After all, how can S6P justify its downgrading Spain ( where public debt is below 40%) and keeping its AAA rating for the UK, or the US, where the financial sectors are in collapse and public debt is skyrocketing beyond any proportion?

    • Vella   February 20, 2009 at 4:59 am

      Good article and even better comment.How is it possible that the fate of million of people around the world be in the hands of “the markets”, who proved to be such an inefficient device that causes the mess we are in tioday?How is it possible that public bail out for banks be asked for, and then the banks at large bet against that same public debt?

  2. bigD   February 20, 2009 at 3:14 am

    I have never read any convincing argument why a possible sovereign default by a eurozone country would hurt the euro. If anything it would be the most euro supportive event one could possibly imagine. Surely not monetising debt, and letting the truly free market do its work will instill faith and confidence in the “euro system”.Of course any “systemically important” bank within its sovereign borders would still need some degree of rescue in the interest of the whole world.

    • Roberto Tamborini   February 24, 2009 at 4:02 pm

      bigD, your comment begs the following questions:1) Why should banks be rescued and not governments? Is any government less “systemically important” than any bank?.2) What is the interest of the whole world?3) Is there now in Europe any government more responsibile for the overall deterioration of public finances than any bank?4) What is “truly” free market? Are now markets “true” or “untrue”? And what work should we expect they are able to do now?

      • bigD   February 25, 2009 at 8:00 pm

        Roberto Tamborini you are very right. I am all for letting banks fold through restructuring (bankruptcy courts), which is in my opinion also a form or rescue. Hence my “some degree” emphasis. There are two things that I implied to say: 1) a government default is not the end of the world, and 2) allowing a government to default removes any guarantees on domestically incorporated banks, so one has to be aware of the implications.On your second point, a bank default will most likely have global impact.I do not fully understand your third question. Would you mind rephrasing it?Four, a truly free market is free from regulatory and political interference. And regulators act free of any special interests. For example there should be no Fed setting interest rates. And laws should create a level playing field and not be skewed towards the big institutions. The latter part of your question cannot be captured in a few sentences. Essentially the current system is corrupted and bust. Perpetuating it will only make matters worse and prolong the economic pain. Allow the healthy benevolent parts of the system to take control of collapsed institutions where necessary. Monetary inflationary policies that are in place now should stop immediately; in the long term they will cause more problems than they solve. All unfunded social welfare liabilities can never be honoured in an inflationary environment.I read between the lines you have your own view on what needs to be done. Would you be willing to share your thoughts please?

  3. M.G. in Progress   February 20, 2009 at 3:45 am

    In english we say that pigs will fly or “quando i mussi i volerà”

  4. Tony Soprano   February 20, 2009 at 2:02 pm

    The use of the acronym “P.I.G.S.” has racist overtones, particularly since each of the named countries is located in what is considered Southern Europe, where the populations have a more “olive” skin. It is not surprising that the term was “coined, in some Anglo-Saxon circles”, which do not have a country included in this pejorative term and where the populations have more a “sickly pale” complexion, more susceptible to skin cancer.The repetition of this pejorative term is not appreciated.