Fiscal Adjustment: Too Much of a Good Thing – Lessons for Risk Management

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The purpose of models is not to fit the data, but sharpen the questions.

                                                        (Samuel Karlin)

 

Carlo Cottarelli, in a VOXEU communique “Fiscal Adjustment: Too Much of a Good Thing” dated Feb. 8^th notes that a sharp reduction in budget deficits in certain circumstances can actually increase risk.  This raises a question when we attempt to mitigate risks: Does a rapid adjustment actually increase risk? 

 

Almost everyone agrees that the fiscal accounts of several advanced economies are in bad shape and need to be strengthened.  But how fast should the adjustment be in the present circumstances.  At time over the last couple of years, the IMF has called on countries to step up the pace of adjustment when they were perceived as moving too slowly.  The IMF has argued that countries should reduce public-debt ratios through a gradual and steady process.  However in the current environment, some countries are moving too fast. 

 

The IMF Fiscal Monitor (Jan. 2012) indicates deficits are projected to fall by 2% of GDP in 2011-12 in the advanced economies, 3% in Eurozone countries.  Adjustment is reasonable in a good growth environment, but in a weaker macroeconomic environment bringing down this quickly can increase risk to the economic recovery.  IMF research suggests fiscal adjustment that lower debt ratios and deficits can reduce government bond spreads when the impact on growth is limited.  Conversely, when tightening fiscal policy reduces growth, bond spreads can widen, especially with weak growth and fiscal tightening is large.

 

In advanced countries with limited financial options, deficit reduction is the best alternative.  Structural reforms to boost competitiveness and growth along with deficit reduction are critical, but take time to work.  It is important for countries to adjust at an appropriate pace and have adequate financing to boost confidence as market perceptions adjust (such as through the European Financial Stability Facility and the European Stability Mechanism).  Markets eventually respond to better fundamentals with stronger growth and reduced deficits, but this can take a while. 

 

If growth slows, countries should avoid further fiscal tightening.  Countries with flexibility, such as some Eurozone members with lower interest rates, can slow the pace of deficit reduction.   The projected 2% reduction in the U.S. deficit in 2012, the largest in forty years, is excessive.  It is more important for countries, such as the United States, to formulate credible medium-term adjustment plans and gradually reduce the deficit.  The adoption of credible medium-term adjustment plans, which is missing in many advanced countries, would reduce uncertainty.  The cost of policy uncertainty is high, especially if growth starts to slow.

 

Can we learn anything for risk management?

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7604

 

 

 

Eurozone Leaders still don’t get it

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Eurozone policymakers have put together another plan to save the euro.  Will it work – only time will tell?  Charles Wyplosz, in a communiqué They still don’t get it (VOXEU, 25^th Oct.) reviews recent progress.  He is not optimistic they will take the necessary steps.  He notes that by rejecting an ECB role, leaders have guaranteed that any package will fail as too little too late.  They are addressing two of the three needed steps: putting Greece on a sustainable path and backstopping banks.  The last stop still needed is to backstop all European sovereign debt to avoid contagion. 

 

The author identified three issues in an earlier VOXEU column (22^nd Aug 2011) for policymakers: a clear misunderstanding of the situation, understanding the danger ahead, and unwilling to take the necessary steps to resolve the situation.  The real danger is contagion has spread to Italy and Spain pass the point of no return and the risk of spreading to core countries.

 

The European Financial Stability Facility (EFSF) is too small to deal with the amounts involved, even under the new proposal.  The authorities must move ahead of the curve and put together policies to contain the crisis and avoid further contagion – the new proposal may not be enough.  This can be accomplished by placing a floor under public debt valuation.  This can be accomplished two ways: the ECB can act as a guarantor of public debt as maturing debt is rolled over and the second approach is to replace maturing Eurozone debt with Eurobonds. 

 

The ECB is the only institution that can deal with the amounts involved and provide breathing space to address bank recapitalization.  The continued rescue packages for banks and government are creating moral hazard problems.  Long-term, authorities must address the weakness of the Stability and Growth Pact and enact restrictive fiscal policies with monitoring.  Wyplosz notes that recapitalizing Greek banks is a temporary solution, but could undermine its purpose by increasing debt levels.  The only solution is to tap the EFSF short-term and involve the ECB to provide a backstop for public debt.

