The Day After... Italy.

[Wonkish1]

Well that (1 day rally) was fun while it lasted. Now back to reality...

"Italy paid the most since joining the single currency to sell new 10-year debt on Friday in the first euro zone bond auction after European leaders agreed new steps to tackle the debt crisis.
...
The auction yield on Italy's March 2022 BTP bond rose to 6.06 percent from 5.86 percent a month ago.
...
The yield on a three-year BTP maturing in July 2014 rose to 4.93 percent, at its highest since November 2000, compared to 4.68 precent at an end-September sale."

Link

As I have said before... either Germany will sign off on unlimited monetization or all the countries under pressure will default (and I consider any kind of monetary separation between Germany and the subject country a default). There is no other way. The movement of the markets are steady, swift and inexorable.

Agreed. By the way, Beet what do you do for a living?

[Wonkish1]

I work in computers... there are a couple others here in these boards who work in economics and finance who know more than me but they are pretty taciturn.

I see. I'm actually pretty sure that ag is an econ professor if I'm not mistaken.

What sparked the interest in finance/econ to a level that you are actually making posts about changes in sovereign credit default swaps?

[Wonkish1]

I have been interested in this for as long as I have been interested in computers, if not longer. So I presume that you do work in the industry?

Yep!

[Wonkish1]

Ag is an Economics professor. I'm getting my master's degree in economics this summer (hopefully). Phnk is getting some degree in economics, I think, but I forget which.

I'm really not very impressed by the EU "solution". My impression is that they're trying to pass the buck into some vague nothingness.

Its like they are trying to make their "solution" as vague and complicated as a structured finance product to confuse the markets just like they accused all of those "greedy bankers" of doing a couple years ago.

[Wonkish1]

Ag is an Economics professor. I'm getting my master's degree in economics this summer (hopefully). Phnk is getting some degree in economics, I think, but I forget which.

I'm really not very impressed by the EU "solution". My impression is that they're trying to pass the buck into some vague nothingness.

Its like they are trying to make their "solution" as vague and complicated as a structured finance product to confuse the markets just like they accused all of those "greedy bankers" of doing a couple years ago.

Yep, exactly. That's why I'm so wary of it.

But even then for those of us that do read all of the terms as they come out, its piece of crap delaying mechanism anyway.

[Wonkish1]

Yep, this will work...

So I just followed along that whole diagram seeing if there is anything I or that sheet is missing and Wow that is a very concise way explain the whole package. I couldn't put all of that in 10 paragraphs and whoever drew that was able to cover at least money flow through the whole plan.

I will say that diagram doesn't cover the 2 legal changes that are occurring though as well. New issuance is now written in English Common Law because it is more friendly to the bondholder yet another thing that will create a spread between old and new issuance. And the other is the retroactive destruction of sovereign CDS contracts by making defaults "non credit events".

[Wonkish1]

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Does this mean that CDS spreads will start to become an unreliable indicator of sovereign default risk? I've been looking mostly at yields anyway, but mostly because of what timely data I've been able to find on my own. I imagine this is a useful market because it would send signals more reliably than credit rating agencies.

It appears to be the case. CDS spreads are now more unreliable because they now have to carry the intrinsic risk of the likelihood of a credit event not being called a credit event triggering the CDS contracts.

People are switching back to good old yields as their indicator of a choice now.

[Wonkish1]

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Does this mean that CDS spreads will start to become an unreliable indicator of sovereign default risk? I've been looking mostly at yields anyway, but mostly because of what timely data I've been able to find on my own. I imagine this is a useful market because it would send signals more reliably than credit rating agencies.

Are they really doing the credit event thing? I read that there was discussion on it, but if they go through with that they essentially kill that market (at least for government debt) because they're essentially saying that they will never let a state fail in a way that will allow the insurance to work.

It's scary how most eurozone leaders display a total ignorance of how markets work. They really seem to not get it.

Yep they already have. They already ruled on it.

[Wonkish1]

Just look at the Italian BTP numbers today! Unbelievable. The only thing that stemmed it for a little bit was the false rumor that Berlusconi was going to resign today.

Italy is screwed!!!!!

