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“Just Buying Time” Is an Invitation to Disaster

“Just Buying Time” Is an Invitation to Disaster

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FINANCIAL CYCLES



opinion, a successful banking union cannot be based only on recapitalizing the banks, because if it is limited to correcting past mistakes then new

mistakes will show up and some of the past mistakes will be repeated.

The chief aim of a European banking union should be to change the way

banks operate.

Prodded by questions by Richard Qwest, of CNN, Strauss-Kahn dwelt

on the issues underpinning the Transatlantic Trade and Investment

Partnership (TTIP, chapter 3), the trade agreement in the works between

the EU and the US. The goal of the US, he said, is to define the global

trading standard. If they succeed in establishing their way in trade matters, they can dominate global trade.

To Qwest’s question if he is frustrated by this situation, Strauss-Kahn

answered he is not frustrated but he is desperate. The situation is worse

than people think. Europe is more than the common currency where all

attention is concentrated at the moment. By leaving other critical issues in

the time closet, they remain unsolved and grow in complexity. Yet Europe

could be one of the leaders in the world if it would speak with one voice,

which simply does not happen.

The former boss of the IMF singled out debt sustainability as being

one of the key issues that attracts a totally inadequate amount of attention. Hence the absence of limits to the rise of public debt-to-GDP ratios

needed to rebuild confidence in fiscal policies. In the years prior to the

crisis, the economic boom had generated a buoyant public attitude toward

spending-and-spending both in entitlements and in other expenditures

till the levels of public spending became unsustainable even in years of

supposedly “generous” government revenues, which in many cases were

only smoke and mirrors.

An example of overblown (if not outright fake) budgetary surplus estimates has been the $5.6 trillion surplus over ten years that the Clinton

administration left as legacy to the Bush administration. Worse yet,

whether real or fantasy, this boost to revenues was not used to build up

fiscal buffers. Instead, the reference to it was instrumental in increasing

primary public expenditures with priority given to less-productive items

such as:

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New healthcare coverage,

Higher public pensions, and

Rapidly rising public wages.



This business of a fake $5.6 trillion surplus is one of the better examples

on how politicians lied to the American public. The departing Clinton



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administration had supposedly managed the US budget so well that it left

its successor a huge surplus. True or false, George W. Bush Jr. the then

newly elected president, used it to justify his oversized $1.6 trillion tax cut

(which benefited only 5 percent of the American public), as well as foreign

wars whose popularity is best described in a bumper-sticker indictment:

“Bush Lied, People Died.”19

In Washington, not everyone was convinced that this bogus $5.6 trillion was something other than a pie in the sky used just to “buy time.”

The skeptics questioned that “surplus,” and many said that tax cuts alone

were no economic policy. Senator Ken Conrad, the Budget Committee’s

senior democrat, was one of the skeptics. “If you endorse these tax cuts,”

he said to Alan Greenspan, the then chairman of the Federal Reserve,

“you’re going to unleash the deficit dogs. All bets are going to be off.

Because all those who want more tax cuts will see this as confirmation

that they’re right . . . What you’ll do is throw fiscal responsibility out of

the window.”20

Conrad’s position was that at least half of the fictitious $5.6 trillion

surplus was Social Security (which in the US is mainly pensions), and if

the government would just engage in honest accounting, and take appropriate notice of its long-term liabilities, there will be no surplus worth

talking about. Not only was Conrad right but he was also conservative

in his estimate. At the time (year 2000) the US Social Security deficit

(unfunded pensions alone) stood at a cool $44 trillion over the life of the

program.

Spending charades like this provide evidence (not just an indication)

that the Western budgetary framework is not providing the necessary

constraints when revenue growth accelerates with temporarily rising economic results. By consequence, almost all Western nations have entered

the crisis with lots of unfunded liabilities and weak structural budgetary

positions coupled with a growing appetite for spending unearned money.

The politicians’ readiness to satisfy the desire to spend made public

finances vulnerable to the sharp economic downturn. Therefore, it comes

as no surprise that when in 2007 and 2008 the global financial and banking crisis took hold, fiscal positions in most Western countries deteriorated markedly. In a way, the deleveraging cycle that followed is unique

because, as already discussed, it simultaneously cut across three major

sectors of the economy:

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Households,

The financial industry, and

The government.



