Waiting For Something To Turn Up: Europe’s Looming Pensions-based Sovereign Debt Crisis

As Irwin Stelzer argued in a recent opinion article in the Wall Street Journal, Spain’s Prime Minister José Luis Rodríguez Zapatero seems to be an admirer of Charles Dickens’s character Mr. Micawber. When asked what he plans to do about Spain’s 11.4% fiscal deficit, first he promises to extend the retirement age, only to later tell us the measure may not be necessary. Then he promises a public-sector wage freeze, only to have his Economy Minister, Elena Salgado, say he really doesn’t mean exactly what he seems to say. And in any event, we shouldn’t worry too much, since given that Spain is a serious country, somehow or other the fiscal deficit will be cut to 3% by 2013, even though most serious analysts consider the economic growth numbers on which the budget plans are based to have their origins more in the dreams of an Alice long lost in Wonderland than in any kind of sober analysis of real possibilities. "We do have a plan," deputy prime minister, Maria Teresa Fernandez de la Vega assures us, but to many that plan now seems to be little better than hoping, like the proverbial Mr. Micawber, that "something will turn up."

The latest to draw attention, to the problematic nature of this "wait and see" approach – and to the gaping hole which is now yawning in Spain’s national balance sheet – is the credit ratings agency Fitch, who only last week warned that many Western governments now face unsustainable debt dynamics following measures taken to address the financial crisis.

The agency singled out Britain, France and Spain as being in special and urgent need of outlining plans to strengthen their public finances if they don’t want to risk losing their current highly prized AAA ranking.

This strong and direct warning was issued by Brian Coulton, Head of Global Economics at Fitch, who said "High-grade sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010 to underpin confidence in the sustainability of public finances over the medium-term and their commitment to low and stable inflation. The UK, Spain and France in particular must outline more credible fiscal consolidation programmes over the coming year given the pace of fiscal deterioration and the budgetary challenges they face in stabilising public debt."

Yet, while criticising Portugal’s gradual approach to fiscal consolidation as a matter of "concern" Fitch senior director Paul Rawkins also argued that the Spanish government had acted swiftly in announcing plans to consolidate public finances. Nonetheless he did still warn that the economic risks facing Spain remain very high, especially since the pace of decline in tax revenues is dramatic enough to be preoccupying, while continuing “labour market inflexibilities could well prolong the economic adjustment”.

The current problem facing Spain (and other similarly affected countries) has its roots in two quite distinct sources. In the first place measures taken to counteract the impact of the financial crisis have been inadequate and have simply produced large short term deficits. However to this short term liquidity and adjustment problem must now be added the further dimension of longer term impacts on public finances which have their origins lie in ageing populations, and the effect on economic growth of having older and smaller working-age populations.

Regarding the first, as Willem Buiter, now chief economist at Citi has pointed out, more than 40 per cent of global GDP is currently being produced in countries (overwhelmingly advanced economies) running fiscal deficits of 10 per cent of GDP or more. Over most of the last 30 years, this level fluctuated in the 0-5 per cent range and was dominated by debt form emerging economies. So the crisis marks a watershed, from which there will likely be no turning back, and in many ways could not have come at a worse moment for those countries who still have to undertake substantial pension reform to put their nation finances on a solid footing when faced with the unprecedented ageing which lies ahead.

Indeed, to take the Greek case, while the short term fiscal deficit has been the focus of most of the press attention, the longer term problem associated with the funding of Greek pensions far outweighs issues associated with the falsifying of national accounts in the early years of this century. A recent report by the European Commission found that Greek spending on pensions and health care for its ageing population, if left unchecked, would soar from just over 20 percent of GDP today to around 37 percent of G.D.P. by 2060. And Greece is simply an early warning indicator of troubles to yet to come, in larger countries like Germany, France, Spain and Italy who have all relied for decades on pay as you go type state-financed pension schemes. Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because fiscal issues associated with the downturn have suddenly pushed at least part of these previously hidden costs up to the surface.

