Greece downgrade - the next phase of the credit crisis

The downgrade of Greece is the next phase of the credit crisis. The behavior of governments to use fiscal policy (deficit financing) to help avert financial disasters is now starting to haunt the sovereign issuers. Let's look at the process of government throughout the world during this crisis.

Private borrowers as well as governments were hit hard by the slowdown in the global economy. This was a result of excessive speculation as well as a commodity shock. Defaults started to increase. Banks became more conservative given the risks and tax revenues declined. In an effort to slow this process, governments followed a classic Keynesian combination of loose monetary policy and deficit financing. By front-loading new expenditures with the existing automatic stabilizers the slowdown was arrested. There is no problem with this process. It saves the economy from a steeper downturn. The cost has been a run up in deficits. The problem is pushed into the future. These deficits by themselves would not be significant problem if there were strong sovereign balance sheets. Unfortunately, for many countries this is no the case.

Deficit financing coupled with already high debt /GDP levels means that the ability to pay for this new financing can be called into question. Future tax revenue is related to the future GDP growth. If debt to GDP is greater than 100% and interest rates are higher than growth rates, all incremental tax revenue will have to go to interest payments and not the pay down of principal.

So how do you pay-down the debt burden? You can grow out of the problem which is not possible if you have a slow growth environment. You can increase taxes but there is the side effect of further slowdown in the economy, or you can inflate your way out of the problem. A final solution is a default but we will assume that repudiating debt is a last resort solution.

The problem is that for Greece, as a member of the EU, there is nothing it can do on the monetary policy side to inflate the economy. Greece cannot inflate because the ECB controls monetary policy. In fact, there is a current bias toward raising rates by the ECB.

There is the additional problem that it may not be willing take collateral from with Greek bonds used as collateral if its rating continues to fall. This is not an immediate problem but one that will have to e addressed. It is unlikely that other EU member will be willing to bail-out Greece so there is the added problem that help will not come form their closest friends.

Fitch downgraded Greece to BBB+ with a negative outlook. S&P has Greece on a negative outlook with A- rating. There will be other countries in a similar situation which start to have investors differentiate across sovereign risks. The next phase.

Bernanke and headwinds

In a speech today, Chairman Bernanke argued that there were "formidable headwinds" that will moderate any recovery. After the euphoria of Friday, with unemployment falling to 10, the markets were slapped with a reality check from the Fed chief. Bonds reversed about half the decline from Friday.

The likelihood of a V-shaped recovery has declined. The chance that we will see a rise in rates from the Fed has diminished. The Fed chairman mentioned weak utilization, labor market, and a lack of lending as all contributing to these headwinds. Bernanke also stated that it was possible that inflation could go lower and there is no assurance that the "recovery will be self-sustaining".

This was a sobering set of comments as we start to close the year.

Credit failure quotes - bond vigilantes live by it

Bond vigilantes will become more important in 2010. Not that they were not important before, but they were ignored. With the expected downgrade of Greece we will see more focus on credit. The overall size of debt to GDP will be an area of increased focus, so there will be more dollar negative talk. As perceptions of a debt problem in the US mount, it will be harder to find the marginal buyer of US debt. Rates will increase.

"Owe the bank $100, that's your problem. Owe the bank $100 million, that's the bank's problem." - JP Getty 

 Don't lend more to big borrowers whether real estate companies or countries.

Capitalism without failure is like religion without sin - it just doesn't work. - Allan Meltzer 

 Failures will occur. If failure is part of the system, it will happen regardless of what the government wants.

Fed independence - what might be the most important fight

Fed independence is critical to the functioning of the US economy. This is not overstating the case. The standing of the US in international markets is affected by the perception of the Fed as having control of money without influence from the government. If the Fed is viewed as less independent, or have less creditability, then there will be a greater inflation premium added to bonds. Rates will go up based on the perceived risk that the Fed will allow inflation to increase in order to meet the needs of government for full employment. The requiring of a monetary policy audits will place the Fed under greater control of Congress.

Of course, the Fed is political and not completely independent of what is happening in the fiscal realm. It has a dual role because of the Humphrey-Hawkins Bill which has the Fed base decisions on both inflation and full employment. Nevertheless, the Chariman of the Fed has the special responsibility to hold off desires of Congress to manipulate monetary policy. In exchange, the Fed is supposed to avoid commenting on fiscal matters.

The key issues will not be decided during the Bernanke confirmaton hearings, but this will be the focus of what may occur in 2010. There are two issues that are relevant during the confirmation hearings:

1. Will Congress move to have formal audits of the monetary policy function of the Fed? This oversight would go beyond the normal hearings as part of the Humphrey-Hawkins Bill. Congress is also looking into many issues of Fed structure including the organization of the regional banks and how directors are picked.

2. What should be the regulatory function of the Fed? The issue is whether the Fed should be given additional powers to supervise financial firms. Bernanke argues that this power is essential to maintain control over monetary policy. Congress is arguing that the supervision job the Fed has done in the past may require that a different agency conducts this oversight.

The current system of multiple regulators was inefficient and a contributor to the crisis, but this does not mean that the Fed should have this responsibility. The Fed needs information on the behavior of financial institutions and the economy to understand what actions should be taken in the pursuit of monetary policy, but it is less clear that they need to be the super-regulator.

Who would have thought that these complex issues would be the focus on the Fed chairman confirmation hearings? However, the Fed has put itself in this condition because of the job it has done of the last few years. Could this crisis have been avoided? Unclear. What is clear is that it could have been better at raising rates at the end of the Greenspan era. It contributed to the housing bubble. It should have been better in regulating banks and monitoring the financial system. It could have slowed the speculation. It should have been better at controlling the crisis in the period from July 2007 through the end of 2008. It should have been planning for systemic risks.

Now there is a time for accounting. The audit is on.