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Each of these sectors has still to wind down debt and rebuild capital.

At the same time it is necessary to restructure all sorts of public services,

including the infrastructure, at a level that is affordable and sustainable.

To be successful, this effort requires both leadership and comprehension

by the wider population of what is needed and doable, without overburdening the future generations with more debt.

Another debate finding no consensus is that of successive (and expensive) stimuli that have so far been a deception. Economists and (believe it

or not) journalists are actively debating whether governments should be

spending more or less money to move the economy, though they know

quite well that by being overindebted Western governments cannot spend

more. In addition, as it has been already explained, without structural

changes “more” will not mean much in terms of end results.

Tax and spend was the socialist policy that brought the current big

debt crisis. Spending nearly always exceeds tax income by a margin.

Something similar can be said about sovereign loans. “No questions

asked loans” allowed recipient countries to put off tough economic and

labor reforms, which only prolonged the outstanding economic problems

and, over time, magnified them. This policy reflected self-interest.

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Deeply indebted countries are more likely to seek bigger loans in the

future, and

The habit of living on debt accelerates, allowing banks to buy questionable government bonds till bankruptcy shaves off the capital

they loaned.



Wealth is no more transferred from the present to the future, but from

the future to the present—promoting the well-being of the parents by

leaving negative assets to their kids. There is no exaggeration in suggesting that from the marriage of capitalism and socialism has been born a

monster. This experiment has pitifully failed and the Western countries’

current economic problems are in large part of their own making.

To avoid protracted dislocations of private and public resources policies that follow speculative excesses, asset bubbles and spending manias

must be stopped at an early stage. Lessons must also be derived from

the aftereffect of deleveraging to help in challenging past beliefs like the

vain thought that good times last forever. While other periods of balance

sheet contraction were often limited, the present one is broad and global.

Deleveraging (chapter 3) must occur on several fronts simultaneously,

with a properly planned period of adjustment in prevailing policies.

Like feudalism (chapter 6), the twisted and highly diluted capitalism

is on the wane but socialism has no chance to last and this for two good



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reasons: One, communism, which followed hardcore socialist principles,

has been a dismal failure in the Soviet Union. The second reason is that

the outcome of the softer end of social democracy underpinning the last

three decades of capitalism has been just as dingy. The solution is to reinvigorate individual initiative; reintroduce the notion of business ethics;

radically cut public spending; and do everything necessary to promote

discipline and competitiveness.



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Debt Sustainability



1. Overindebted Countries Abandon Their Sovereignty

Since the Treaty of Westphalia of 1648, the sovereignty of states has been

sacrosanct. That treaty more or less amounted to an international agreement that nations are open to attack only when they do something that

threatens or harms others. By contrast, under the Bush and Obama doctrines it is sufficient to get a favorable UN vote in order to attack other

states without even declaring war.

The Bush Jr. doctrine said that nations simply amassing what has been

called “weapons of mass destruction” must forfeit their sovereignty. Iraq

was the first example of this policy and we know what has happened

afterward. The Obama doctrine focused on regime change in sovereign nations, even in cases that did not affect US security policy. Worse

yet, it has been applied in spite of the negatives resulting from such an

intervention.

Libya is a case in point. Contrary to Afghanistan, the invasion of Libya

by US, British, and French air forces as well as the supply of arms to the

jihadists and intensive air strikes, this was not an effort to dissuade a

potential adversary from pursuing a military or subversive buildup. The

further irony is that a UN resolution was twisted around. Instead of protecting civilians, as it prescribed, they were bombed.

Iraq, Afghanistan, and Libya have joined Vietnam as failures of

Western policies established more by way of political miscalculations

and by drifting, than by way of well-thought out decisions that consider

present and future costs as well as likely outcomes, risks, and benefits.

Hit-and-run military campaigns are by no means the only failures perpetuated in the West.

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The hydrogen bomb’s equivalent of human overpopulation, particularly in the less developed countries, and



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FINANCIAL CYCLES



The mismanagement of the Western economies are equally dreadful

examples.



