THE BEAR'S LAIR Europe's Lehman Brothers
By Martin Hutchinson
There has been considerable discussion as to whether the potential Greek
default makes it this cycle's Lehman Brothers, but that is surely wrong. Greece
is much too small to destroy large areas of the world economy, as did the
bankruptcy of Lehman Brothers. It is also being bailed out on exceptionally
favorable, not to say squishy terms, as was Bear Stearns, where shareholders
received an entirely unjustified US$10 per share from JPMorgan Chase.
To be Lehman Brothers, one must be a previously undoubted name, albeit with
hidden weaknesses in management, whose bankruptcy is large enough to disrupt
the entire global economic system and plunge it into depression for years
thereafter. There is surely only one candidate for such an honor: it is not
Greece, Portugal or Ireland (too small) or Spain (getting better
management, and stronger than it looks - think Citigroup) but Italy.
In the past decade, Italy under Silvio Berlusconi has been considerably better
managed than was Lehman Brothers. The now former prime minister Berlusconi and
in particular his finance minister, Giulio Tremonti, had an excellent grasp of
Italy's weaknesses, and tried within the constraints of the Italian political
system to bring the country's bloated spending under control, improve its
abysmal tax compliance and, as a corollary, reduce its excessive burden of
taxes.
In consequence, the Berlusconi governments at least stabilized Italy's grossly
excessive public debt, which had risen disgracefully from 30% of GDP in 1970 to
120% in 1995 but has been flat since then in spite of Italy's deteriorating
demographic profile. They also accomplished a considerable amount in pension
reform, but did not adequately reformed Italy's corrupt public sector, its
over-burden of regulation or its opaque and sluggish corporations.
The main criticism of the Berlusconi governments, which should really be
directed at the leftist governments that intermingled with them, is that they
did not prevent a substantial deterioration in Italy's relative productivity
against its eurozone neighbors, which has gradually made Italian exports
uncompetitive and widened its balance of payments deficit to 3.7% of GDP.
Italy's problem is now a political one. Under Berlusconi it was mostly
competently run and could hold its own internationally if only through the
force of Berlusconi's personality. As the market figured out in its negative
second-day movement after Berlusconi's departure, it is most unlikely that any
Berlusconi successor will be anything like as good. Even if some figure from
Berlusconi's own party, such as Angelino Alfano, were to succeed him, he would
have far less authority over the fractious center-right coalition and far less
ability to keep the necessary budget-cutting reforms moving forward.
A "technocrat" successor such as the much loved (by the European Union
bureaucracy) Mario Monti [at present the prime minister designate] would be
much worse; he would secure a large handout from his friends at the EU or the
International Monetary Fund, and would then waste the proceeds in government
aggrandizement, making an eventual Italian bankruptcy 12-18 months down the
road all the more painful. Since the market would quickly spot the road down
which a Monti government was heading, it would withdraw support for Italian
bonds within weeks, well before that inevitable destination had been reached.
Of course, if Italy had kept Berlusconi there would have been a clear solution
to its problems; departure from the euro. Unlike Greece, whose currency parity
needs to drop to a third or less of its current euro parity to be viable, Italy
becomes competitive with a devaluation of no more than 20% or so.
With a Berlusconi to keep public spending under control, an Italy devalued 20%
could even service its public debt, since its average maturity is relatively
long and any cost increase resulting from re-lirazation could be easily
absorbed over time. The current panic at bond yields over 7% merely reflects
the youth and inexperience of the trading community, which fails to remember
the double-digit yields of a generation ago.
Such a devaluation would break up the euro as it currently exists, since Italy,
unlike Greece or Portugal, is a major component of the currency. Indeed it
would almost certainly also lead to a departure from the euro of Spain, France
and probably Belgium, since they would find themselves more uncompetitive
through the Italian devaluation.
However it would not remove the currency bloc altogether, which could happily
continue with Germany, the Netherlands, parts of Scandinavia and its highly
competitive and flexible East European members Slovakia, Slovenia and Estonia.
There would be no world recession, and no major bond defaults beyond Greece and
possibly Portugal.