[Wonkish1]

How can this euro thing work without a common fiscal policy?  And if all of this lending by banks to the sickie countries had not occurred, would it be a problem to just let them default?  Someone needs to educate me on this. I feel at sea.

If the EU was going to be structured as a fiscal union decades ago or if they tried to pull that today countries like Germany would give them the finger and walk away because it would invariably be just a constant stream of transfer payments from countries like Germany to countries like Greece, Spain, Slovakia, etc. That is like asking the United States to go into a fiscal union with Mexico. The people in the US would be rioting in the streets at even the notion of the idea by the US government.

[Wonkish1]

Gustaf,

But that depends on what you mean by Germany 'paying' for the Club Med countries. Arguably, simply by being in a currency union with the Club Med countries, Germany is paying for them already, because it is supporting their purchasing power and they are leeching off Germany's purchasing power. Also, the EU has a ton of agricultural subsidies, etc. etc. The free trade zone, movement of labor agreements, even the forced austerity and restructuring are all forms of German subsidy to the weaker countries. So if that's the principle you're after, it's been violated long ago.

True, but that seemed to them at least to be a worthy deal like it was for China and the US. Where they draw the line is when they can actually force Germany to make a direct transfer payment or sign up for a future direct transfer payment.

[Wonkish1]

Gustaf,

But that depends on what you mean by Germany 'paying' for the Club Med countries. Arguably, simply by being in a currency union with the Club Med countries, Germany is paying for them already, because it is supporting their purchasing power and they are leeching off Germany's purchasing power. Also, the EU has a ton of agricultural subsidies, etc. etc. The free trade zone, movement of labor agreements, even the forced austerity and restructuring are all forms of German subsidy to the weaker countries. So if that's the principle you're after, it's been violated long ago.

True, but that seemed to them at least to be a worthy deal like it was for China and the US. Where they draw the line is when they can actually force Germany to make a direct transfer payment or sign up for a future direct transfer payment.

What? China or the US never signed up to any such thing. And the Common Agricultural Policy is direct transfer payment.

Come on you what I mean. China keeping its currency devalued causes their population to subsidize our population through purchasing power so that their exporters can benefit. China elected for the same thing the Germans wanted in creating the EU. The only difference is that Germany signed up for a combined currency and China just pegged theirs.

[Wonkish1]

True but by starting the 'printing presses' Germany isn't technically paying anything because it isn't German money. It's just currency created out of nothing. The impact on Germany comes from only secondary sources-- by increasing or decreasing the euro exchange rate.

But since Germany is the biggest economy and since its "currency" was the most undervalued by switching to the Euro you and me both know that inflation would be particularly bad in Germany and they don't even get to benefit from the ECB bond purchases.

[Wonkish1]

But since Germany is the biggest economy and since its "currency" was the most undervalued by switching to the Euro you and me both know that inflation would be particularly bad in Germany and they don't even get to benefit from the ECB bond purchases.

But that's a secondary effect, not a direct effect. Just like, the Euro is devalued simply by Italy's membership inside of it, is a secondary effect. Plus we don't even know that it would be inflationary at all. The Euro would rally if the crisis were resolved, and that would deflationary.

I think the amounts that we are referring to here make the idea of it being deflationary pretty much impossible. These countries are in excess of 120% of debt to GDP. From my perspective they need to monetize that down to at least 70% or the higher borrowing costs are just going to each them to shreds anyway.

Printing 50% of GDP of a bunch of the Eurozone countries isn't going to be easy on them.

[Wonkish1]

I disagree, but I don't want to get into a long discussion now. Let me just restate that I think there is a strong chance such an action would result in a higher-valued Euro than the alternative of continued deepening of the crisis.

I don't want to get in a long discussion either. So I'll just say that increasing the money supply by lets say 30% is going to result in inflation.

[Wonkish1]

But what evidence is there that European governments would "borrow to the hilt" as you say, and then "blackmail the ECB"? You talk as if European governments were rabid animals without restraint or intellect. I give them more credit than that. Surely they would see that what you describe is a tragedy of the commons scenario and not do what you say.