By mid-2014 debt had soared to well over $100 trillion, largely on government budget overruns. Argentina, Ecuador, Egypt, Ghana, Lebanon,

Pakistan, Ukraine, and Venezuela have been “B” countries in credit rating

(next to the lowest level of creditworthiness). Argentina went bankrupt

on the last day of July 2014, and Italy has been at the edge of the precipice

but its arrogance went on unabated. The way Matteo Renzi, Italy’s prime

minister, put it on July 31, 2014: “You change the tune that Italy is overindebted or I blow up the Euroland”1—a statement that needs no further

comment.

A few weeks earlier, on July 8, 2014, European Union finance ministers clashed over how to interpret EU’s budget rules amid criticism of

Matteo Renzi’s proposal to exempt spending on digital infrastructure

from calculation of deficit limits. The push by the Italian prime minister

drew swift rebukes from Wolfgang Schäuble, the German finance minister, and Siim Kallas, of the European Commission. Renzi knew very well

that he has to deliver structural reforms, Schäuble said. Even Pier Carlo

Padoan, the Italian finance minister, backed away from Renzi’s plan by

adopting Kallas’s thesis that “spending is spending.”

This incident is one more evidence of Rome’s policy against the needed

restructuring and austerity measures, even against a reminder that Italy

is overdoing it with its huge mountain of public debt. “Expenditures cannot be excluded from the budget deficit calculations, this is something

fundamental,” Kallas said. “There cannot be bad and good expenditures.

Expenditures are expenditures, debt is debt.”2

According to Schäuble projected structural reform is not an alternative for fiscal consolidation. “If there are really structural reforms, frontloaded, not just promised but delivered, with real impact on the budget,

that could actually allow a country more time,” said Jeroen Djisselbloem,

the Dutch finance minister who chairs Ecofin, Euroland’s finance ministers’ working group.3

While the Italian government has been complaining that it cannot make

ends meet, it continues throwing money to the four winds. An example is

the unwarranted asylum it provides to pseudo–asylum seekers through its

“mare nostrum” operation, a title borrowed from Benito Mussolini’s book.

On the contrary, countries that have finally got hold of their finances are

putting some order and avoid throwing away their capital.

An example is Denmark where, as at the time of writing, asylum seekers

must earn their access to free medical services by way of a multiyear probation period during which they will have to pay for their consultations,



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examinations, or operations involving public health services. The time

has come to put in place more restrictive conditions, said employment

minister Inger Stojberg. In his opinion it was important that people merit

such advantages because as a welfare state Denmark could easily be taken

advantage of.

Precisely because decades of socialist rule have been the costs of the

nanny state spike, countries are borrowing too much. The trouble is that

at the same time lenders are eager to oblige. They are not carefully following the No. 1 rule of lending: find out whether the borrowing sovereign

will be able to pay an interest and repay the capital. When this happens

four options open up:

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Debt forgiveness

Special conditions IMF-type

Debt restructuring

Bankruptcy



If the debt culture is deeply embedded in the sovereign either of those

four options is apt to create a vicious cycle. For instance, even if debts are

forgiven new debts will amass in no time and with them the same problems will reappear. The question therefore becomes: What sort of criteria

and limits can be set to ensure that debt will not grow to unaffordable

levels again? As well as:

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Who will be empowered to look after excesses?

Who will take corrective action?



There are no answers to these queries on a national scale, let alone a

global one. Even if a court takes a decision, which is doubtful because no

global court exists in this particular domain, no judgment may be carried out against the profligate country because this will compromise its

dependence—though in the case of a common currency the other partners in the currency may require that the legitimate government honors

the newly applied conditions.

This leads to the second option of IMF-type tutelage. Several economists, however, suggest that the IMF as well as other authorities implementing an austerity policy on the debtor nation have failed in doing the

right job. Giving more loans to a country under their tutelage in expectation that it can pull itself up by its bootstraps leads nowhere, unless the

country is productive and has an industry that allows it to export and

earn foreign exchange with which it can repay its loans. Short of that, the

new loans only serve to pay interest and capital on the old ones.



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The productivity of an economy ultimately determines how efficiently

the input factors of capital and labor can be transformed into marketable output. Technological progress is an important determinant and the

same is true of training, organization, and discipline. Innovation also

plays a major part.

