It's not a debt crisis

It is a cliché that the big fear for markets is that Italy will suffer a full-blown debt crisis. This leaves an important point unsaid.

Italian government debt is €1.8trn (pdf), or $2.5trn. If it were to default on 50% of this - worse, I suspect than most people‘s worst-case scenario - there’d be a loss of wealth of €0.9trn or $1.25trn.

This is not much. Two things tell us so.

First, the marginal propensity to consume out of financial wealth in the euro area is around 1.4c per euro. This implies that if Italian debt were held by euro area households, such a loss would lead to a drop in consumption of 0.014 x 0.9 = €0.126trn. This is 0.14 per cent of euro area GDP. Which is barely significant*.

Secondly, economies have suffered far larger losses than this and survived easily. Between March 2000 and October 2001, the Wilshire 5000 index fell from 14750 to under 9900. Holders of US shares therefore lost $4.9trn - four times that loss on Italian debt.  But that led to only the mildest of recessions.

Why then are relatively small - and theoretically manageable - losses so frightening the markets?
It’s not because the problem won’t be confined merely to Italy. Throw in a 50% write-off of Spanish and Portuguese debt as well, and we still have a loss of only €1.3trn ($1.8trn).

One possibility is that in 2000 investors regarded high share prices as “house money” - the result of good luck - and so were more relaxed about its disappearance than they would have been had it been the “real” wealth that is government bonds. 

This, though, might not be all the story. Expectations for equity returns in 2000-01 - among both households and companies - were high, so the market’s fall came as a shock. That should have hit consumer spending and capital spending.

Instead, there’s another reason to fear. There’s a massive difference between US equities in 2000 and Italian government debt. US shares were held mostly in small sums by millions of investors. The losses were thus small and manageable for most sensible investors, and even where they weren’t, the losers were not strategically significant for the economy. Italian debt, however, is heavily held by a few banks and their losses - unlike the larger losses on US shares - threaten to have multiplier effects via a reduction in bank lending.

This seems obvious. But it represents a (further?) rejection of the neoliberal pre-crash orthodoxy. This said that the virtue of freeish financial markets was that they allowed risk to be split up and borne by those best able to bear it. But the euro debt crisis shows this not to be the case. If government debt holdings were dispersed, the crisis would be trivial. But they are not, so it isn’t.

What we have, then, is not a government debt crisis at all. Instead, we have a crisis of risk-bearing.  The problem is that risk is borne by not by markets but is excessively concentrated in systemically important financial institutions (SIFIs). Which poses the question raised by Thomas Hoenig: do SIFIs have a future?

Ideally, the answer would be: no. The problem is, though, that European policy-makers are not even asking the question.

* Things aren’t quite so simple. A Italian default could actually boost the wealth of Italian tax-payers (there are some) by reducing future interest payments. This might, however, be offset by higher interest rates on the remaining debt as investors require compensation for the risk of further default. I’m ignoring this complication. 

Comments

[Luis Enrique]

If these sums are so small, why all the fuss about tax payers having to bailout insolvent banks with far smaller sums?

Your argument about risk bearing needs to account for regulations that specified OECD sovereign debt was to be treated as risk free.

[Luis Enrique]

This sounds like an argument for Kotlikoff's limited purpose banking. After all large banks aggregate the savings of many - if losses by large banks could be translated into losses by their many account holders, as they would be if all this debt was owned by mutual funds, there would, as you say, be no problem. Rather then having bailouts and crises, we'd have millions of savers just each losing some money.

[Metatone]

@Luis Enrique

Why all the fuss? - Religious beliefs about rewards and punishments.

(Not to mention a religious belief that all of Greece's problems are because the hairdressers retire at 53 on a full pension, twice that of a German auto worker...)

[Jim]

@Metatone: enlighten me - what is the source of Greece's problems, if not that they've been spending more than their income for 30 years+?

[Matthe]

The chart shows banks hold €100bn of Italian debt, less than 6% of the total. That doesn't seem so concentrated?

[Matthe]

Also could you explain this bit of the report:

"a 10% increase in financial wealth leads to an increase of between 0.6% and 1.5% in consumption"

that seems much higher?

[Metatone]

@Jim - enlighten yourself - read Keynes discussion of fixed exchange rate systems and his case for an international clearing union. Sadly enough, all the flaws he discusses with the gold standard apply within the euro...

Or read Yanis Varoufakis about other aspects of the crisis.

But in the end, the real issue is that even if all of Greece's problems are self-inflicted, economics isn't a morality play and the best option for the rest of the eurozone isn't necessarily perfect punishment of Greek wrongdoings.

[Shuggy]

"Why then are relatively small - and theoretically manageable - losses so frightening the markets?"

