Kevin Hassett must have been asleep for the past two decades.
First, in a column yesterday on sovereign debt, he argued (correctly we think) that the current rescue package for Greece is doomed:
The fatal flaw in the plan is that the European nations bailing out Greece — even Germany, where government debt has risen to about 80 percent of gross domestic product — have similar budget problems and even less political will to take similar medicine. Their plan appears to rest on the hope that lenders won’t notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty.
But he starts heading for the deep end (emphasis added):
In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower.
During the financial crisis, faith was restored in large financial institutions because toxic assets were essentially exchanged for government bonds. If government bonds become toxic, there will be no effective treatment options remaining. The collapse will have no bottom.
There are three problems here.
First, to call European governments “hopelessly bankrupt” is to simply recognize that the EMU was designed in such a way as to prevent the ECB from monetizing the debts of member nations. Some relatively simple changes to the EMU framework would prevent EMU member governments (or a supranational fiscal body) from ever becoming ”hopelessly bankrupt.” Such changes might not be high probability, but they are clearly on the minds of European leaders and policymakers.
Second, to say that there are “no effective options remaining” if all of Europe were to face default is bizarre. In a sovereign debt deflation spiral, some level of monetization, either via direct open market purchases of government debt, or unsterilized fiscal expansion, or both, is the patently obvious answer. And his convenient use of ”essentially” in describing the prior chapter in the global financial crisis allows him to leave out a critical step – money creation. And no, Cassandra, in a debt deflation spiral, monetization and fiscal expansion are unlikely to prove inflationary.
Third, to claim that a “collapse will have no bottom” is rhetorical fear mongering, devoid of any conception of natural cycles, including human ones. Every collapse has an end, by definition. In the worst case, the world’s monetary and financial systems collapse, and we end up bartering with our neighbors, friends, and families; in other words, a two century step backwards. Not pretty, but not exactly “bottomless” either. And to believe that the world’s institutions would stand by and let such a thing happen is ridiculously far fetched, better suited to a backyard-bunker novel than a business column.
He then goes off the deep end completely (emphasis added, black only):
While the U.S. has been above the fray so far, an International Monetary Fund working paper published in 2003 suggests it is hardly in safe territory…
The paper, written by economists Paolo Manasse of the University of Bologna along with Nouriel Roubini of New York University and the IMF’s Axel Schimmelpfennig, studied historical sovereign-debt crises, exactly the situations that Western nations are hoping to avoid. They found that external debt levels — money owed to foreigners — exceeding 50 percent was a key indicator that debt default may occur.
Here is the chilling fact: the average external debt as a percent of GDP among countries in their sample the year before a sovereign debt crisis was 54.7 percent, and 71.4 percent in the crisis year. The U.S. external debt on Dec. 31, 2009, was $13.77 trillion, or almost 100 percent of GDP. For much of Europe, the story is worse.
A key force driving external debt higher has been the increase in government borrowing. In its first year, the Obama administration managed to add more than $8 trillion to the expected 2019 debt, now projected to reach $17.5 trillion.
Even the optimistic scenario only delays the inevitable. Along this path, lenders continue to happily purchase government debt in the near term. But even then, the relatively healthy U.S. will look like Greece within a decade.
Our advice? Read the paper before letting Kevin get too far under your skin. The Manasse-Roubini study’s sample was composed of 54 “market access countries”, which means emerging economies with significant access to international capital markets. Examples include Algeria, Argentina, Bolivia, Brazil, Chile, Costa Rica, Egypt, Indonesia, Jamaica, Jordan, Korea, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, South Africa, Thailand, Turkey, Uruguay, and Venezuela. It was not a study of mature economies with deep and fully developed capital markets and an internationally recognized currency, e.g., the U.S., the U.K., Japan, and western Europe. Chilling??? Come on, Kev…
For Hassett to extend the study’s findings to the U.S. and other developed economies without serious qualification betrays a certain degree of historical ignorance (including Japan, whose recent history he must have slept through), or financial ignorance, which seems unlikely given his credentials, or just good old intellectual dishonesty in the service of political ends. Whichever one is at work, it reflects poorly on him.
He continues:
The only path forward is one in which the major developed nations collectively make long-run budget adjustments designed to soothe market fears before a crisis ensues. Given that the only nation serious about deficit reduction right now is Greece, it seems almost impossible for this story to reach a happy end.
Which markets is he watching, exactly? Credit spreads have been coming under increasing strain as countries have been rolling out their austerity plans. And if being “serious about deficit reduction” is a magic pill, why is Greece’s sovereign debt still the most loathed in the EMU?
And which nations is he listening to? Spain, Portugal, and Ireland are clearly serious about deficit reduction, and Italy is signalling that it might be; and yet their credit obligations are also relatively unloved by the market. Hassett is clearly missing some part of this dynamic.
And recent flights to safety notwithstanding, the USD and Treasuries have been strengthening as deficit reduction moves towards center stage in U.S. politics. This is eerily similar to how Japanese Government Bonds and the Yen behaved from 1989 — incessantly grinding higher despite repeated warnings like the one Hassett is now making to ”the major developed nations.”
What’s happening in Europe, and to the debt of Greece and the other ‘PIIG’ nations in particular, is being driven by the combination of an undeveloped fiscal structure for the EMU and strict constraints on the ECB’s open market activities. Yes, Greece’s prior government screwed up royally (apparently with some help from our sacred financial sector) and needs to make adjustments and amends to its fellow EMU members. But certain aspects of the crisis are also related to national policies and the EMU’s institutional framework that are depressing total output in much of the EU — in other words, there are amends aplenty to go around. And most importantly, hairshirt economics are not likely to improve the situation.
Hassett concludes:
Our choice is panic now, or panic later.
Clearly, Hassett is choosing panic now. And the last people you want by your side in a crisis — much less making decisions — are the panicky types.
URLs:
http://preview.bloomberg.com/news/2010-05-17/greece-s-bailout-heroes-arrive-in-leaky-boats-commentary-by-kevin-hassett.html
http://www.businessweek.com/news/2010-05-17/eu-faces-trichet-s-quantum-leap-call-as-euro-falls-update2-.html
http://www1.voanews.com/english/news/europe/Greek-PM-Considers-Legal-Action-Against-US-Banks-93885419.html
http://www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece
News and Views | art May 17, 2010 | 
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