Dr Strangelove: or how I stopped worrying and love the debt

Major T.J. “King” Kong: “The contents of your survival kit is... one pair of nylons, five condoms, one .45 caliber pistol with two magazines, $200 in gold coins, 2 packs of chewing gum, one miniature bible and combination Russian phrase book... OOOOOWEEE, a feller could have a pretty good time in Vegas with all that!

To many investors there is a new doomsday machine, the European sovereign debt crisis, and they can be forgiven if they are mistaking European politicians for the cast of Stanley Kubrick’s famous black comedy, President Merkin Muffley, Premier Dmitri Kissoff, Group Captain Lionel Mandrake and General “Buck” Turgidson among others.

Unlike the doomsday machine though, this crisis can be stopped if decisive action in taken.  The one lesson of past financial crises is that authorities must get ahead of events and stop them by applying massive force.  Mexico in 1994 is perhaps the best example of that.

Unfortunately, the EU has done the opposite, partly out of pride (no, this is not Latin America, and no, we don’t need the IMF) and partly out of inexperience.  While the initial tab was put at €30 billion, it is now in the trillions.

As I have argued in this blog, there is no way for Greece to pay off or even service its public debt, and as a result, there is little incentive for it to make drastic adjustments; the Greeks, and other countries in the same situation, have to understand that they need to sacrifice as much for their own benefit as for that of their creditors.  This presupposes that the debt be significantly reduced both via “haircuts” and large scale privatizations.

Whether Greece remains a full member of the EU or not is not easy to answer.  In either case, it would need to make profound structural changes, as did Chile in the 1980s, otherwise, it would continue to stagnate (if it stayed in the EU) or would expose itself to exploding inflation (if it exited).  My view is that if Greece exited the EU it would probably not come back; as much as sticking to the euro would represent a headwind, being a member of the EU would maintain pressure on Greece to practice good economic management.  All things considered, it is probably best for it to stay in the EU.

The heavy lifting is really about Italy, and to a much lesser degree, Spain.  Quite simply, there is no EU without Italy. Germany and the rest of Northern Europe should know it and act in consequence.  Likewise, Italy should realize that not making the kind of adjustments that are necessary will sink the euro, and they will sink with it.

So for all of you in Berlin, Paris, Rome, Brussels and elsewhere in Europe, here is, one more time, Major T.J. Kong:

“Well, boys, I reckon this is it - nuclear combat toe to toe with the Roosskies. Now look, boys, I ain't much of a hand at makin' speeches, but I got a pretty fair idea that something doggone important is goin' on back there. And I got a fair idea the kinda personal emotions that some of you fellas may be thinkin'. Heck, I reckon you wouldn't even be human bein's if you didn't have some pretty strong personal feelin's about nuclear combat. I want you to remember one thing, the folks back home is a-countin' on you and by golly, we ain't about to let 'em down. I tell you something else, if this thing turns out to be half as important as I figure it just might be, I'd say that you're all in line for some important promotions and personal citations when this thing's over with. That goes for ever' last one of you regardless of your race, color or your creed. Now let's get this thing on the hump - we got some flyin' to do.”

Michael Phelps and me

I am a masters swimmer who particularly enjoys the 200 and 400 medley events.  As the new season begins, each member on our team sets his goals for 2011-2012.  Suppose for a second that our captain should tell me that my goals are too modest, that instead they should be to beat Michael Phelps and train in consequence, that anything less would be viewed as failure and evidence that I was a slacker.  I love swimming, I love training, but I think beating Michael is not in my cards.

Today, the Greek public debt represents anywhere between 160% and 170% of GDP, and with GDP shrinking hard, that percentage is more likely to rise than to drop.  The Greeks know it, the EU knows it and creditors know it too.  In fact, Greece is as likely to pay its debt as I am to beat Michael.

Yet the fiction of quasi full debt service (quasi because of the 21% haircut proposed on 2011-2014 maturities) is maintained.  This is proving little incentive for the Greeks (why should we sacrifice for an unattainable goal?), the creditor banks (why should we recapitalize now if we might drag this for another year) and the rest of the EU (Germany will eventually have to step up to the plate).  Worse, the whole affair is shaping up as a dangerous game of musical chairs, where the actors keep a wary eye on each other, ready to jump at a second’s notice, and where markets are gradually seizing up.

A better strategy would be to accept reality and provide the basis for a successful workout.  Greece can only pay a fraction of its debts but that should not result in a regional or global market and economic catastrophe.  Indeed, I believe that such a strategy would result in a sharp recovery in confidence and thus stock and bond valuations. 

Such a strategy would rest on two pillars: the first would be to reinforce those European banks that need it, most likely via capital subscriptions from the European Financial Stabilization Fund.  Bank valuations are so depressed now that relying on private capital is not feasible, except perhaps for a fraction of the amounts needed.  In this regard, it is crucial that the terms of the EFSF capital injection not be punitive, and this for two reasons: banks can be castigated for making bad loans but not so much for buying their country’s sovereign debts, and it is important for the future that private investors want to buy bank stocks.  TARP is a good example to follow.

