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Europe Delays the Inevitable

by John Rubino on May 10, 2010 · 18 comments

While working on a post about what a waste the European bailout of Greece will turn out to be, I found this from Hussman Funds’ John Hussman, who comes at it from an interesting angle:

Greek Debt and Backward Induction

On Sunday, the IMF approved its 30 billion portion of the 110 billion euro bailout package for Greece – the remaining funds to come from the European Union. The reason for all of this cooperation, of course, is that Greece has enormous debt that is owed in the euro, a currency that it cannot devalue. For many years, Greece has allowed government spending and wage agreements to grow rapidly, thanks to ability to borrow in euros as if it were little different from Germany or France. Unfortunately, the Greek economy faces a debt burden that its economy is now unable to service. If Greece were not part of the European Monetary Union and its debt was denominated in drachmas, it would be able to satisfy its debts by devaluing its currency, essentially making Greek goods, services and wages worth less in terms of foreign goods, services, wages and currencies. In other words, it could alter the relative price of Greek labor and output, imposing extreme cuts in government spending, and without inducing what amounts to an internal deflation. Since this is not possible, keeping Greece as part of the European Monetary Union requires it to impose extreme austerity toward its own citizens, which has predictably led to strikes and rioting. Greek debt problems also predictably imply problems for the European banks that have lent to the country.

The bailout package for Greece should keep it from having to tap the open market for capital for about 18 months. Yet it is hard to look at the possible trajectories of Greek output, deficits and debt without concluding that a debt restructuring will ultimately be necessary – meaning that owners of Greek debt are likely to receive only a portion of face value. What European leaders seem to be attempting is to buy Greece more time, essentially to smooth the potential amount of this restructuring and its impact on the banking system, perhaps three or four years from today when, hopefully, Greece has smaller deficits and the ability to operate without new borrowing.

While this is a hopeful scenario, backward induction is not kind to it. In Game Theory, there’s a technique called “backward induction” that is often used to identify the likely outcome of a game that is repeated again and again for multiple periods. Essentially, you evaluate what would be the best move for each player that would be optimal in the very last period, then assuming those moves, you evaluate what the optimal moves would be in the next-to-last period, and so on to the beginning of the game.

Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures – the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.

Still, for Greece, it appears that the IMF and EU will provide the funding for the May 19th rollover of Greece’s debt, so there’s some legitimate potential for short-term relief. The larger problem is that Portugal and Spain are also running untenable deficits (think of Greece as the Bear Stearns of Euro-area countries). European officials deny the possibility of contagion that might call for additional bailouts, but my impression is that Greece is the focus because its debt is the closest to rollover. The attempt to cast Greece as unique is a bit strained – Christine LaGarde, the French finance minister suggested last week “Greece was a special case because it reported special numbers, provided funny statistics.” In other words, Greece gets the bailout because it had the most misleading accounting?

The bottom line is that 1) aid from other European nations is the only thing that may prevent the markets from provoking an immediate default through an unwillingness to roll-over existing debt; 2) the aid to Greece is likely to turn out to be a non-recourse subsidy, throwing good money after bad and inducing higher inflationary pressures several years out than are already likely; 3) Greece appears unlikely to remain among euro-zone countries over the long-term; and 4) the backward induction of investors about these concerns may provoke weakened confidence about sovereign debt in the euro-area more generally.

Despite the potential for a short burst of relief, the broader concern about deficits in the euro-area make it unlikely that global investors will be appeased by a large bailout of Greece, or will go forward on the assumption that all is back to normal once that happens.

Restructure, Restructure

Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.

Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.

“Failure” and “restructuring” mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.

Why was the EU willing to pull out the big guns in service of bondholders? Because the bondholders are mostly big banks, with French, Swiss and German banks on the hook for over half Greece’s debt. So this is not about Greece; it’s about BNP, UBS, and Deutsche Bank. See Here’s Who Just Got Their A$$ Saved By The Huge Euro Bailout.

Viewed this way, today’s bailout and the many that came before are wasted effort. As Hussman notes, they don’t reduce the amount of debt in the world, and since the global economy already owes more than it can service, we’re just delaying the inevitable — and piling up even more debt with each passing day.

  • Bruce C.

    Of course it’s a waste of money. And it’s time to call the bluff of the banks and financial heavyweights. Once it becomes clear to enough people that our financial system is being destroyed then the “risk” of calling the bluff of the banks, et al will be more palatable – both politically and financially. The article below called “How the Big Banks, Federal Reserve, maintained grip on U.S.” is chilling, but also maddening. Politicians are sooooo complicit and disappointing.

    But, if people know what to expect, then they won’t be as surprised and probably better able to handle it. The truth must be made known so people can choose intelligently how to proceed. It’s either bite the bullet now, allow the de-leveraging, loses, asset revaluations, etc., and then rebuild from a solid foundation, or continue to “deny, pretend and extend” until we all bleed to death.

