Tuesday, November 29, 2011

Europe retries the "Mellon Experiment"

What happened to Italy and Spain in the past year? How did they go from being respectable AA sovereigns able to issue debt at low yields to international basket cases having to pay Latin American rates? Did their credit ratios change? Did they lurch to the left?

Well, no. Nothing happened. They have the same credit metrics today that they have had for years. But something happened. What was it?

What happened was PSI, German for “private sector involvement”.

Until last summer, it was eurozone doctrine that “default by a eurozone sovereign is unthinkable.” Which meant that the eurozone was a collective credit, in which the weak were supported by the strong to everyone’s mutual benefit. This was a great policy so long as it existed only in theory and not in practice. Then the high-living Greeks came along and demanded a bailout.

Faced with bailing out a hopeless quasi-marxist charity case, German voters balked. Germany decided that it wouldn’t support a bailout of Greece unless there was PSI, meaning that bondholders must “participate” in the “burden sharing”.

The theory was that by injecting risk into eurozone bonds, the market would encourage fiscal discipline in a way that the original eurozone treaty  had failed to do.

The German desire for market discipline in the eurozone worked as well as anyone could have hoped. The market realized that the bonds of eurozone sovereigns and banks were risky, and began to price in this risk.

The  credit risk premium demanded by the bond market is a function of expected loss. If default is impossible, expected loss is zero. If a default is a given, expected loss is the “loss given default”, the difference between the present value of the promised and expected cashflows.

Greece has announced that it will provide its bondholders with a deal worth 25% of the promised value. Therefore the “official” expected loss on Greece’s bonds is now roughly 75% (but actually more, since the deal involves new paper of questionable value). So, not only is there now risk in the eurozone bond market, there is a lot of risk.

Once the bond market understood that eurozone sovereigns were standalone credits, it began to look at them as such. Not only did investors have to analyze each of these credits (using, God forbid, financial ratios!), it had to anticipate how other creditors would act, since not only were these countries exposed to insolvency risk, they also faced liquidity risk.

Using the “liquidity risk screen”, out popped two names: Spain and Italy. They popped out because their market takings are so large and everyone’s exposures are so large. Reductions in investor and counterparty concentration limits would push these names out of the bond market (since everyone was at their limits already).

So now Italy and Spain no longer trade as double-A western Europeans; instead they trade as BB “special situations”. Investment grade portfolio managers are selling them in anticipation of the inevitable downgrades into junkland.

So, thanks to the miracle of market discipline, we are now looking at defaults by Greece, Italy, Spain and Portugal. Isn’t market discipline a wonderful thing?

During the the Depression, the secretary of the Treasury, Andrew Mellon,  advised the president, Herbert Hoover:
Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. (Herbert Hoover, Memoirs)

The Mellon Experiment lasted four long years (1930-33), and was an economic disaster on a scale that beggars the imagination. We are about to watch as Mr. Mellon’s experiment is tested once again, this time in Europe. Will it be more successful there? Will it help people to work harder and live more moral lives? Will the fragile political institutions of southern survive what they were unable to survive the last time?

The deus ex machina for the US in the Depression was the replacement in 1933 of the deflationist Hoover team with the inflationist Roosevelt team, which took the US off gold and flooded the economy with dollars. Europe has no Roosevelt in the wings, only Mario Draghi.

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