This brings up the third option of partial forgiveness through an

orderly restructuring, in appreciation of the fact that a heavy public debt

poses a problem to the sovereign’s economy, which finds it nearly impossible to come up from under. How much will be, or should be, this haircut

is a question without a rational answer because it does not depend only on

the country’s economy but also on:

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The sovereign’s negotiating ingenuity, and

The skills exercised by the lenders, including their guesstimate of

how much they can get.



A debtor country may use the fourth option, bankruptcy, to obtain better terms on the third option. In December 2001 Argentina declared bankruptcy and then engaged in prolonged negotiations till March 2005 when

76 percent of its creditors agreed to a haircut of a slim over 76 cents to the

dollar. Since then the Argentinean economy has been limping along and at

the end of July 2014 bankruptcy became the order of the day again.

Still, bankruptcy is the more radical solution to overborrowing and it

severely penalizes those who engage in overlending. It is as well more or

less inevitable when a sovereign’s debt to GDP? Ratio is unbearable. The

question “What is bearable?” has no easy answer and many economists

suggest that a better criterion may be the share of a country’s exports

eaten up by servicing foreign debts.

This is a different way of saying that even “reasonable” debt levels can,

and often do, turn into a heavy burden with dramatic consequences for

the economy. This is one, but only one, of the reasons why many governments are mismanaging debt. The accumulation of liabilities is full of

dangers that very few politicians truly appreciate, and central bankers

don’t always dare to bring this to their attention. Look at the way Ben

Bernanke has been dealing with George W. Bush and Barack Obama in

terms of:

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Mounting debt, and

Ever-growing current account deficit



“That which is not sustainable will not be sustained,” says Josef Stiglitz,

the economist. “The costs and benefits of debt are unequally distributed.

Debt and its aftermath contribute to poverty and inequality.”4



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Like people and companies, sovereigns must have reserves not only to

keep balance between their assets and their liabilities, but also to manage the

risks they face in normal times and in an emergency. The cost of debt can

change in unexpected ways. Without a comfortable buffer to confront such

changes the sovereign will be at the edge of confronting the four options we

just discussed. The central banks should explain this to their governments

and see to it that it is not only understood but also put in practice.



2. The Sense of Debt Sustainability

What the reader should see when observing mountains of public debt,

like the €2 trillion ($2.7 trillion) of France and €2.5 trillion ($3.4 trillion)

of Italy, is not only spoilage but also abuse of state power. If the effect

of a high public debt was not dramatic, this whole business of wholesome indebtedness would have been simply comical, demonstrating how

easy it is to be seduced by debt-hungry creeps when banks and other

intermediaries are making you an offer “you could not refuse.”

But is such a high level of public debt sustainable? The short answer

is that there is no international standard defining debt sustainability and

its limits. To study this issue, economists often use scenarios, hypotheses, and answers to some critical questions. The most important of the

investigative queries is: Can the indebted country afford the debt it has

contracted?

Politicians rarely ask these questions in their public speeches, which

would have been most appropriate in a democracy. Some politicians,

however, do venture a reply in private sessions though their response

is usually qualitative, which means subjective. Too much subjectivity is

counterproductive because such answers are open to abuse or at least to

undocumented wishful thinking.

While it is indeed impossible to separate sharply what is sustainable

and what is unsustainable in terms of public debt, in my studies I have

found that a danger zone of sustainability tends to fall in the band of

8 percent to 10 percent of interest cost to government revenues. Ratios

beyond 10 percent are unsustainable. Ireland, Italy, and Greece are in that

area of above 10 percent.5

For Portugal and Spain the ratio of interest cost to government revenues falls between 8 percent and 10 percent—which means that they are

in the danger zone. (Spain’s other exposure risk is the bottomless pit of

its banks’ capital reserves, which has been partly neutralized through the

€40 billion provided by the EU.)

An interest cost to government revenue ratio between 5 percent and

8 percent is high but more comfortable than the two higher ranges we



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have spoken about. Belgium, Slovakia, and Slovenia (in that order) fall in

this band, and while Belgium at least tries to keep a tab on its debt ratio,

as we saw in chapter 5 Slovenia and Slovakia have contracted new debt in

2014. Several economists think that:

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If the interest cost to government revenues falls below 5 percent,

Then, other things being equal, the chances are good that it will be

sustainable.



