THE RETURN OF THE BOND VIGILANTES

“You mean to tell me that the success of my program and my reelection hinges on the Federal Reserve and a bunch of f***** bond traders?”
-Former US President, Bill Clinton, said early in his first term

“We now see herd behavior in the markets that are really pack behavior, wolf pack behavior.”
-Finance Minister Anders Borg of Sweden, speaking on the Greek crisis

¡Defenderé el peso como un perro! – “I will defend the peso like a dog!”
-Former Mexican President Jose Lopez Portillo, prior to a major peso devaluation and bank nationalization in 1982

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Dogs, wolves, whatever. Corrupted as they may be by government-derived moral hazard, the markets are the last line of defense against what really is a hundred year accelerating tide of fiscal governmental irresponsibility.  Greece faced an unpleasant reality. It couldn’t roll over its debt. The markets wouldn’t cough up the money. That’s the bottom line.

Politicians always come up with self-serving condemnations of the markets. They should be careful. Supposedly, once he retired President Jose Lopez Portillo for the rest of his life couldn’t go anywhere in public without being barked at.

As I wrote in the last Dismal Optimist, if present trends continue Greece is the future. Greece is just the first.

In a widely quoted book entitled The End of History, Francis Fukuyama wrote about the intellectual and practical triumph of democracy as a system of government. No further political paradigm shifts would be required. Democracy was the omega end point of the historical process of human sociopolitical evolution. Great reading, perfect for the 1990s when American triumphalism and the Washington Consensus reigned supreme. But Fukuyama seems to have overlooked the tendency of modern democracies with universal suffrage to glacially move towards bankruptcy by promising their voters entitlements that these governments cannot afford. Barry Eichengreen, in his widely acclaimed Golden Fetters, argued that universal suffrage granted during World War I made a return to the gold standard impossible. The newly expanded electorates wouldn’t stand for a submission of national monetary policy to the stateless discipline of gold. Could Eichengreen have gone one further and argued that universal suffrage and national fiscal discipline were incompatible?

More questions: Are we headed into a post-Fukuyama world where universal suffrage inevitably leads to universal state bankruptcy? Or will the bond (and currency) vigilantes preserve Fukuyama’s world by forcing fiscal prudence?  Will the “advanced” nations take the latest Greek tragedy as a warning and get their fiscal houses in order? Are the markets to be the ultimate saviors – or the terminators – of democracy?

Meanwhile back on the US side of the Atlantic the CEO of Goldman Sachs sat like a deer in the headlights before Senator Carl Levin to answer for transgressions so arcane that armies of lawyers will have trouble understanding. (Of course they will be paid handsomely for trying.) Not that the general public had trouble. When bubbles burst, the public wants scapegoats and throughout the ages moneymen have served quite well for this purpose.  As I watched this, I kept imagining Levin, with his massive jowls overflowing, attired in the black and white Dominican robes of a medieval Inquisitor. And I kept asking myself, where were Goldman Sach’s coconspirators? For example Fannie Mae and Freddie Mac. And how about the SEC itself that in 2004 let the big investment banks leverage up to their eyeballs. That would make for an interesting legal case – the SEC vs. the SEC.  Or Allan Greenspan’s Federal Reserve that held interest rates down and poured monetary kerosene on the housing bubble. Or the Chinese, who to bolster their exports to the US, held down the value of their currency and poured dollars back into the United States. Or President Nixon for that matter who blew up the semi-gold standard Bretton Woods System in 1971.

Gold showed its true worth in the last week and hit new heights. The message: Fiat currencies cannot be trusted. The “barbarous metal”, in Keynes’s words, served as valuable alternative to the faltering euro. One wonders what Keynes would call gold today. The American IRS calls gold a “collectible”, denying it more favorable capital gains tax rates. Governments don’t play fair with their competitors. Still, gold and other precious metals are insurance that portfolios can’t be without.

Greece Lightning Strikes the Euro

As this went to press, the financial news wires were filled with conjectures about the spread of the Greek crisis to Spain and Portugal and the demise of the euro. In my opinion the euro will survive. It is too valuable as a medium of exchange to be allowed to die. Europe’s myriad member states need a common currency. But as a store of value the euro has taken a fall. Its days of being considered the deutschmark reincarnated are over. In retrospect, Europe and the Germans might have been better served if, instead of creating the euro, all of Europe had just used the deutschmark.

