By Peter Boone and Simon Johnson
Bubbles are back as a topic of serious discussion, as they were before the financial crisis. The questions are: (1) can you spot bubbles, (2) can policymakers do anything to deflate them gently, and (3) can anyone make money when bubbles get out of control?
Our answers are: Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit. But policymakers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse. A few investors can do well by betting against such bubbles, but it’s harder than you might think because you have to get the timing right – and that’s much more about luck than skill.
Bubbles are usually associated with runaway real estate prices (think Japan in the 1980s and the US more recently) or emerging market booms (parts of Asia in the 1990s and, some begin to argue, China today) or just the stock market gone mad (remember pets.com?) But they are a much more general phenomenon – any time the actual market value for any asset diverges from a reasonable estimate of its “fundamental” value.
To think about this more specifically, consider the case of Greece today. It might seem odd to suggest there is a bubble in a country so evidently under financial pressure – and working hard to stave off collapse with the help of its neighbors – but the important thing about bubbles is: Don’t listen to the “market color” (otherwise known as ex post rationalization), just look at the numbers.
By the end of 2011 Greece’s debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time – for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently). About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany. Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders.
What if Greek interest rates rise to, say, 10% – a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called “austerity” program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe? Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years).
This is simply impossible and unheard of for any long period of history. German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings). Neither of these were good experiences.
On top of all this Greece’s debt, even under the IMF’s mild assumptions, is on a non-convergent path even with the perceived “austerity” measures. Bubble math is easy. Hide all the names and just look at the numbers. If debt looks like it will explode as a percent of GDP, then a spectacular collapse is in the cards.
Seen in this comparative perspective, Greece is bankrupt today without a great deal more European assistance or without a much more drastic austerity program. Probably they need both.
Given there’s a definite bubble in Greek debt, should we expect European politicians to help deflate this gradually? Definitely not – in fact, it is their misleading statements, supported in recent days (astonishingly) by the head of the International Monetary Fund, that keep the debt bubble going and set us all up for a greater crash later.
The French and Germans are apparently actually encouraging banks, pension funds, and individuals to buy these bonds – despite the fact senior politicians must surely know this is a Ponzi scheme, i.e., people can get out of Greek bonds only to the extent that new investors come in. At best, this does nothing more than postpone the crisis – in the business, it is known as “kicking the can down the road.” At worst, it encourages less informed people (including perhaps pension funds) to buy bonds as smarter people (and big banks, surely) take the opportunity to exit.
While the French and German leadership makes a great spectacle of wanting to end speculation, in fact they are instead encouraging it. The hypocrisy is horrifying – Mr. Sarkozy and Ms. Merkel are helping realistic speculators make money on the backs of those who take seriously misleading statements by European politicians. This is irresponsible.
What should be done?
1. The Greeks and the Europeans must decide: do they want to keep the euro, or not.
2. If they want to keep the euro in Greece, the Greeks need to come up with realistic plan to start paying back debt soon. Any Greek plan will not be credible for the first few years, so the Europeans must finance the Greeks fully. This does not mean 20bn euros, it means making available around 180bn euros – i.e., the full amount of refinancing that Greece needs during this period.
3. If they don’t want to keep the euro then they should start working now on a plan for Greece’s withdrawal. The northern Europeans will need to bail out their own banks, because Greek debt must fall substantially in value – euro denominated debt will need to be written down substantially or converted to drachmas so it will be partially inflated away. The Greeks can convert local contracts, and deposits at banks, into drachma. It will be a very messy, difficult transition, but the more the debt bubble persists, the more attractive this becomes as a “least awful” solution.
Regardless of the decision on whether Greece will keep the drachma or give it up , the IMF should be brought in to conduct the monitoring and burden share. The Europeans flagrant deception which we now observe – claiming the Greeks have made a big step and encouraging people to buy Greek bonds – proves they do not have the political capacity to be realistic about this situation. Who can now be believed on needs for Greek financial reform and what is truly a credible response? The only credible voice left with the capacity to act is the IMF – and even the Fund risks being compromised by the indiscreet statements of its top leadership as the bubble continues.
If such measures are not taken, we are clearly heading for a train wreck. The European politicians have been tested, and now we know the results: They are not careful, they are reckless.
An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.