I mean, is it not fair to say that during the first seven years of the euro, no European governments felt any fear of bond vigilantism? And during this time, they did indeed run up deficits. But not nearly so much as you say here. Further, the Euro during this time did not depreciate to a value 'less than the drachma' would be worth. It actually appreciated from about par to the dollar to well more than the dollar. And certainly this crisis has focused the minds of Europe's democracies on the problem of debt more than they had been before.

Is it just me Beet or did you change into a completely different person since like a week ago!

I mean prior to a week ago you were in agreement with us that the Euro had to break up, that bailouts and money printing wasn't going to work, didn't like ECB actions, etc.

All of sudden your defending the idea of the ECB printing by saying that you think it would actually come to a better result than now, a year ago, break up of the monetary union, defaults, and actually it if they just printed it would be all bunnies and rainbows.

What happened man? Did someone hack into your account or something and start acting as you?

[Wonkish1]

Ouch!!! That margin hike certainly did a number on the BTPs and the rest of the world today.

I think its finally dawning on people around the globe today that this $hit is real, its not going away, and new developments as the situation gets worse can really, really hurt!


European politicians are absolutely delusional to think they're getting themselves out of this. I've switched my outlook from Italy is more than likely to default to it will default.

[Wonkish1]

Italy must refinance 200 billion euros in the next year, while revenues and expenses are roughly 600 billion euros. Italy has about 75 billion euros worth of gold bullion. If it sells all of its gold bullion, refinancing remains 125 billion euros. If one expands beyond gold to all foreign exchange reserves, Italy has 125 billion in foreign exchange reserves. Refinancing costs fall to 75 billion euros. If the IMF and the EFSF can be persuaded to cover the remaining 75 billion, Italy is solvent for the next year with no revenue-adjusted fiscal adjustment.

I'm aware of that.

Didn't say its going to be soon. Your not accounting for bank recap though either! They will scrounging every Euro they can out of those places just to make good on the Eurowide "no Lehman's" promise. After that its just simply looking at the cost of capital issue and I don't see how you can come to the conclusion that potentially 9%+ 10 years next year isn't going to eventually catch up to Italy given its quantity of sovereign debt.

[Wonkish1]

@opebo: The ECB is not allowed to buy debt directly from governments. Unlike some of its other, errr, unusual traits, that one is actually fairly standard among world central banks. It can only buy on secondary markets.

Italy must refinance 200 billion euros in the next year, while revenues and expenses are roughly 600 billion euros. Italy has about 75 billion euros worth of gold bullion. If it sells all of its gold bullion, refinancing remains 125 billion euros. If one expands beyond gold to all foreign exchange reserves, Italy has 125 billion in foreign exchange reserves. Refinancing costs fall to 75 billion euros. If the IMF and the EFSF can be persuaded to cover the remaining 75 billion, Italy is solvent for the next year with no revenue-adjusted fiscal adjustment.

...and ZERO reserves whatsoever?
From bad to worse.

So what's your proposal, Italian? It's your country. (and yes. I've thrown out about five different proposals. I have certain preferences and beliefs, but right now I'm not completely wedded to any one solution, including this one).

Simple(from Italy's perspective) now that they are in it deep they do what Greece is doing. More austerity, try to get every single Euro you can out of the overly generous European core, and then go through painful debt restructuring when the Euro money runs out. People act like sovereign default is the end of the world. Its not! It sucks really, really, really bad, but give it a few years and you wont even be able to tell.

And if your looking at it from the European core(like Germany) the best thing is to figure out that the rest of Europe is going to keep on using you and suck you dry unless you tell them they are on their own. Since they are likely going to restructure their debts when the money turns off Germany is better to not be in a currency union with a bunch of countries going through debt restructuring. So they need to get the hell out of there.

[Wonkish1]

Sovereign default is not the end of the world (who said it was?), but it's still pretty bad. To restate the obvious, Italy is a G-7 nation, part of the core of not only Europe but world capitalism. A default would be the biggest economic failure in the capitalist world for 65 years. It's bad enough to consider lots of different alternatives to see if any would be better. Keep in mind what Greece has been through in the past couple years, and they haven't even really defaulted yet. To Greece's 300 billion euros of debt, Italy has 2.5 trillion euros of debt.