In fact, unfunded pension liabilities far outweigh the high levels of official sovereign debt. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to something like 875 percent of its gross domestic product. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent. Other countries have obscured their total obligations as well. In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Of course, these numbers are arguable, and may well be in the excessively high range, but the fact still remains: outstanding and unfunded liabilities are huge, and would have been difficult to honour even without the present crisis. As it is, we are now in danger of spending the seedcorn which could have been harvested later on down the road.

Public opinion has yet to assimilate the seriousness of the issues involved here. As Pimco Chief Executive Mohamed El-Erian said in a recent FT Opinion article, the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. With time, this issue will prove to be highly consequential. The latest Fitch report is simply another warning shot. The sooner we all recognise this, the greater the probability of our being able to stay ahead of the disruptions this adjustment to reality will cause. It is time to stop simply waiting around to see what is going to turn up, since if we do continue like this we won’t like what we eventually find.

6 Comments
  1. David Merkel says

    Good piece, reminds me of my recent: http://alephblog.com/2010/03/14/promises-promises-2/

    This is going to weigh on the developed world for some time to come — I wonder if anyone has done similar analyses for Asia and the developing countries?

  2. Element says

    Tuesday, 16 March 2010 – EU Finance Ministers agreed that there would be assistance – a bailout for Greece but only if Greece asks for it, hinting at very onerous and desperate terms, to deter Greece from asking for it. The details of an EU structured EMF for doing this will be worked out over the coming weeks and months. No details of what, or where from whom from were given. Frankly, I think this is words to try and re-assure the market as there’s zero chance the EU can get away with unilaterally deciding to put EU taxpayers on the hook for Greek debt, via fear of not doing it. That could easily cause a continental political revolt and they will not risk that. What will occur is that EU states will hold their nose and buy a slice of super high-risk Greek bonds (which I think everyone knows can not be cashed-in at full ticket value) *IF* a Greek bond auction is failing. That’s what they want the world to know. That default will not be allowed to occur. An EMF is just to make severe national spending-cuts the preferred (and actually unavoidable) medicine.

    But for the PEOPLE of Greece non-default makes ZERO DIFFERENCE.

    Their economy and banks will be stuffed for >>10 years, so the fact that there’s no technical default is purely a financial sector issue, principally for containing wildly sloshing money flows. It has nothing to do with the people’s outcome. It is NOT a ‘solution’ – as we are being encouraged to believe. For the people it’s possibly even worse if the Govt doesn’t default. I would not so hastily rule-out that voters say NNOOOO to an EMF-type outcome. Effectively insisting on National default and dismissal of its creditors claims on their taxes. The current MMT theory, “it’s impossible to involuntarily default” etc., forgets about what the people will want. And that’s where the theory crashes against the rocks of political street-level reality. The people can demand default, as occurred in Iceland on 6th of Jan 2010. The banks are rightly terrified of it. There’s nothing an EMF or financial market can do if or when that happens.

    Then everyone realises default can still occur, even when there’s a consensus political determination to make sure a voluntary avoidance mechanism exists. From the population’s perspective, “well, if we are going to go through this depression anyway, why not just default, and thus dramatically reduce our tax rates, via eliminating liabilities, and dramatically shortening the pain?

    What’s the imperative here to not default?

    And don’t dare think they won’t come to that conclusion, and demand negotiated default.

    The imperative to avoid default is with the foreign creditor banks, and the respective Federal Governments. No one respects Greece now, and they already have no credibility so don’t think they won’t do it. There’s really nothing the Greek voter can do to avoid the worst effects, so what do they have to fear now?

    It’s actually other countries that are frightened by this.

    Remember the hardline Iceland took, severely pissing-off vital EU neighbours and the UK on Jan 6th this year? A Greek default is two orders of magnitude bigger but there’s now a precedent for the citizens to demand this outcome. If a majority of taxpayers demand default they can and will get it. They are not going to be too worried about what anyone thinks of this.

    So don’t confidently bet that national default won’t take place, no matter what’s done to avoid it. If you don’t have the ability to bamboozle or buy-off the population anymore, you’re going to lose the bet.

    Remember; they’re only borrowing to refinance old debt, not for expanded spending. So why not eliminate that economic dead weight altogether? Yes, they’ll suffer, but they’re suffering anyway, so why not just say NNOOOO! Thus to dramatically shorten this suffering? i.e. if we have to live within our means then so do our creditors.

