The three-ringed circus

There's a great piece today by former IMF chief economist, Simon Jonson, in which he argues that:

Greece’s EU/IMF program heaps more public debt onto a nation that is already insolvent, and Ireland is now on the same track. Despite massive fiscal cuts and several years of deep recession Greece and Ireland will accumulate 150% of GNP in debt by 2014. A new road is necessary: The burden of financial failure should be shared with the culprits and not only born by the victims.

The fundamental flaw in these programs is the morally dubious decision to bail out the bank creditors while foisting the burden of adjustment on taxpayers. Especially the Irish government has, for no good reason, nationalized the debts of its failing private banks, passing on the burden to its increasingly poor citizens. On the donor side, German and French taxpayers are angry at the thought of having to pay for the bonanza of Irish banks and their irresponsible creditors.

Such lopsided burden-sharing is rightly angering both donors and recipients. Rising public resentment is testing German and French willingness to promise more taxpayer funds. German Chancellor Angela Merkel’s hasty and ill thought out plan to demand private sector burden sharing, but only “after mid-2013”, marks a first response to these popular demands. We should expect more.

Financial crises are actually not rare, and the rules for their resolution are clear. The fundamental insight is that huge amounts of financial losses, of seemingly real value, need to be distributed across creditors, debtors, equity holders and taxpayers. The first step is to bring the current budget deficit under control to achieve a primary balance, which both Greece and Ireland are now attempting. The second is to attract sufficient emergency funding, which the IMF and the EU essentially have done. But in neither Greece nor Ireland is that sufficient. They still have unaffordable debt burdens. Therefore, one more measure is needed, namely a reduction of the public debt.

The public debt can be contained in two ways. The first and preferable option is that the state never nationalizes private bank debt as Ireland has done. For Ireland, this opportunity has probably passed, but other countries should be warned not to make the same mistake. Kazakhstan’s refusal last year to bail out its major banks, despite strong demands from the senior creditors of these banks, has proved a far more successful path. Banks can and should go under if they have failed. The state should only defend small and medium-sized depositors.

If the state has taken on too large debt, sovereign default is the natural outcome.

...Sovereign defaults are always contentious, but they don’t need to end in catastrophic financial collapse ... Troubled nations, as part of their rescue plans, can and should introduce legislation that permits a qualified majority of creditors to change terms on outstanding sovereign and bank debt, while protecting bank deposits. Such rules could, for example, require 2/3 of non-protected creditors agree to a restructuring plan. This reduces the risk that holdouts can prevent a deal from being reached, but still gives creditors clear powers to negotiate terms.

Well-planned debt restructuring will not cause a systemic financial collapse. It is misleading to draw parallels from the chaotic liquidation of Lehman Brothers for the outcome of debt relief in Europe. The direct impact of debt relief for Greece, Ireland and others is easily measured and managed. The debtors and creditors are well known."

This blogger could not agree more with the principles described here but as it has illustrated before, it does not share the sanguine view of the outcome.

The global economy is a three-ringed circus. The inner ring is real commerce, production, consumption and trade. This is the layer at which fundamentals like supply and demand operate. The second ring is a layer of financial transactions, currencies and debts that most of us think of as global capital movements. This is the level at which macro-economics operates. The third ring is the global meta-economy of derivative gambling that leverages off and arbitrages prices in the first two rings.

The outer ring is the problem. Because of its leverage, opacity and magnitude, it massively amplifies any sudden movement in the underlying two rings.

Simon Jonson may be right when he says that the creditors who will take losses are well known. What is a total mystery, however, is to which counterparty they are hedged and, to which counterparty that counterparty is hedged, ad infinitum.

Is it any wonder then that policy-makers feel they must bailout and that markets themselves enter total panic at the prospect of no public support. The three-ringed circus dispensed with the fundamentals of market discipline long ago. Now, it's all bets are on, then all bets are off.

Jonson is right that Ireland is not Lehman. It's a debtor default this time we're looking at, not the collapse of a key counterparty in the outer ring daisy chain. But there are three senses in which he is wrong that an Irish default would be low-impact. First, after decades of regulators ignoring the growing inherent instability of global finance, markets are now well accustomed to their own power. If Ireland goes for haircuts, as clearly, in theory, it should, it will be a huge shock. Second, there'll be a run on all other PIGS' debt (h/t Anon). Third, it will cause chaos in the euro as it's future is cast into doubt and bets are reversed. That, in turn, will reverse the global reflation trade as all and sundry bolt for the $US, global liquidity dries up and commodities correct.

If you think Ireland is going to default (sooner or later someone is going to, and why not the Irish?) then panic now.