    Now for my rant:

    Only the Europeans could come up with something as convoluted as the EU, and then adopt it. It’s rife with inherent conflicts of interest and logical contradictions. If bonds issued by Greece are tacitly backed by all EU nations, then why even make the distinction? Why aren’t they just called “EU bonds”?

    As “a stupid American” I couldn’t care less if Greece defaults on it’s bonds, and it wouldn’t change my evaluation of the Euro one bit (I wouldn’t like it any less). Who in their right mind thinks that any security is “riskless”, never mind bonds issued by a-country-like-Greece/a-union-of-variously-socialistic-governments? Isn’t that why one receives interest?

    Just as we’re learning that investors in mortgage-backed securities in the the states didn’t really understand what they were buying (except for that vague belief in the tacit backing by Uncle Sam (so what difference does it make?)), the clowns who bought Greek bonds seemed to assume that the EU/Germany backed them too. Ironically, even if neither ever was completely true, it has become so. It is absolutely criminal to bail out big money investors and make the little money investors, the innocent and the unborn, tow the line.

  • Brad Thrasher

    Hmm, it’s been called the 2nd Gilded Age, The Great Recession, The Greater Depression. How ’bout The Stupid Depression? The one that didn’t need to happen but for our own stupidity.

    IRRC it was my early twenties when I was schooled on the stupidity of throwing good money after bad.

  • Henry Coulter

    This is exactly how it is supposed to play out. The is no problem big or small that they can’t fix by throwing oogles os money at it. I learned that from your books. In a weird way it is conforting to know that they are so predictable.

  • Duane

    Bruce – I just read the article you cited, and it is chilling and maddening.

    Another article called “Incoming” by Brian Pretti is worth a look-see. This time IS different, at least when compared to other recessions over the last 50 years. While this is not the first jobless recovery, this is the first time that incomes are still declining this long into the “recovery”. And they’re down a lot from the last peak, which is also unusual. Incomes always recover, or at least stabilize by now (again, his data set goes back 50 years). A pattern can be seen.

    Regarding the increase in personal consumption, Pretti attributes it to those in higher income levels, who are more levered to improving equity prices – they are likely spending more. We previously discussed the strategic defaulters who have given themselves a raise equal to their mortgage payments plus property taxes. Also, government transfer payments have helped fill the gap in income and jobs. So if we’re being told that we’re spending like recovering consumers, well income data flies in the face of that. Why would we spend more when we make less and have fewer jobs? Unless to relieve depression?

    He gives a bit of perspective at the bottom about who this recovery is really helping, and how we might logically react to the reality of the situation, without getting mad. (I’m not saying he has the answers, just some perspective to help us keep our wits about us).

    Geez, now I’m writing article reviews.

  • Bruce C.


    Check out “How Wall Street Destroyed Main Street” if you don’t mind slumin’ it a little.

  • Brad Thrasher

    Found “How the Big Banks, Federal Reserve, maintained grip on U.S.” so compelling I read all six parts of the series.

    Just six years ago, after the election of 2004, I mused that America’s long flirtation with fascism had peaked. Little did I know that the paper money boys were merely about to change the face of fascism rather than the fact. Obama is Bush in brown skin.

    We’ve gone from the Oil Administration to the Goldman Sachs Administration. If you thought Bush suspending habeas was bad or the Patriot Act an over reach what Obama & AG Hopper seek to do to miranda is frightening.

    I had been astute to accurately predict every presidential election from ’76 forward. My secret was to watch the Fed funds rate after the midterm. Up meant change, down meant re-election. Even having that in my hand my faith was such I viewed it as the politics of competing interests.

    Little did I know my system was just a measure of the paper money boys success. I was part of the creative team that developed “Real Change Deserves A Fair Chance” for Joe Clark’s conservatives. Yes guys, I was once a conservative. Just one of the indiscretions of my youth 😉 Still, I’ve always known people voted with their wallet.

    To quote from the article; As the former populist Senator Huey Long once said, “When fascism comes to America, it will come in the form of democracy.”

    I will continue to find solace in Churchill, “You can always trust the Americans to do the right thing; after they’ve tried all the wrong things first.” I will continue to learn from our brief history that has given us four central banks but only one Treasury.

    I will remain hopeful up until the day that people no longer do anything they can to get here. As bad as things look, that day seems far off indeed.

    And now I will enjoy Keith Olberman for an hour and read “How Wall Street Destroyed Main Street” this evening.

  • Henry Coulter

    A bit off topic but, I just noticed that it is always the same people who write comments. I am one of you, always obsessed about the economy, politics, status quo, government grabbing too much power, World going to hell in a handbasket, another great depression. Sometimes I just wish we could get it over with and get on with our lives. I know, I know, it’s hard to enjoy life when you’re trying to make ends meet and stay ahead of the curve, not be just a sheep headed for the slaughter, but sometimes I can’t help but think it is better to be oblivious. Don’t pay attention to me I’m just ranting.

