While global investors’ focus has been on tomorrow’s U.S. mid-term elections and the Fed decision on Quantitative Easing on Wednesday, a less noticed development of potentially major significance took place in Brussels last Friday during a meeting of European Union leaders. At issue was the expiry in 2013 of the EUR440 billion bailout package for sovereign nations arranged by the EU earlier this year.  The stabilization program, which also involved the participation of the International Monetary Fund, required no debt reduction on the part of countries in crisis such as Greece, and no “haircuts” for creditors, but would provide new loans to debtor nations from the EU and the IMF in return for pre-agreed austerity programs. Some member nations had sought a permanent status for the bailout fund in order to lower the yields on southern European countries’ debt, allowing them to borrow at lower cost in global markets. Germany, the major creditor nation and the biggest single contributor to the bailout package, agreed on Friday to provide the fund permanent status, but only based on a sharing of the debt reduction cost with investors.

The implication of the shift was immediately apparent to the participants. Jean-Claude Trichet, President of the European Bank, who has generally sided with the German position on the need for increased fiscal austerity, had a public disagreement with German Chancellor Angela Merkel. Requiring bondholders to take “haircuts” would spook the already nervous financial markets, Mr. Trichet reasoned, making investors unwilling to finance future borrowings by these nations. While “the President of the European Central Bank . . . wants to do everything to ensure that markets take a calm view of the Eurozone,” Mrs. Merkel replied, she could not ask taxpayers to bear the entire burden.

Southern Europe has a Solvency Problem, Not a Liquidity One

The German position implicitly recognized that the southern European sovereigns and banking sector are suffering from an excessive debt burden rather than merely experiencing a liquidity problem. Had it been the latter, the German (and other EU) taxpayers would not be incurring a loss in coming to the aid of Greece or Ireland! And if the problem were one of solvency, then why not require debt-holders ­­- who had made their investments after considering the risk - to bear a portion of the cost involved in the debt reduction? Unsaid by the EU leaders, but just as important, a faster recognition of the true nature of the European debt crisis would allow the debt to subsequently trade at levels determined by the free market rather than by considerations of the extent of taxpayer-financed bailouts. And from the point of view of the debtor countries, a reduction in debt to a level that can be serviced more easily would enable them to enjoy economic growth at a faster pace rather than impose further austerity, resulting in slower economic growth and a rising level of debt.

Chancellor Merkel may also have been thinking of the next German federal elections set to occur in 2013, probably in late-September. Given the unpopularity of the bailouts with the German electorate, debt sharing with private creditors would be a welcome alternative to requiring, say, that Germans work longer to support early retirement on the part of Greek workers. And while France’s contribution to the bailout package is significantly less than the German share, President Nicolas Sarkozy is already facing intense union opposition to raising the French retirement age from

60 to 62 years. Not involving debt-holders in a restructuring process would only increase taxpayer resistance in creditor countries to sustain fiscal profligacy elsewhere in the Eurozone.

 

Lessons for the United States

Developments on the other side of the Atlantic are not merely of intellectual interest in the United States. Whether it is large private financial institutions which were considered by the Obama administration in its opening months to be “too big to fail”, or Fannie Mae and Freddie Mac, which were left out of the recently passed FinReg measures, U.S. authorities will have to deal with the issue of whether to let the free market play its role in bringing about an equilibrium between demand and supply. The alternative would be the continued use of arbitrarily timed government interventions and subsidies to support selected interest groups. In the case of the large banks, a decision to nationalize troubled institutions followed by their being broken up and put back into the market (the “Swedish model”) was rejected in favor of a government role in facilitating takeovers, and adding to the capital of the failing banks (the “Japanese model”). The bailout of the financial institutions was a gift to the shareholders of those institutions but involved taxpayer funds to get that done. 

Similarly, the continued existence of Fannie Mae and Freddie Mac is meant to keep mortgages cheap and facilitate homeownership. The $8,000 credit for first-time homebuyers which expired earlier this year also had the objective of increasing homeownership. If the role of Fannie and Freddie were more restricted, or if the first-time homebuyer credit had not been introduced, operation of the free market would still have brought about equilibrium between demand and supply - perhaps with more expensive credit but at lower home prices. Most likely, existing homeowners would have suffered a bigger drop in prices, but the operation of free markets would have been welcomed by young, aspiring homeowners.  

As in the decision which the European leaders were forced to make last week as they attempted to lower fiscal deficits, the Obama administration will have to decide during the second half of its term on how much of a safety net to provide to the financial institutions or to housing. In a manner comparable to Greece or Ireland having a reduced debt burden which would facilitate less expensive borrowing in the capital markets and enable faster economic growth, the choice in the United States is likely to be whether to continue the various subsidies or allow players in the private market to arrive at their own decisions. The sooner the powerful hand of government is removed from the workings of the economy, the faster would be its return to healthy self-sustained growth.

With U.S. voters said to be angry that the improved fortunes on Wall Street afforded by the Obama administration have not been matched by prospects for Main Street, a variation of the decision that Germany arrived at last week is likely to confront President Obama during the next two years. And more than the size of the fiscal deficit depends on the President’s decision. U.S. economic growth can accelerate to more healthy levels with the operation of the free market and helpful structural adjustments.  Simply put, there is nothing inevitable about the New Normal - the economy can perform well in an atmosphere that provides better incentives to investors, and appropriate conditions for growth in overall productivity.

 

Komal S. Sri-Kumar

Chief Global Strategist

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www.tcw.com