That might be true in “normal” times, but not necessarily in the general case. An ongoing economic crisis—like the one that started in 2007

with the subprimes and reached its first high-water mark in September

2008 with the Lehman Brothers bankruptcy—and austerity and/or deflation may shrink the indebted country’s GDP. Therefore, it is wise to keep

some safety margins with the ratios I have just mentioned; and it is wiser

still to abstain from contracting more debt.

The best proof a sovereign can provide that his nation-state is serious

about restructuring its balance sheet is to publicly announce and implement policy decisions before he recycles his existing loans. This can be

seen as evidence that the top political leadership, not just the finance

minister, is committed to real reforms. As a matter of principle, “prior

actions” policy directives are essential while lack of action amounts to

negation of spoken words and promises.

Vague pronouncements like “We are committed to significantly

reducing the budget deficit and backing reform” are insufficient. Even

if the government would like to carry out sound policies, their success

would hinge on how convinced the political establishment is, and plenty

of observers will be watching whether all leaders, and evidently those

running the government, have the will and the ability to make difficult

and (in all likelihood) unpopular choices.

Furthermore, a basic criterion of debt sustainability is whether the

borrowed money is invested in profitable projects or in paying salaries

and pensions. Profitable investments increase the probability that the

loan(s) will not turn sour; hence, they will not cause problems. The risk

is that once profitable investment opportunities are exhausted, the sovereign’s desire to seek more money has persistently proved too great to

resist. Eventually there comes a point when lenders are no longer willing

to finance more “projects,” like football stadiums, and investments that

looked as being profitable sour up.

It is not that easy to comprehend how sovereigns prone to piling up

public debt fail to appreciate that income from taxes and other sources

that could be used to improve public education and the infrastructure has



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to be deviated to service and repay loans. They find it easier to argue that

deleveraging means such income is being used to pay down debt, rather

than to invest. They forget that deleveraging becomes necessary because

of wrong-way policies in past years.

While a properly done deleveraging takes a holistic view of debt sustainability, the effect of simple spending cuts does not bring along the

needed longer-term effects. In the US spending cuts have helped reduce

the 2012 budget deficit to 4.3 percent of GDP, down from a peak of

10.1 percent in 2009. But economists believe that long-term obligations

such as Medicare, Medicaid, and Obamacare will bring it back above the

10 percent level.

This will be a real disaster as the American public debt-to-GDP has more

than doubled since 2007, and in the same period the Fed has expanded

its balance sheet by trillions to a total of over $4 trillion. Above that stand

the sovereign’s unfunded liabilities, a risk that hangs like the sword of

Damocles over the heads of the majority of Western governments.

Public debt is in no better condition in Europe than it is in the US.

Above that Euroland also confronts currency uncertainties. Interviewed

by Sky News on May 14, 2012, a British economist suggested that nobody

in governments, central banks, and the banking industry at large understands what is going to happen if Greece quits the euro. Hence they cannot make meaningful decisions to be in charge of the situation.

The common currency’s uncertainties are a good example of the fact that

“other things” may not be equal. A deep crisis of the euro will tend to turn

on their head the ratios in the danger zone mentioned in the early paragraphs of this section. A similar argument exists in connection with a spike

in interest rates. If a major adversity hits, then 8 percent to 10 percent ratios

(and may be even ratios just above 5 percent) can become unsustainable.

To make matters worse, the zooming public debt levels at peacetime,

dysfunctional sovereign finances, and state budgetary process with plenty

of red ink increase the probability of a technical default, even if the ability

of major Western sovereigns to repay their creditors might look beyond

doubt. In the globalized economy, the central bank’s printing press is a

very questionable “asset” as networks and the media immediately transmit worldwide news of even slight economic and financial earthquakes,

which in the past might have gone unnoticed.

Monetary policy and debt sustainability are correlated. If the monetary authorities are set to inflate another bubble, as it happens with quantitative easing and other unwise measures, then the aftermath may not

only be the hydra of inflation but also the public debt’s unsustainability.

It is no secret that capital is misallocated in a boom, as well as when the

market is awash with money.



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“Just Buying Time” Is an Invitation to Disaster

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