    That’s the more attractive public option today, or soon will be. So the problem goes straight back to the creditors, the uber-bonus reaping super smartie-pants bankers. And when you look at it that way why wouldn’t you DEMAND your Govt default on the debt?

    Or is suggesting this too close to the bone for people to face, yet? I think you soon will, whether you want to or not.

    We don’t only have to worry about bond buyers not showing up. What if the bond issuer doesn’t hold an auction? Just doesn’t bother to rollover the debt? Then the dynamics completely reverse. Now the taxpayer becomes the hunter, and the banks become the hunted.

    Oh yes, you better believe it, they will do this. This is how direct democracy will fight back. Old-school people-power. The bank’s only remaining option then is to renegotiate the debt, and take huge losses. i.e. this is what Dubai’s Govt did to its Euro creditors – renegotiate, take a big loss, provide a delay, or get nothing at all.

    Take it or leave it. And of course, they took it, what else were they going to do? Same with the case of Iceland, taxpayers said NNOOOO, and that was it. Renegotiate and take a big hit, or get nothing at all. All the fear and uncertainty of the ‘markets’ is actually the fear and uncertainty of the creditor banks. It’s these banks that have the problem. A default will not add NET problems to Greece, except commit the country to deficit less than real GDP growth. But the dead weight of debt and debt servicing and high bond margins are gone. Recovery can occur much faster.

    As a citizen, I would much prefer that option for my children’s future.

    This can happen, and sooner than anyone currently expects. It won’t involve flat-out naked default it’ll be negotiated, but it will still be a headshot for the Euro banking system’s zombies. Will German taxpayers then bailout their German bank, in this reversed circumstance? That’s the question we need to focus on. Because the other PIGS will do similar. Are Euro taxpayers going to stand for massive bailouts … of zombie banks … yet again?

    No, I don’t think so. That trick only works once in a generation.

    2010-11 is going to be a very revealing period for world financial and political history. A lot of sacred cows are going to be slaughtered this year, very publicly, in technicolour. If it were your family, your future, your country (and it soon WILL be…) what would you do? Protect the banker’s claim on your taxes? Or to hell with these bank, as you can easily and quickly start new ones, if you really have to. And now you really do have to.

    This is a no-brainer for the public. And this is where things are actually headed.

    European banks will be the societal ‘scape-goats’, the cast out offerings to salve the seething mass of taxpayer voters. It won’t fix anything, and it’s not supposed to, quite the reverse. This is merely lancing a boil to get the puss and filth out, so recovery, rather than protracted infection, finally occurs. It will mark the start of building a functional banking system and eliminating 80% of the thoroughly pointless and destructive financial sector. Proper allocation of investment towards healthy growth, of a real economy, and the end of the Ponzi distraction, away from the real reasons for having an economy and banks, and debt.

    Debt that eventually pays for itself rather than just bleeds everyone dry.

    This is what the 21st century requires. It won’t be the Govt and the Banks that come up with the ‘solutions’. It will be the people’s imperative-necessity acting as the mother of invention. And God help any Government or financial institution that stands in the way. There’s always room for more scape-goats.

    Is this bleak? No. It isn’t at all. It’s not even a step backwards. The dynamics of what we have right now is what’s bleak and backward, with no serious attempts made to fix anything to produce a sustainable RECOVERY OF PEOPLE-not mere banks.

    Governments are paralysed and can not fix this so people-power must fix it and the Govt will play an intimidated second fiddle as this occurs. A public demand for sovereign default will be what forces total reform for the sole purpose of the PEOPLE’S recovery. The Govt won’t do it until overwhelming people-power on the streets insists on this and can’t be fobbed-off any longer by inaction and flashy oratory BS.

    Banker’s ‘interests’ will then be a very low priority (and they really should not want this). If whole countries are going broke then the creditors are going to be destroyed. Quid-pro-quo.

    This is nowhere as complicated, or as unthinkable as doing nothing about the zombies constantly demanding more public money from us. Now that’s bleak. And totally pointless! Why give dead banks a thing? Because of the optimistic 1 in 10 chance they might survive, and in 8 to 10 years fully recover? Who cares if they don’t? What about the other 9 of the 10 that didn’t survive but got the money? There will still be more than enough banks around in 5 to 10 years, as a matter of necessity, just as there was in 1935.