  • Brad Thrasher

    It’s okay Henry, you’ve entered the econ-law-polysci geek zone. Ironic we appear consumed by the Chinese curse, “May he live in interesting times.”

  • Bruce C.

    I’m just curious…

    Does any one think that this EU bailout deal will have a similar effect (i.e., the inflation of assets/equities) in intensity and duration as the US bailouts? How high do you think the stock market will go? How long will it last?

  • Brad Thrasher

    Hey Bruce C., according to available info this bailout is just the beginning. Coming soon to a corporate welfare bum near you is the pain in Spain, the dire-land known as Ireland, the pity that is Italy and I’m stumped on what to call Portugal but new reports suggest the contagion has smitten Britain.

    Will the EU banks use bailout bucks for capital reserves or will they put it out into the general economy? My guess is they follow the American model.

    Gold set another new high today. I read this as another sign the market is screaming “Stop the insanity!” A tad too soon for me to predict highs though I’m certain we will test the lows the March ’09. Testing the ’08 high of 14,400 seems unlikely though inflation could easily put the Dow well past that number.

    Sorry can’t help you with that pesky timing thing. Two reasons, (1) not enough info available; (2) I’m just not that smart and if I were not sure I’d tell anyone 😉

  • Duane

    I agree w/ Brad and not knowing that I’m not sure I will venture where he will not. Here’s the way I see it. Congress is well cowed by the Da Boyz’ (thanks Scott) impressive powers over the markets. Wall Street needs well-trained dogs and ponies in Congress, and Congress wants to be re-elected. Congress is feeling especially vulnerable having passed unpopular legislation. The banks will rig a continued rally, or at least run it sideways, through Nov. 4. Now, trying to drive it up too high increases the risk of a crash, but running sideways with no strength is probably risky, too. So, my first order (zeroth order?) guess is that we will see a moderately strong continued rally, with a few corrections along the way to reduce risk. I don’t expect much market participation from the typical investors, whatwith all the evidence of manipulation, so Da Boyz will have the control they need. For example, both Goldman Sachs and JP Morgan have made a profit every single day of the first quarter this year – no down days! Goldman Sach’s averaged $25M per trading day. And few investors have illusions about what happened Thursday, May 6. Many want no part of this rigged game. I alone am riding out the stocks because the rally still is what I always thought it was. I expect 12500, as a rough continuation of what we’ve seen this year. A big corrective crash after Nov. 4 leaves plenty of time, two years, to stage a recovery rally again, plus the opportunity to further consolidate power. It’s a poliscycle. The fundamentals aren’t considered relavant to my analysis.

    If the Congress and SEC shows itself to be serious about prosecuting Goldman Sachs and others for fraud against their clients, manipulating PMs, or whatever else, then I’m out!

    These are the new fundamentals, as I see them.

  • Bruce C.

    Hey Thrash,

    How ’bout the “poor-not-frugal” Portugal?


    Have you studied Prechter’s wave/cycle analysis prediction? He says the rally from 3/09 should have peaked by May 7 and will now drop for the next six years. What’s fascinating to me is that his analysis does-not/needs-not account for any of the current events. They’re all baked-in somehow. What do you think?

  • Brad Thrasher

    Recently I’ve noticed references to counting debt in quadrillions. U.S. debt is reportedly approaching 1 quadrillion! Estimates are running as high as a breathtaking 800+ trillion dollars.

    Bruce C., please don’t take offense, but given the circumstances I find attempts at precisely timing the crash kinda funny. The ability of the oligarchs and plutocrats to keep it running thus far is impressive indeed!

    Actually I think John Rubino is quite right that volatility reigns during a long decline.

    If there’s a sudden unmistakable collapse maybe an inability to fulfill contracts on the paper gold market spreading to other commodities as being the trigger. A sudden run on USD’s would be another.

    But what triggers the trigger? Maybe we’re just seeing the beginning of the stress as more long positions are beginning to take delivery.

  • Bruce C.


    I basically agree with you about the timing of market actions going forward given the alleged (?) market interventions. However, I find it interesting and kinda’ funny that “technicians”, “chartists”, “cycle analysts”, “wave theorists”, etc. claim that such things don’t matter. Or, in other words, that such interventions (or exogenous events, etc.) are somehow accounted for within their data.

    The more I read about Wall Street shenanigans the more I doubt that such interventions are anything new. I remember talking to my father (who was a stock broker in the 50s and 60s) about trading on insider information, and he said it went on all the time. I think to believe otherwise is naive. The only question in my mind is how much more of it is going on now compared to the usual amount, and is it enough to have changed the traditional ways of analyzing the markets.