Further, from a political standpoint, I don't agree that Italy should keep stringing along the IMF/EU and then default when the money runs out. If default is inevitable, I argue it would be better off defaulting straight away for the following reasons. First, it already has a primary budget surplus, so delaying default only means more interest payments that disappear into nowhere. Second, the IMF/EU will try to force through massive structural changes that the Italian people will not be able to decide upon democratically. It is better to keep economic decisions under the purview of Italy's democratic institutions. Third, look at what has happened to the Papandreou government. It has lost all popularity and credibility. A new government coming in straight off an election with a solid majority, would do better by defaulting straight away and taking as much economic pain as possible in the first year, so that by the third or fourth year when new elections are coming up, a recovery is already visible, as you hinted.

Finally, it is unclear whether or not even a hard default would resolve the problems here. The main examples pointed to (Argentina, Russia, Iceland) all combined default with a currency devaluation. Even after a hard default, is the country were still using the euro, it may not be able to avoid a hard internal adjustment, difficulty which is unpredictable. I cannot think of any historical examples.

Fair point about the primary surplus already. But keep in mind that a large portion of those interest payments are to domestic banks the more you get in handouts the more you can ween your domestic banks off of holding that debt and onto a different country that your about to screw over. Also keep in mind that the bank issue is why countries don't default and repudiate the entire amount. They always restructure the debts based on their ability to pay. So that does mean that help from other low cost of capital sources makes it easier to restructure with a little less damage to your financial system.

Since I can't think of an example of a country defaulting in a currency union I'll pass on speculating about the issue of devaluation.

[Wonkish1]

And what if the markets are not reassured, despite enacting some of the measures asked by the EU? What then?

A default is not the end of the world.

Again, no one said it was the end of the world, but it is a lot of money. I mean, we're talking about an Italian default here. This isn't peanuts. Come on, guys.

No question about that! But given the sheer amount of total credit market debt in the world today and the fact that the real deleveraging anywhere is in default, wouldn't you agree that if to much debt = bad that there are some good things that come when defaults occur?

To much debt puts too much of a damper on your ability to grow so I think many people in the world will see a few years after a cluster of sovereign defaults that those countries are doing quite alright given the lack of the public debt drag on their economies.

[Wonkish1]

Sure, there are some good things that come when defaults occur. I just think the costs outweigh the benefits on this particular default. There may be a time when that is no longer true, but at the present time it is certainly very true, IMO.

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Oh there is no chance Italy will become like Sudan or Zimbabwe. Perhaps Argentina is more like it. But, because you have surrendered your monetary independence to Frankfurt, Italy does not have the power to defend itself from an uncontrolled default.

And it's not in the European interest to have an uncontrolled default.

I would dispute the notion that there has ever really been a "controlled default". Maybe Iceland, but if you look at them today you know that they are going to default again because the first round wasn't even close to sufficient.

Countries and businesses that are going through painful debt restructuring try to default on just enough to put them on strong footing, but no more than that because of the damage it will do its creditors(for countries its their own banks and people-- for businesses creditors own the business during bankruptcy). So there is damage mitigation through the process. But if you mean "controlled" in the sense that any entity can prevent systemic risk spreading through all of those that have exposure I can't think of any example in history. Bankruptcies/defaults/debt restructurings are very uncontrolled by their very nature(if there was an answer that allowed the entity to avoid doing it they would be doing it).



And Beet, I hope your not coming to the conclusion that having almost every major developed country in the world at 100%+ Debt to GDP is somehow a good thing for growth or systemic risk. I mean we can run around the world and say well "that country defaulting hurts" or "that country default hurts", and therefore we should take the pain away by continuing to transfer the risk and the debt to more solvent and stable parties. That looks like a seductive answer when you look at it from a case by case basis, but lets take a step back for a minute...