    It’s not as if the banks are in any position to lend anyway, or for us to borrow in this situation. Who cares if it’s messy? Who cares if this zombie banking system is ripped to shreds in order to fix it and make it functional? Doing nothing but to try and reinflate the previous unsustainable situation is totally pointless.

    So don’t give them a public cent and they and their problems WILL go away. The new problems created by that process certainly would not be worse, or any more pointless, than giving dead banks public money, that they don’t deserve, and which we definitely can’t afford.

    Hence public protest and sovereign default risk. This cycle must end, and thus it will, and sooner than you think.

    Dubai and Iceland were just the first to do it. The peculiar thing is that so few people seem to have realised that there actually have already been two sovereign defaults in the last few months. People keep talking like it hasn’t happened yet.

    The mass-strikes, street protests and riotous civil disobedience directed at Govt authority figures is not going away in Greece, it’s intensifying.

    Don’t expect it too go away, it won’t. As deprivation grows they will get more extreme until default becomes the only accepted bad option. Macro theorists need to consider this within their otherwise perfectly rational theories. Former Kennedy and Johnson Administration US Sec-Def. Robert S. McNamara warned in the documentary-movie ‘Fog of War’, that “rationality can not save us” [from ourselves].

    We ultimately only approximate rationality most of the time. But McNamara deduced his great truth about rational decisions from decades of seeing the results of perfectly rational decisions that produced completely irrational and devastating outcomes. This was not unusual, during extremis, like wars. He warned a length of the dangers of it, using the Cuban Missile Crisis and Vietnam as stark examples of the insoluble dangerous limitations of rationality in cumulative outcome terms.

    Optimal rational choices which seemed sound and wise led to extreme danger, barbarity and actual destruction of whole countries (Cambodia is one). The dawning realisation of this pattern horrified McNamara, and he came to realise that these lessons will be important to highlight the enormous future dangers of it (as per his detailed Cuban Missile Crisis example).

    Unfortunately, GW Bush’s initial Sec-Def, Donald Rumsfeld, also experienced this same extremely destructive rational failure and entanglement. His “unknown unknowns” remarks revealed how he processed his remarkably similar ultra-rational macro-scale failures, that again destroyed a country.

    We have to fully understand this, about the thought processing we all utilise, because in international extremis, innocent rational acts can very quickly “destroy whole countries”. There’s “no second chance”, when it happens. In other words, 100% rational decisions and actions, taken in good faith, can lead to extremely dangerous situations, that destroy whole countries purely by accident or incident, rather than by designed intent. Macro-theorists need to understand this, but most don’t.

    Other factors they never imagined or properly considered, in terms of scale and implications, will drive events in extremis. Theorising the assumed effects or outcomes, for countries, of unaffordable public debt, and what people will do in this situation, is extremely dangerous, and almost guaranteed to wildly non-approximate ensuing reality. Rational theoretical estimates of extremis conditions and outcomes almost always get it completely wrong. We know this is the common pattern.

    Thus McNamara’s “Rationality will not save us” conclusion is perhaps his most helpful insight about the terrible hidden dangers of applied rationality in global crisis decisions. We ignore that bitter example at our peril. Consider it next time a macro theorist full of misplaced confidence in theoretical hubris tries to bend your ear towards a non-conservative, non play-it-safe position in extremis conditions.

    No matter how logically clear and rational it appears, that’s in fact the danger itself. You’re always stomping around a minefield when rational theory is applied in a crisis. Guru Alan Greenspan has become the economic equivalent of Robert S. McNamara. Do you think Greenspan understands the root folly of his destructive macro theory application, which is suddenly condemned today? (and which Bernanke mirrors still!)

    This is a crucial lesson to be learned by economic theorists and associated leaders. It’s application is serious, in all cases, and in extremis, it can become totally destructive of whole countries. Haughty or complacent but consistent rational theory will NOT save us in such circumstances. I hope that you will reflect on this one day when the current trendy theory about sovereign default, goes up in smoke.

    You can not borrow your way to recovery of people.

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