    Furthermore, Prechter with his socioeconomics and wave/cycle analysis claims that even unprecedented interventions or whatever else are all accounted for because even those things occur in waves/patterns/cycles.

    I’m just trying to understand it all. I may conclude that it’s all B.S. Let’s face it, most of these guys are selling news letters, etc. so that may be all their is to it – another kind of snake oil. They probably just put their own money in to Treasuries, despite what they advise others to do. (And most are careful to not even advise. They just give suggestions or point out ways of looking at things.)

  • Brad Thrasher

    Hey Bruce C.,

    Your interest in insider trading is intriguing. My particular passion and study in law is economic bias in the system. Told ya I’m a lib 😉

    Sadly, there is no “duty of confidentiality” in U.S. law governing congress, congressional staff or the executive. There a few, never before tested legal theories such as common law relationships and the history of confidentiality. Like I said, untested legal theory prohibits insider trading by congress and the executive. Additionally, elected reps must periodically disclose their investments and thus the People can vote them out office. So there is “democratically mandated accountability.” Are you snickering?

    Available studies indicate our elected reps enjoy ROI’s of 12 to 25% above what the average investor earns and 6 to 19% above that earned by corporate inside traders.

    H.R. 682, also known as the Stock Act is an attempt to halt public employees, including elected representatives from trading or disclosing inside or non-public information. As of 04/05/2010 the bill is “ahem” presently under review by the subcommittee on the Constitution, Civil Rights and Civil Liberties.

    A report describing how prohibiting insider trading by government employees is somehow unconstitutional, a violation of the plutocrats civil rights and liberties would make for interesting reading, no?

    There are numerous data mining companies tracking the legal insider trading of elected representatives and government employees. Somehow I strongly suspect subscribing would take the intellectual challenge out of the game for you.

    OTOH, we’re talkin’ ROI’s of 12-25%. So if you’re looking for a legal shortcut whereon you won’t do a perp walk…

    Hope this tangent hasn’t killed your question on wave theory for Duane.

    All the best,

  • Duane

    Bruce – yes, and I have more confidence in Prechter than most. Lately, I’ve also been studying Steve Keen and Minsky’s financial instability theory (one and the same). Without having laid Prechter’s waves side-by-side with Minsky’s stages of instability, Minsky seems to be describing a similar phenomenon to what Prechter has modeled with Elliott Waves. So we are now (presumably) in the terminal stage of Ponzi financing as described by Minsky, which is analogous to what Prechter recognizes using the wave shape, the strength indicators and the sentiment indicators.

    What’s interesting about all three of these guys is they do not believe in capitalism’s inherent stability and resulting equilibrium, such as the mainstream economists believe in. Rather, economic growth occurs at the expense of stability, followed by a contraction, and it starts all over again. I imagine Kondratiev’s cycle is the same idea. Our vaunted mainstream economists do not have models that predict recessions or depressions, and basically use static models: they say if you add a bunch of money, for instance, the economy just finds a new equilibrium.

    I guess Prechter would say that current events largely flow from the overall mood and conditions, and/or that they don’t substantially effect the major trend – I don’t know what else to say on that score.

    Well, at some point I may lose faith in my theory that the Fed and Treasury can continue to stage a rally up to the election, and pull out because it’s too dangerous. If I get bitten badly because I didn’t listen to Prechter, I might feel twice badly.

    My abiding hope is that we learn something from all this that we can take away and teach to the next generation. Or at least I have some gold I can pass on!

  • Brad Thrasher

    Hey Duane,

    Is the issue with economic modeling that all is based upon an assumption of scarcity when in fact recessions and depressions occur when we are unable to distribute an abundance of goods and services?

    Is this what you mean by the phrase “static models?”

    For example, during the Great Depression people starved while graineries remained full. Today shippers are profiting handsomely because exporters, having filled the warehouses, are using cargo ships for storage.

  • Duane

    Brad – That’s very interesting. It’s not what I was referring to, but it may end up there. Static models do not show variations with time, so they don’t directly predict a contimuum where the economy is healthy and growing and then some time later degrades catastrophically. A dynamic (i.e. time-varying) model would be more applicable. Also, neo-classical economists assume that free markets seek a healthy equilibrium state.

    That imbalance you are describing (lack of distribution) – could it arise from excessive risk-taking, speculation and Ponzi financing, ending in defaults and a credit collapse? Could that show up in the distribution network first? Is money diverted elsewhere? These are along the lines that Minsky’s Financial Instability theory would consider. He neatly describes the continuum, starting with a recovery from a recession, followed by a period of very conservative lending and very conservative projects, and progressing eventually to very risky financing and very risky projects, ending in defaults, credit collapse and recession. Keen is trying to dynamically model this type of thing.

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