Two months ago we wrote in our monthly letter that we anticipated social unrest will ripple through Europe as fiscal retrenchment is imposed across a number of eurozone nations. We were not kidding – it is said civilization has a thin veneer, and we do not offer such warnings lightly. These are matters of some gravity.
This month’s letter spells out some of the key aspects of the challenges facing not only many of the peripheral eurozone nations, but also the UK, the US, and Japan. We told you two months ago we thought Greece would not default, they would begin to implement government spending cuts and tax hikes, and there would be a back up fiscal assistance facility put in place for the region in the event bond auctions began to fail. So far, this is precisely how the scenario has played out.
The next act gets tougher to predict. Greece and other countries now face falling private sector incomes – that is, after all, the direct and immediate result of higher taxes on businesses and households, and lower government expenditures. Unless the trade deficits of these nations can swing sharply into surpluses (as lower domestic incomes lead to less import demand, and lower costs of production lead to higher exports), private debt defaults will now start to multiply and cascade through the system. Last week, as we mentioned, Moody’s placed 4 Greek banks on downgrade watch. This is just the start – the fiscal retrenchment has only just begun to take effect. By taking these steps to avoid a public debt default, we would suggest these economies are now poised for more private debt defaults.
We believe private investors do not yet get this connection, but it will be made very clear in the months ahead. Latvia, with a GDP collapse of nearly 25%, will become the poster child of the region in this regard. This private debt distress will back up into higher loan losses at German banks. Loan growth is already dead in the water in Europe, and banker perceptions of private sector creditworthiness are about to go “pear shaped”, as they so delightfully put it in London.
But that’s not all. Each of these countries are about to discover the paradox of public thrift. Argentina discovered this in 2001-2. Latvia and Estonia have recently rediscovered it. Ireland is rediscovering it, and within the next three months, Greece will no doubt discover it as well. We will let the following post we came across on an economics blog we frequent depict the nature of this paradox for you, because it really does capture the essence of the dilemma at hand:
“From Ireland: Gov’t took billions of €’s out of the economy in the form of public service pay cuts, pensions cuts, dole cuts + wave of private employees replaced by agency workers at minimum wage rates…
Guess what? January tax receipts crashed yet again below projections.
After two systemic budget cuts, the tax receipts keep tanking.
The mainstream consensus?
We need more cuts (except for bankers and top civil servants who don’t have to take wage cuts)! And the international bond market is happy with Ireland.
One day we shall be able to compete with China on a level wage scale, and generous tax incentives for Multinationals. In the meantime, say hello to all the Irish immigrants for me.”
This is the future discovery awaiting Greece, Spain, Portugal, Italy…and the UK…possibly Japan…and perhaps the US will manage to skirt the issue, at least for another year. If your private sector is retrenching already, and your public sector retrenches on top of that, unless you get a massive swing in foreign trade in your favor, you are inevitably inviting falling private nominal incomes and private debt distress into the picture.
As private incomes fall, tax revenues fall. In order to hit fiscal targets promised to bond holders, further expenditure cuts must be implemented, and further tax hikes must be rolled out. As the Irish blogger reveals above, this is not a theory – it is already happening, but policy makers and investors are not willing to acknowledge it.
We are by no means defending the generous pension benefit levels of eurozone government workers, the early retirement ages, the corrupt tax practices, etc. These are decisions the citizens of each nation need to make on their own, preferably in full awareness of their consequences, both short and long run. It is not our place to dictate the trade-offs citizens chose in each nation.
We are also intimately familiar with the notion some short term pain may be required in the adjustment process in order to accomplish long term gains. Ideally, businesses and households will find ways to adjust to the fiscal retrenchment by abandoning low value added economic activity for higher value added activity. In the US, sometimes we do this by opening up a new biotech plant near Cambridge, and sometimes we do it by opening a new meth lab near Boise.
Regardless, in the best of all possible worlds, the productive structure will become better adapted to the true underlying structure of demand. That is part of the force that can drive better trade balances – it is about product innovation and productivity gains, not just cost cutting. This takes time, it may not be smooth, and it usually involves some degree of hardship for those who have to make the change and take the risks. But that is to some inherent in the nature of any evolving economy.
The question we are raising, however, is whether the private leverage ratios in many of these countries will allow them to withstand the pressures of making such transitions. The quest for fiscal sustainability may place these economies on a path of private debt default, which is ultimately unsustainable for the economy as a whole. Orderly private debt renegotiation and private asset liquidation must be accomplished at a large scale and in a timely fashion, yet our experience is this is no easy trick. Usually such a recipe delivers a financial implosion. We believe a second blog comment succinctly sums it up in the context of Greece:
“Returning to the Greek problem.
1. Balance of payments deficit.
2. Private budget surplus (profits spent on imports, capital outflow, domestic savings deposits privacy protected and real estate purchases at underreported prices).
3. Private debt less than GDP
4. Unreported GDP near 40% of reported GDP.
5. Private productive investment practically nil.
The result is public deficit to support GDP and public debt higher than reported GDP, mostly owned by foreign funds.
Austerity program implemented to satisfy foreign funds holding maturing debt to be renewed at higher spreads at the expense of GDP which will decline from both effects, leading to a crisis spiral and a crash.”
That, dear readers, is the real deal, and it is not being reported or openly discussed. We have seen this movie before in Argentina almost a decade ago. They eventually got out with a massive currency devaluation and an equally massive swing in the trade balance.
The eurozone has, up until recently, run a very slight trade surplus, close to 1% of the region’s GDP. The peripheral eurozone nations have run fairly large and consistent trade deficits. That means unless a) they can find markets for their existing tradable products outside the region, or b) they can come up with new tradable products to grow global markets for their output, the attempts of the peripheral nations to right their own ships will undermine the trade balances of Germany and other net exporters in the eurozone.
So here is what the good news of Greece’s fiscal retrenchment brings to Germany (and remember, Greece is only the second stop in the fiscal “sustainability” program: Ireland already went, and Spain and Portugal are next). German holders of Greek government debt believe they no longer have to worry as much about a default. The Greek government is delivering the 4% of GDP cuts in the fiscal deficit as required. But now German holders of private Greek debt (namely, German banks) are about to discover that fiscal rectitude will bring private debt default. Next, German companies are about to discover their export sales to the eurozone are coming in below plan, and below the expectations they set for their investors.
The fix, in other words, is not in. Far from it. Rather, the sewage is backing up in the system. We honestly do not see an easy way out of this mess. But we do know this: whatever relief rally shows up here in eurozone equities or the euro itself on the good news that Greece is taking the bitter medicine is built on a mistaken or at best partial understanding of the dynamics that have been set in motion. We prefer that our readers be forewarned – this is indeed March Madness.
Rob Parenteau, CFA, is sole proprietor of MacroStrategy Edge, editor of the Richebacher Letter, and a research associate with the Levy Economics Institute.
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