via John Hussman weekly commentary [bold emphasis mine]
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.
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.