The second pillar of the strategy would be to provide an incentive for Greece to make tough decisions.  This means that creditors should share in the pain and that Greece should share in the rewards of making sacrifices and revamping its economy.  The idea is not new and there are many ways to do so.  Obviously, refusal by Greece to try hard should be sanctioned severely by the rest of the EU.

It is the ancient Greek mathematician, Archimedes, who said “give me a fixed point and I will raise the world with a lever”.  What modern Greeks need is a lever to raise their energies, i.e. a reasonable baseline with a clear upside and downside.  And what I need is for Michael to give me a one minute head start, on the 200 that is.

Mrs. Merkel makes a good move

The widely leaked existence of a Plan B whereby Germany would support its banks and insurance companies should Greece default on its debt is a constructive move forward:

1. It attempts to delink Greece from the European and world financial markets.  As Mrs. Lagarde noted last month, banks are unfortunately very efficient instruments of contagion, so that strengthening them is the best way to contain the Greek crisis;

2. It sends a very clear message to Greece that Germany is not obliged to bail it out, particularly if it doesn’t fulfill its commitments.  By announcing Plan B, Mrs. Merkel defuses any possible blackmail from Athens;

3. Finally, it forces France, Italy and others to provide similar protection to their own banks, which in turns should stabilize the financial markets and set the stage for a realistic Greek debt workout.

Bond and stock markets have lost a multiple of Greece’s public debt in value.  It shouldn’t be, and this move by Mrs. Merkel is welcome.

Longer term, it is getting ever clearer that the Greek debt will be restructured along realistic lines.  While I originally thought that a wider privatization program could keep the total “haircut” at or below 20%, I no longer feel that confident.  Even if Greece embraced a €100 billion program, I don’t see how the haircut could be less that 40%.

Finally, the Merkel move is also a warning to Portugal and Ireland, although their prospects are not as dim.  As for Spain and Italy, there is no European plan yet.  Spain seems to be taking measures to reduce its deficit, but Italy is further behind, appears less committed and represents a much bigger challenge.  No doubt Mrs. Merkel will need to keep working hard.

The US Presidential Election: A Democratic alternative?

By all accounts, President Obama has had a difficult summer 2011.  His approval ratings are close to their all times low.  More worrisome than the overall score are the underlying dynamics. 

The Rasmussen Presidential Tracking Poll is calculated by substracting the percentage of voters who Strongly Disagree with Mr. Obama’s conduct of affairs from those who Strongly Agree.  While the Strongly Disagree rating has fluctuated around the low 40s mark since the spring of 2010, the Strongly Agree rating had fallen from the high 20s to the high teens.  In other words, the President is not gaining core supporters, and he is crystallizing opposition against him.  According to IBOPE Zogby, the President’s approval rating now stands at 40%; Gallup gives him 42%.

But it is the economy that is Mr. Obama’s biggest challenge, as only 26% of voters approve of his management according to Gallup.  Given the depth and range of the problems and the inability so far of the President to reach a consensus with the Republicans, it seems unlikely that he will be able to turn the situation around quickly.

This week, he is to present his plan to create more jobs.  Some of the leaks point toward money for infrastructure, unemployment benefits and reduction in payroll taxes.  Will this package be big enough to change sentiment and to make a difference? Are there enough “shovel ready” infrastructure projects? Will the bidding terms be designed to stimulate rapid mobilization or to secure high union participation?  The President suffers from a credibility gap both with his left and the opposition.  It is therefore difficult to expect a miracle from this forthcoming announcement.

So far, no Republican candidate has succeeded in rallying both Republicans and Independents; moderates such as Romney and Huntsman are viewed with suspicion by party members, while more conservatives candidates like Perry seem unlikely to win over many Independents if they win the primaries.

But the President remains vulnerable as the Democratic Party may not want to go with a candidate who has low ratings and is unlikely to win votes across party lines.  Democrats will also worry that of the 33 seats in the Senate that will be contested, they currently hold 21 vs. 10 for the Republicans.  Incumbents are very unpopular, so that Democratic seats are proportionately more exposed, and with that, the control Democrats have of the Senate.

Thus, the main danger for Mr. Obama, in my view, is the rise of a moderate Democratic candidate for the presidency who could appeal to Independents and some Republicans, and also who could protect Senate seats.  If she were to run for president, Secretary Clinton would keep most of the Democratic votes (losing some on the left to abstention) and she could win over many Independents.  By winning 20% of the Republicans she should secure victory.

Clearly, it would be very awkward for her to campaign, even if she left the cabinet.  Even then, I suspect that she would not want to run against the man who offered her the second most powerful position in government.  There are only two ways for her to secure the nomination: for President Obama to announce that he is not running, or for the Democratic Convention to make the decision for both of them.

This is not an issue that is receiving much attention for the moment.  It may never materialize if the President succeeds in turning sentiment and the economy around, although this would likely require him to make some very important changes in his goals and modus operandi.

If he does, the prospects of the US economy look brighter.  If he doesn’t, they also look brighter because markets will start factoring the possible entry of a moderate Democratic challenger.

So far however, markets extrapolate current trends in a straight line; they do not consider the possibility of an inflection point.  In the real word, there is no such thing as a straight line for ever.

If only Europe could make progress on its debt problems!  But there too, although it is probably too early, trends do not follow straight lines and they will inevitably encounter an inflection point.