As they have done and are continuing to do in Greece, the EU panjandrums, by
taking over the management of Italy by putting in their man Monti and providing
limited bailout help, will make matters much worse. For one thing, their
solution and the austerity they will call for will have very little legitimacy.
As we saw only last week with Ohio voters' rejection of the Republicans'
perfectly sensible reforms of that state's public sector workforce and its
pension and healthcare rights, claims of actuarial catastrophe have very little
salience with the electorate. Voters don't understand the actuarial
calculations involved, which are of necessity opaque, and they rightly suspect
that the political class is capable of producing spurious scientific-seeming
justifications when it wants to do something.
The same distrust will attach itself to Monti's calls for austerity, and
whereas Berlusconi's policies could be opposed within the system by aligning
with the parliamentary left, opposition to Monti's apparently high-minded
reforms, which will not tackle the corruption endemic in Italian politics, will
spill into the streets.
With the budget more out of balance than under Berlusconi because the
politically connected lobbies that Monti has brought with him will seize the
opportunities to seize available resources, the markets will wrongly perceive
Italy as being as much of a basket case as Greece, and close access to Italian
government re-financing.
Within a very short period, that may not drive Italy out of the euro, but it
will produce a default on Italian debt that could have been avoided with better
management. Since Italy's debt is so huge, the resources for a full bailout do
not exist (even Germany's taxpayers suffer under a high tax regime that is
within a few percentage points of becoming counterproductive) and so the
southern European government securities market will collapse.
Just as with Lehman Brothers, regulatory actions, and not just the misdirected
short-term maneuvers of politicians and banks, will bear a considerable share
of blame for the debacle. In this case, the Basel rules assessing Organization
for Economic Cooperation and Development government debt as having zero risk
and thus requiring zero capital allocation will be most to blame. Those rules
allowed banks, without constraint from their capital inadequacy, to load up on
debt that had less economic reality behind it than the debt of any solid
well-established corporation.
Britain came close to default in 1797, not because of any failure of its
burgeoning economy, but because its government approached the limits of its tax
capacity at around 20% of GDP (and France suffered the revolution eight years
earlier through a similar problem).
In modern societies, with income taxes and the great majority of populations
well above the subsistence level, national tax capacities are well above 20% of
GDP, more like 50%. However they are not 100% or even 70% of GDP, nor can they
ever be anywhere close to those levels. Taxation at that level produces
economic decay even in the short term, as Sweden discovered in the 1980s.
With 20th century welfare systems strained by the aging European population, it
was always absurd to assume that any modern government's debt was "risk-free"
except for that of a few countries like Singapore and South Korea whose tax
systems were operating far below their maximum capacity.
Countries can increase their own economies' viability and their governments'
tax capacity, as a percentage of GDP, for a few years by a one-off devaluation,
but as various South American states have shown (albeit at a lower level of
income) that too is only a short-term solution.
Whereas Italy could probably service its debt through austerity and devaluation
(as Britain did after its 1967 devaluation) Greece is quite unable to reach any
such equilibrium. In Greece's case, devaluation is necessary to get the economy
working at all, but after devaluation output will still not be great enough to
service the country's gigantic debt.
The last three years of ultra-low interest rates and government profligacy and
meddling thus seem all too likely to produce a second financial crisis, an
unprecedentedly short time after the first. Presumably the Reinhart-Rogoff
argument in their book This time is different, that financial crises are
especially difficult to emerge from, will apply with redoubled force to the
emergence from two crises rather than one.
Sadly, even this second disaster seems unlikely to be sufficient to discredit
the policy foolishnesses that have caused both crises or to prevent a spiral of
money creation, meddling and debt that will lead to a third crisis and
long-term economic decline.
We are supposed to be an intelligent species, which can learn from our
disasters. With such learning very unlikely, the global economy may be destined
to decades of decline, from which emergence may be impossible.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found on the website www.greatconservatives.com -
and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley,
2010). Both are now available on Amazon.com, Great Conservatives only in
a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com.
Copyright 2005-11 David W Tice & Associates.)
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