Because it's indicative of a more general absence of political will? Are the markets not asking, via the Greek issue, a fundamental question - does the Eurozone, and by extension the EU, actually exist at all? - and getting answers that are rather more opaque and equivocal than they might have hoped for?

[bayan escort]

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[Keith]

Matthe, I agree that economics is not a morality play, but politicians often try to make it one! To disguise their deceptions, and if it was a morality play impoverishing poor citizens of a relatively poor country for the mistakes of their unaccountable elite makes for a poor play.

The actions of Sarko and Ms. Merkel and the rest of the EU elite indicate that they think a default by any Nation in the Euro will ruin the Banks. If only ordinary people stood to lose their savings they would not give a f*ck. Only wealthy Banks and people get this protection. Probably for helping the ruling class with their Tax avoidance and off shore trickery. Spreading racist ideas about lazy greeks is a well trodden path by the elite to avoid the responsibility for their errors and lies. Best to not fall for it here or else where.

[Niklas Smith]

As Luis Enrique pointed out, surely the failure of risk-bearing has something to do with both regulators and financial market models decreeing that OECD government debt had zero credit risk?

The disappearance of the "risk-free asset" may be one of the most intellectually challenging results of the financial crisis for participants in financial markets.

But even without models telling them that government bonds are risk-free, banks will always have to hold bonds simply because they need liquid assets to be sure that they can meet demands for deposit withdrawals or make large loans. Banking can't exist without liquid assets.

[George Carty]

Isn't modern Greece (since its independence from the Ottoman Turks) virtually a third world country that has been unusually generously aided by the West because it was viewed as the "cradle of Western civilization"?

[Paolo]

The resistance against the euro project and the EU is politically motivated. Germany, France and UK are right wing, and this explains a lot about the kicking of the can attitude of the first two in particular: Merkel and Sarkozy going populistic to appease domestic pressures that want to teach a lesson to the southeners, even though this could have been sorted out an year and a haf ago avoiding reaching this crisis level.

No surprise at all here.

The most disappointing fact is the lack of initiative on the left. The Occupy movement, protesters in Greece-Spain-Italy (who being mainly public/private employees cannot evade taxes, and thus bear the brunt of the austerity programmes) are calling for higher taxes on high income earners (either corporate and/or private), lower inequality and less precauriousness. This are all left-wing instances. The EU could provide a great instrument to implement these policies in a coordinated way, preventing a "race to the bottom".

Left parties all across EU should coordinate to reinforce the EU, actually to seize control of its institutions, now in the ends of neoliberals, as they stand far better chances of bringing forwards those changes at a EU level than unilaterally at national level.

The ECB sending dictacts to countries like Italy calling for labour market reforms and other policies from the Washington consensus toolbox is a case in point. You can use the EU to either lower social/welfare standards or raise them, it is a pity at the moment it is the former.

I notice that today the head of Goldman Sachs stated that EU fiscal integration would be unappealing. No wonder, they perfectly know that more EU (rather than less) will provide the ideal platform the revert this disastrous tendency to more neoliberalism across the EU.

Left leaders should campaign for more EU, should explain to the occupy protesters/indignatos that it is by seizing control of the EU institutions that they will really have a chance of rebalancing towards less inequality and precoutiousness. Not doing so will be missing the last chance of avoiding disaster.

[PaulB]

Banks hold sovereign debt because it's a liquid, interest-bearing, supposedly low-risk and low-volatility security that they can use as collateral. (Some banks tried holding AAA-rated mortgage-backed securities instead, but that didn't work out well.)

Euro-denominated sovereign debt tends to be held by European banks because it gives them no FX risk, and perhaps because it's relatively attractive to them because the Eurozone is motivated to protect its banks from default.

It's not obvious that a hundred small banks doing this instead of ten big banks would be any less of a problem in the event of a sovereign default.

If banks didn't hold sovereign debt, I suppose governments would have to pay higher interest rates to induce pension funds to hold it instead.

[Keith]

You could say it is a monetary crisis however. Trying to safe guard the Banks by fiscal austerity is not really working as the tightening of fiscal policy cannot work when combined with hard money policies. If the ECB expanded the quantity of money sufficiently then in theory the Banks could rely on the future validity of government debt as as store of value. GDP growth allows debt interest to be paid. But the crisis arises from the very narrow focus of policy. Trying to both stop any monetary expansion and tighten fiscal policy every where is totally mad. It is the placing of finance before actual economic development that is the problem. You cannot have stable finance without economic development.

[Mark Wadsworth]

Thanks for linking to my NIMBY post.

As to your article, people forget that financial assets are NOT net wealth. One man's asset is another man's liability, so if Italy defaults, then the losses suffered by investors are offset by the gains to the lucky Italian taxpayer who no longer has to repay teh bonds.

