The Dismal Optimist


MORAL HAZARD TRADES

Trade One: Buy Greek Government Bonds

In my last Dismal Optimist, I argued that the euro in the long run would be better off if Germany and the other stronger EU states did not bail out Greece. I referenced the 1841-42 defaults of eight American states and one territory as one example of where states defaulted and the monetary union survived.

But economic optimality and investing sometimes diverge. Investors search for assets that will rise in price. If politics trump economic rationality, that’s life. In the case of Greece, the “smart money” apparently is counting on a bailout. For example, Bloomberg reported on Feb 12 that Blackrock, the world’s biggest asset manager is increasing its Greek bond holdings, betting that the EU won’t allow Greece to default. “They won’t allow a Lehman-type crisis,” a senior Blackrock official was quoted as saying. The odds – unfortunately – favor his being right and as this was written it appears that some type of bailout was going to happen.

This isn’t 1841. Greece is too big to fail. And so will be Spain, Portugal, Italy and Ireland if it comes to that. Modern governments cannot endure short term pain.

In my opinion this is all long term bad news for the euro although in the short term as the market smells a bailout the currency is strengthening. “Too big to fail” is incompatible with free market capitalism. Germany will come to regret its bailout if it goes that route. Germany itself is running a government net/debt to GDP ratio of close to 60%. No gratitude will be forthcoming from Greece whose politicians have already dusted off a laundry list of reparations supposedly due the country from the German occupation of WWII.

The Greek moral hazard trade may ultimately prove a disappointment. Think Argentina 2001. All the IMF’s money and sage economic advice ultimately couldn’t prevent default by a corrupt government that didn’t know how to spell “fiscal discipline.” Greece has net government debt to GDP in excess of 100%, a budget deficit in excess of 13% of GDP, a huge overpaid militant public sector, and a low skill private sector that cannot compete with Asia with a euro exchange rate largely determined by its industrious neighbors. Its public sector borrowings have been to finance consumption and bloated government payrolls. It’s often argued that one handicap for the European Union is that, unlike Americans, Europeans are unlikely to move from their home states to find greener economic pastures. Labor mobility isn’t what it is in the US. Greece should count itself lucky in this respect. Half the country would move to Germany if cultural and linguistic barriers did not exist. Pain and domestic deflation lie ahead.

Default may be Greece’s best alternative. Greece can default and stay in the euro. Default will relieve it of its debt load and reduce the necessary deflation. Some settlement will no doubt be worked out with creditors later. The Germans and the other Europeans will have to bail out their own banks which are heavily exposed to Greece. Perhaps the banks will then learn next time not to rely on “implied guarantees”. Greece leaving the euro and reinstating its own currency the drachma (call the new currency the dracula?) would be a nightmare. Totalitarian methods would be needed to force Greek citizens to use it. Argentina had a currency board whereby one peso equaled a dollar. And in typical Argentine style that currency board “cheated” a little bit and did not maintain 100% dollar backing. Argentina had never fully given up its own currency. And Argentina was in the far away periphery, somewhere at the bottom of the world. Greece is in Europe. It’s too late to leave.

Trade Two? – Buy State of California Bonds

Actually several US states could be chosen. But California, with its yet to be financed $6.3 billion projected budget shortfall, is the poster child for fiscally challenged US states.

For starters, there is a huge difference between California and Greece. California’s debt to GDP was a miserly 7% at the end of 2008 and its budget deficit in that year was in the 2.5% range. California is the largest GDP state, with its agriculture, entertainment, high tech, defense, and a myriad of other industries. Still anyone buying California General Revenue bonds is counting on a Federal Government pouring in money because state spending is inexorably being pushed upward and revenues, hammered by the recession and structural factors, cannot keep pace. Further net borrowing to fund rising budget deficits is prohibited under the state constitution. California, like almost all US states, is supposed to operate on a balanced budget.

Consider:

  1. The term “bailout” is admittedly a murky one when it comes to state governments. According to economist Gary Shilling, the Federal government is transferring $246 billion to the states in Federal fiscal 2010 to help them fill in roughly 30-40% of their budget gaps. At the same time the Federal government imposes expenditures on the states such as their share of Medicaid which comprises an estimated 21% of state expenditures. Bailout in this context is the Federal government funding above and beyond what it was going to dole out to a state.