 

The worst outcome is to reject a role for the ECB.  The lack of a backstop for public debt prices will allow the crisis to fester and deepen pushing up the cost of resolution. 

 

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/6845

The Euro Crisis Reaches the Core – What is your Risk?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The author, Daniel Gros, noted in a recent communique (VOXEU, August 11^th) that the current euro crisis has reached the core.  Investors and treasurers need to ask themselves what is their exposure in a worst case scenario?

 

Investors anticipate the unraveling of the 21 July 2011 “solution” and a potential Lehman type breakdown of the interbank-market and put the European economy into an “immediate recession” like the one experienced after the Lehman bankruptcy. The European Financial Stability Fund (EFSF) was designed to provide liquidity financing and not solve solvency issues.  Gros argues that without quick and bold action such as giving it access to unlimited ECB re-financing there will be a generalized breakdown of confidence.    

 

Greece is not interpreted as a special case, but viewed as the manifestation of a general problem: (1) as a sign that the Global Crisis was spreading to public debt; and (2) as a sign that capital markets would no longer refinance excessive levels of public debt, especially in the Eurozone members who could no longer rely on central bank support.   The EFSF was sized to provide the financing promised to Greece, Ireland, and Portugal and provide lower rates for their long-term financing.  However, if the borrowing costs of Italy and Spain stay at crisis levels, how can they be expected to provide billions in euro in aid to peripheral countries at 3.5% when they pay a much higher rate?  Any decline in the core Eurozone members that remain to back the EFSF and the debt burden would become unbearable. Italian government debt alone is equivalent to the entire German GDP. 

 

The situation is critical due to a domino effect. At this point the Eurozone needs a massive infusion of liquidity.  Given that the cascade structure of the EFSF is part of the problem, the solution cannot be a massive increase in its size.   

 

Banks are the weakest link due to European debt exposure.  This increases the cost of capital for banks exposing them to a breakdown in the interbank market and credit circuit.  If the EFSF was registered as a bank and given access to unlimited re-financing by the ECB, it is the only institution to provide liquidity quickly and in convincing quantity.  This solution has the advantage that it leaves the management of public debt problems in the hands of the finance ministries, but provides governments with the liquidity backstop that is needed when there is a generalized breakdown of confidence and liquidity as a lender of last resort.  A massive increase in the ECB’s balance sheet (which if the US experience is any guide will not lead to inflation) constitutes a lesser evil compared to a breakdown of the Eurozone financial system.

 

What is your exposure to European sovereigns and banks?

http://www.voxeu.org/index.php?q=node/6853 

 

Risk Management in Large, Complex Organizations – Lessons from the Eurozone

By Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Guillermo de la Dehasa wrote an interesting paper for Voxeu called “Eurozone Design and Management Failures” (May 2011).  The paper provides an interesting perspective on the role of risk management in a large, complex organization.  The risk management failures include: taking into account and ignoring known risks, monitoring and managing risk, and using the appropriate risk metrics.

 

Europe’s sovereign-debt crisis is a defining moment for the Eurozone in that it exposed the weakness of the monetary union’s design, governance and management.  Academics pointed out three basic initial design flaws overlooked by policy makers in their haste to create the euro:  the lack of price and wage flexibility, a monetary policy where one size fits all and the lack of monitoring of individual countries’ fiscal policy.

 

The Eurozone sovereign-debt crisis uncovered more serious flaws:  the Eurozone policymakers (IMF was) were not equipped to deal with a solvency crisis; the European Financial Stability Fund (EFSF) only provided a short-term liquidity facility.  A liquidity facility may delay the day of reckoning and raise the cost and lastly there was no provision in various Eurozone agreements for resolving a solvency crisis.  The present system, at best, contributes to the creation of a debt overhang increasing the cost of crisis resolution.

 

The three current bailouts were triggered by policymaker management failure to address the solvency issue.  The failure to incorporate risk analysis into Eurozone policymaker culture and strategic thinking could prove extremely costly for investors and painful for Eurozone citizens.