A facility of almost a trillion dollars was announced on May 10 by the EU and the IMF to shore up the euro and be of assistance to eurozone countries under market pressure. This is in addition to the 110 billion euro package already agreed to for Greece.  Details of the new facility are still murky and apparently exceedingly complex, a fact not helping the euro in the markets.  Interestingly, all EU countries including Spain, Italy and Portugal will be contributing along with Germany and France. I bail out you and you bail out me. And– to reference Josef Ackerman, CEO of Deutsche Bank– Greece will still likely require restructuring when all is over. An early default as advocated here would have been so much better.

Damaged is the reputation of the European Central Bank for being a politically independent bastion of a sound currency. This son of the Bundesbank has been turned into a prodigal. Damaged is the reputation of ECB President Jean-Claude Trichet who somehow didn’t discuss the ECB’s buying government debt one day and then just a few days later enthusiastically decided to have the ECB start buying. Damaged is the reputation of Angela Merkel as a tough guardian of the fiscal purse.

I have used the expression “in the land of the blind, the one-eyed man is king.” It applies again. The dollar is today’s one-eyed man. Further downward pressure on the euro against the dollar may be expected. But the dollar – as does the British pound and the Japanese yen – also suffers from the Greek disease of rising public sector debt and rising public sector expenditures. It seems absurd that the dollar should be strengthening. The US has to become an exporter. All this implies more upward pressure on the Asian currencies. And once we get by the Chinese slowdown, it seems likely that capital will pour into Asia.

Where Have All the Keynesians Gone?

Last year it was de rigueur for all responsible governments to implement large and irresponsible stimulus packages. Everyone was a Keynesian with the exception of Angela Merkel. Government spending, any kind of spending, had to be mobilized against the threatening downward spiral of economic activity.

The downward spiral seems to have been arrested. Whether this happened because of, or in spite of, the stimulus programs will be open to debate for years to come. But the stimulus programs helped bring about a gigantic increase in government debt in many countries, notably the US and the UK. And now the world has done an intellectual about face. Suddenly spending cuts and tax increases are in. The bond and currency markets must be placated. Thus the new UK coalition government has pledged to come out with a new austerity program.  Spain is busy preparing a budgetary hair shirt. As is Portugal. Loans to Greece are being conditioned on the implementation of a drastic austerity program.

It might be useful to review the impacts of both government spending cuts and tax increases. They are different.

First spending cuts.  A rough rule might be that for the typical Western country cuts in government spending would have a negative impact on economic activity in the short run but a positive impact in the long run. Some government spending is essential and contributes positively to economic activity. Other government spending does not. It is reasonable to assume that cuts in government workers and salaries would have a positive effect longer term for the majority of Western economies where governments are overstaffed and entitlement programs are exploding upward. Resources would be shifted from low or negative marginal product government activities over the longer term to private sector activities which had a higher contribution to productivity. But in the short run the impact would be negative for economic activity.  In addition, cuts in transfer payments in the short run would further reduce consumer spending.

Tax increases on the other hand will be negative in the short and long runs. Most Western economies are highly taxed. Increasing tax rates further will greatly inhibit economic activity and productivity growth. That’s pretty simple. And in some cases increasing tax rates may not increase the total tax take. The Laffer curve at work.

So the austerity program being forced on Greece may turn out to be lethal in terms of economic activity. The patient will not be able to take the chemotherapy being imposed. It is interesting that Cristina Fernandez de Kirchner, current President of Argentina, has warned that austerity measures being imposed on Greece are likely to fail. Normally, advice from an Argentine leader on monetary and fiscal policy would be treated as a curiosity. But just ten years ago Argentina was in the same downward spiral as Greece. Argentina spurned the advice of the IMF, defaulted and then devalued by breaking its currency peg with the US dollar. It then registered a strong recovery, even as it left a trail of very unhappy bondholders in its wake. Argentina, or at least the Kirchners, regards itself as a success story of sorts.

I do not believe Greece has the option of leaving the euro. But the euro has been heading south. So devaluation to some extent is happening. A Greek default can still happen. Germany and France of course would have to bail out their banks in the event of a Greek default. But a cheap euro may help those two countries’ exports.

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Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong
Peter T Treadway, PhD
Historical Analytics LLC
www.thedismaloptimist.com
pttreadway@hotmail.com
1 305 761 4718
852 94091186
May 16, 2010