Having every major country in the world at 100%+ debt to GDP means that there are officially no more sufficiently solvent and stable parties left to transfer the risk and debt to. Now can you honestly tell me that from a systemic point of view that things get easier when a new problem develops at that standpoint? From my view the sheer quantity of debt across the board means that painful debt restructuring in many, many locations is already "baked into the cake". You can't avoid it. The ultimate question isn't whether its going to happen, but to how many countries and trust me its not just localized to Greece and Portugal. Mark my wards its going to be a lot more than that.

[Wonkish1]

What ever happened to balancing the budget and paying off your debts? Has that become unthinkable? I'm such an old fuddy duddy.

There are a few reasons as to why that can't be the answer when you look at constantly transferring risk and debt to the more solvent and stable party.

1) Large quantities of debt hinder growth. When you transfer just enough of it to another party it to avoid default the debt doesn't go away.

2) Debt servicing on high public debt have large drags on public budgets and your ability to balance the budget going forward.

3) If this kind of crisis doesn't cause the political will to end many welfare promises that these countries have made I don't know what will produce that political will. From the politicians stand point better to default and cutoff our access to new debt and let that be the pressure going forward on further austerity than to have absolutely huge spending cuts that would make default impossible.

4) If risk and debt does get transferred from you to someone else it has become clear to you that the other party has blinked and will likely continue to blink so might as well not take austerity seriously. Better to just wait until 1 of 2 things happen 1) the country bailing you out gets sick of it and then whoever is in charge then can make the tough decisions of what gets seriously cut or 2) some growth returns to your country and you can start returning to profligate spending again because you know said country will blink when the $*** hits the fan once more.


For many countries its going to have to be default and dealing with that pain and for others its going to be the realization in watching this that debt matters and they will cut spending and start balancing budgets. That is what started happening in the late 30s and 50s. Watching other countries default(many people forget their was a cluster of sovereign defaults starting in the 30s) allowed the US to care about making sure it wouldn't happen here and Eisenhower aggressively tried to balance the budget and get public debt down in the 50s because had realized that debt matters. Today people in the US seem to not have learned that lesson, but trust me watching the pain of others on the TV is going to force most people to ask themselves what is more important this program or that program or avoiding *that*!

[Wonkish1]

There are a few reasons as to why that can't be the answer when you look at constantly transferring risk and debt to the more solvent and stable party.

1) Large quantities of debt hinder growth. When you transfer just enough of it to another party it to avoid default the debt doesn't go away.

Actually, technology and innovation are what determine growth, not debt levels. After the Napoleonic wars, Britain had the highest government debt levels the advanced world has ever seen, then or since, at 250 percent of GDP. What followed? The industrial revolution.

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Certainly, but the only reason to balance the budget is to avoid default, and if you are advocating default, the entire point is moot.

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The problem is not welfare. In fact, the precise danger is that the welfare state is un-democratically destroyed on a needless basis. Sweden has a welfare state, and it has no crisis. Germany still has a welfare state. The UK still has a welfare state. Even the US has elements of a welfare state. None of these countries have sovereign debt problems. The problem is not the debt level, the problem is the euro currency and the inability of the multiple parties to reach an agreement.

The precise danger and worst outcome from all of this is that the neo-liberals use the crisis to smash whatever economic security the lower and middle classes have left under the guise of the 'welfare state has failed' when it is their own foolishness that has caused the catastrophe.

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First of all, just because 'the other party has blinked' it does not mean they 'will likely continue to blink' in the face of continued intransigence. This is the kind of thinking that leads to all diplomatic and political failures. Give an inch and they'll take a mile, etc. I say, give an agreement a chance to work, for a while. Make it clear what will happen if the other party does not follow through on its commitments. Italy and France are not Greece. Their economies are in better shape and they have better prospects for success.

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If I believed that, I would have no problem with default. The difference is that I think a default by Italy or France would be far worse economically than anything that happened in any non-WWII years between the late 30s and 50s. It is not the end of the world, but it could potentially be very, very, very bad and I would like to avoid it if at all possible. I think there are many alternative, achievable paths besides this that would result in more wealth for everyone.

Wow you certainly added a lot to everything I wrote that I never said.