  2. In theory governments, unlike corporations, only default by choice. Government’s can always raise taxes and/or confiscate their citizens’ assets. In California however that’s not so easy. Tax increases require a 2/3 vote of the legislature. California is already one of the most highly taxed states. The Republican minority in the legislature will not easily accede to tax increases. Even if they do, California is on the wrong end of the Laffer curve. (Economist Arthur Laffer himself recently moved straight down his own curve from California to no-state-income-tax Tennessee.) Further tax increases may not bring in the desired revenue.

  3. California has been hard hit by the recession with a December state unemployment rate of 12.1%.

  4. California, along with other states, is seeing its annual expenditures being pushed up by generous compensation packages awarded to its unionized employees. It’s a simple conflict of interest model. Public sector unions – which became legal in most states only in the 1970s--vote for the politicians who in turn reward them with generous compensation packages. (Not an unfamiliar phenomenon in Greece.) 61% of state and local California employees are unionized. According to a recent paper by Chris Edwards of the Cato Institute, California had an average annual compensation in 2008 for state and local employees of $86,417. This was the highest of any US state. According to Bureau of Labor Statistics data cited by Edwards, average total compensation for state and local workers nationwide was forty five percent higher than their equivalent private sector peers. Frequently public sector union contracts are back loaded with super generous retirement benefits. Public sector employees generally retire earlier than private sector employees (in California 50 for public safety workers and 55 for other workers.) usually with defined benefit programs and lifetime medical coverage. With most of the states, double dipping (public sector workers retire with full pension and then take a new public sector job), pension spiking(inflating the final preretirement year’s salary), and phony disability claims are frequent public sector phenomena. Most importantly, the courts have ruled that public sector contracts cannot be broken. And legally it is not clear if states, unlike corporations and municipalities, can declare bankruptcy. If California cannot go bankrupt and has to choose between its union contracts and its bondholders, in my opinion it will have to choose the former. Unless of course the Federal government plugs the shortfall.

  5. California is faced with negative demographics. Higher income professionals are leaving the state. High taxes, environmental rules and hostile attitudes toward business are contributory factors. New in-migrants on average are poorer and more needful of government services.

  6. With entitlements and state and local workers compensation soaring, California, as have been so many states, has been cutting essential services and those expenditures which made the state attractive in the past. The world renowned state university system for example has seen its budge slashed dramatically and tuition fees hiked. K-12 class sizes have been raised. The list goes on. Public sector union contracts must be honored, Federally imposed mandates must be funded, essential services to the public be damned. A downward spiral.

Asia Should Do What?

The massive growth of government debt in Western countries and the Greek problem has focused attention like never before on the coming crisis in unfunded and ever so generous government welfare benefits. Huge unfunded future expenditures are projected in the coming decades as worker/recipient ratios become more unfavorable as these societies age and the generous benefits promised by governments to their electorates pile up. In the US, Social Security, Medicare, Medicaid, (the Obama health plan?), all present major fiscal challenges that will be added to already burgeoning government debt.

The first social security program was first proposed in Germany in 1881 by none other than Otto von Bismarck. "Call it socialism or whatever you like," Bismarck famously said. The US under Roosevelt essentially copied the Iron Chancellor’s program. Roosevelt rejected any sort of privatized or defined contribution program.

Western economists have been lecturing China and other Asian countries to decrease their savings rate by instituting government programs that would reduce the average citizen’s need to save. Perhaps they should think twice before giving this advice. Or more realistically, perhaps they should advise defined contribution, privatized plans. Asian countries including China are one step behind the West regarding aging. (Japan already is already there) Prosperity drops the birthrate, politicians desirous of reelection add to the benefits of public social welfare programs. Do the Asian governments need to emulate the West and bankrupt themselves in the process? Conversely, will not countries without massive governmentally run defined benefit and health programs offer superior long run investment returns as compared with those that have these programs?

Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong.

David Hume

David Hume (1711-1776)

Although David Hume (1711-1776) is primarily known as a philosopher, his price-specie flow model explains the fundamentals of the international gold standard.

Versions of the international gold standard dominated international finance from 1871-1914, 1920-1933 and 1945-1971.