On a personal level, I am a fiscal conservative, in an ideal world there'd be no government deficits and certainly no large public sector debts. And defaulting is of course a form of theft, just like inflation, but there's no point pretending that the world caves in when a country defaults. It simply doesn't.

[Andrew]

I find this post confusing.

"What we have, then, is not a government debt crisis at all. Instead, we have a crisis of risk-bearing. The problem is that risk is borne by not by markets but is excessively concentrated in systemically important financial institutions (SIFIs). Which poses the question raised by Thomas Hoenig: do SIFIs have a future?"

1. I would have thought the point here is that "risk" is a subjective judgment and that the markets are changing their view of the risk borne by these SIFIs from "no risk" to "loads of risk".

As you tentatively allude to with your comparison with the stock market or gambling, this represents a relatively higher RISK ADJUSTED loss than the same loss in something previously perceived to be risky.

This government bond crisis is just part of a global repricing of risk that means that all global output RISK ADJUSTED, is significantly diminished. Italy going from risk free to certain loss is just part of us all realising that no-one will be actually be getting 8% a year on our pension plans.

2. Your point about SIFIs I also find very confusing. On the one hand, they do more damage when concentrating risk (why? - what is actually wrong this?).

Yet on the other, they must be doing amazing work "multiplying" up wealth (we seem to be roughly regarding consumption as wealth here). If they weren't doing this amazing work, then they wouldn't be a big risk, but the reverse must also be true. If this concentrated effect on reducing lending is so bad, then it must have been good so long as it was undiminished.

Similarly, spreading risk amongst all these households who would barely notice the loss, would also mean that, in the absence of SIFIs, this same capital would never have been multiplied up and juiced the economy.

What are you suggesting regarding abolishing SIFIs? That the risk should be spread amongst a million tiny banks? If these banks did as good a job multiplying up capital as the SIFIs have, the effect on lending would be identical!

3. Money is fungible and a loss of capital in the economy is a loss of capital. I have no idea why a small loss spread over all European households should be less damaging over the long term than an equal loss concentrated in a SIFI.

If these households hold wealth in bank accounts and pension plans then this is an equal loss of lending capital than if directly held by a SIFI. What difference does it make if a household notices it or not? The capital is gone regardless.

4. I have no idea why you use consumption as your endpoint for economic analysis here. How on earth can we tell whether households consuming more or less is a good thing without further extensive investigation? Consumption increases in Greek households turned out to be not such a great idea over decadal timescales.

This "lack of consumption/demand is the problem" mantra from mainstream economists (I hasten to add I exclude CD here!) really pisses me off. It is utterly simple minded. Prima facie, recognising losses that have already occurred (the Italians were never going to pay 100% on that debt) must surely be a GOOD THING since it increased the accuracy of our view of the world.

Similarly if a SIFI has been leveraging up this non-existent future production into current consumption, that is a BAD THING since it misallocates resources over the long term.

Such an institution going bust would therefore be a GOOD THING.

Why is the above (based on nothing but the idea that a rational assessment of existing wealth is a good basis for proceeding) any less valid than this "marginal effect on consumption"-based speculation above?

/rant.

[Andrew]

No, I just don't get this "concentration of risk" and "SIFI" meme. I think this topic deserves a whole post from Christ!

1. What does risk concentration actually mean anyway? That losses will be less evenly distributed? What is wrong with that? It means that a variety of strategies are in play and the market will weed out the bad ones.

If risk is perfectly spread, we have a homogenous market and no selection. What advantage does that have?

2. If you are saying that risk concentration is bad because of secondary losses resulting from institutional detonations, then actually you are not saying that risk concentration is the problem. What you mean is that there is too much TOTAL risk in the system.

3. If the above is true, then what do you propose to do about it? Spreading risk doesn't alter total risk by definition, so why should it in the specific case? You never hear this argument made.

4. If there is enough total risk around to detonate a bunch of SIFIs, then by definition there is massive systemic risk. Spreading it won't help, only reducing it will.

5. New recognition of massive systemic risk is by definition also a recognition of massive reduction in risk-adjusted returns.

6. Risk-adjusted returns tend to equivalence with absolute returns over the long term.

7. If follows from 5 & 6 that a huge recognition of losses must occur REGARDLESS OF WHETHER THESE RISKS HAVE MATERIALISED.

8. It follows from 7 that a prior reduction of systemic risk would only have modified the losses resulting from the global financial crisis, not prevented them.

[Ethical Deleuze]

Right, but what about the moral culpability in deciding to just forget-a-debt? I mean, the Italians default. What message does that send? Economically viable. Ethically?

[Seattle IT Services]

It is the positioning of money before real financial progression that is the problem. You cannot have dependable money without financial progression.