1)I said that large debt hinders growth I didn't say it was impossible to have growth with large debt. The reason why it hinders growth is because most of capital that would be made available to spark the next industrial revolution is sitting in government debt. Are you trying to say that any amount of debt has no affect on growth rates? Can you as a person produce the same net worth growth with 80% DTI vs. 20% DTI? Why do you think its all that different for a nation?


2)The point of balancing a budget is to avoid the pain for your country that comes with a default. I'm advocating default because for some of these countries they've already crossed the point of no return.


3)You act like all welfare states are created equal. There is a big difference between Germany and the US with some basic levels of a safety net and a country like Greece where everybody is trying to get onto the public dole as best they can and where every new government is trying to hand out the most government jobs and benefits to their supporters. These promises and this way of doing business doesn't work. And instead of for example cutting half of the government employees and cutting half of the pension benefits to completely alter the budgetary position of Greece they just engage in the bare minimum austerity to get debt bailouts from Europe.

And that is your opinion of the "worst outcome" my opinion would be that it would be the best outcome, but if would take at least 10 pages to move either one of us a tiny bit on the issue so lets just not go there.


4)I fully expect that countries like Germany wont "blink" in perpetuity, but any notion that a country like Greece is going to take the help seriously and actually try to right its situation went down the tubes when they continue to only agree to the bare minimum of austerity to get the new debt bailout. Any notion that they will all of sudden be responsible stewards in the future is a joke.

And look at the austerity measures in Italy and France. I don't call them that serious. And if we have to go down this road of constantly trimming the welfare state around the edges because real budget restructuring is to politically challenging than so be it, but the notion that Italy and France are stable for the long term without large changes to its budget is a laughable joke. Its not looking at reality.


I agree, but the difference between me and you is that I acknowledge the reality that it has to happen and you haven't hit that point yet.

[Wonkish1]

1)I said that large debt hinders growth I didn't say it was impossible to have growth with large debt. The reason why it hinders growth is because most of capital that would be made available to spark the next industrial revolution is sitting in government debt. Are you trying to say that any amount of debt has no affect on growth rates? Can you as a person produce the same net worth growth with 80% DTI vs. 20% DTI? Why do you think its all that different for a nation?

Sure. If the person has 80% DTI, they can grow their net worth faster because if they invest the money they borrowed, any capital appreciation will add proportionately more than if they had not leveraged up.

But the entire exercise is silly. Comparing people to nations is silly. Yes, there is plenty of capital available for ventures even in countries with high debt. When is there no capital available for new ventures? When the markets have collapsed due to sovereign default, that's when. But I stick to what I said before about technology and innovation.

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Nope. The Greek model was perfectly sustainable on the drachma. They've just traded and honest and democratic form of welfare state for an unstable, dishonest and disastrous form of "currency welfare" where Germany subsidies them by propping up their currency, while the rest of their society goes to pieces. However, they're so determined to remain in the euro that they may make it yet, after completely defaulting. Or not. We'll see.

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Italy and France could be plenty sound under their own currencies. Italy, for one, has a very small overall deficit, and has run a primary surplus for years. France has a relatively small deficit. Both are wealth nations with diversified, productive economies. Both are facing liquidity attacks. Unfortunately, under such circumstances even fundamentally sound economies can go down, hard. We agree on what will likely happen (in fact I've been warning about it for over a year now on these boards), but I strongly disagree with you that it has to happen.

1) Debt is previously spent money. It can't be invested. If you are talking about new debt that would be a different story, but its not that easy to take on new debt when your at 80% DTI already.

Why is there no capital when a sovereign default occurs? There is obviously a lot less available capital when there is a lot of debt already out there. You disagree with this?


2) I would point to Greece's numerous defaults in the past as key evidence that the Greece model wasn't sustainable for the Drachma.


3) You honestly think given both France and Italy's current public debt amounts plus the future public liabilities in their budgets that they can continue as is in perpetuity without any changes to their budget whatsoever? Because if you actually believe that then there really isn't any point in discussing this anymore. I mean how do you think these countries amassed this public debt? Or maybe you think public debt can explode with revenues being equal or higher to expenditures. The fact is that these countries budgets were a little to high for many years and this stuff just accumulated overtime. And looking forward the expenditure side of equation is looking worse not better just like it is in the United States.