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Panic exhaustion?



It should be obvious by now that financial markets have been in a panic for the past two months over the increasing likelihood of a Greek default, and all the death and destruction that could follow in its wake. In my posts I've tried to quantify the panic by looking at a variety of market-based indicators of the panic: the zero rate of interest on T-bills, the record-low level of Treasury yields in general, the very high level of implied equity volatility, the very high level of the ratio of implied volatility to the 10-yr Treasury yield, the very high level of Eurozone swap spreads, the generally low level of market PE ratios (as contrasted to the record-high level of corporate profits), the pronounced underperformance of Eurozone equities relative to US equities, and the huge declines suffered by Eurozone bank stocks. For an even greater variety of charts and figures, I suggest this post from Pater Tanebrarum, in which—among other things—he makes it absolutely clear that European bank stocks are collapsing. (HT: Tom Burger)

The charts that follow are a closeup look at some of the more important panic indicators from the US market. It is too early to draw a firm conclusion, but it looks to me like the panic is slowly fading. A skeptic would say this is just the last gasp of the bulls, but it's hard to square that with the fact that the news out of Europe has only gotten worse, as the first chart below (Greece 2-yr bond yields) shows. Perhaps the market is just getting exhausted from so much panic?




After a swift plunge in early August, US equities have been inching slowly higher.


The implied volatility of equity options, a good proxy for raw panic and fear, shot up to an impressively high level in early August, but since then it has been trending slightly lower.


The 10-yr Treasury yield also plunged in early August, but since then shows tentative signs of having bottomed.


The ratio of the Vix to the 10-yr shot up in early August and has been quite elevated ever since, but it has failed to make a new high.

Or here's another thought: maybe the panic has been overdone?

Most observers agree that the biggest problem these days is too much debt. Debt burdens are smothering economies, and a default by one government could spread like wildfire to others and quickly bring down the entire European banking system. Banks are undercapitalized and over leveraged, with too much exposure to a PIIGS default. If the banks fail then the wheels of commerce grind to a halt. 

But as I argued awhile back, the real damage that too much borrowing causes has already happened. Greece has been borrowing money for years and squandering it on inflated pensions, a bloated bureaucracy, corruption, etc. Greece has taken resources from the productive parts of the world and basically flushed them down the toilet. The money is gone, and its economy failed to grow enough to support the repayment of its debt obligations. The losses have occurred in fact, but it takes awhile for them to be recognized and written off. What we have seen in the past two months is the agonized attempts of market participants to avoid taking some of those losses. It's like a game of financial musical chairs: suddenly everyone realizes that there is one less chair (Greece's inability to repay its loans), and all scramble to avoid being the one left holding the bag.

Once again: it's not the burden of debt repayments that smothers economic growth, it's using debt for unproductive purposes that smothers an economy. That's why US economic growth has slowed even as government spending and debt have exploded; we've been wasting money left and right, and that reduces our capacity to grow because the money otherwise would have been used for more productive purposes.

So instead of fearing the eventual Greek default, we should realize that the damage has already been done and we have been living with the consequences for years. The losses have been incurred, and the market is well on the way to apportioning the losses by slashing the price of Greek bonds and decimating the market cap of the banks that hold Greek debt. These price declines don't mean more bad news for the economy, since they are merely the price tag for the mistakes of the past. 

The good news that will come out of all this is that Greece won't be able to continue to waste the world's resources nearly as much as it has in the past. Like it or not, in one way or another, the Greek economy is going to have to get by on less and lots of people are going to have to tighten their belts. Before Greece joined the eurozone, this would have been solved by a devaluation. (Devaluations are the process by which a government steals wealth by force from its citizens.) If Greece only does one thing right, it should remain in the eurozone and thereby avoid a devaluation, but then of course it would have to make the adjustments obvious (and politically painful) by cutting spending and raising taxes.

What about the likelihood of bank failures when Greece and perhaps another PIIGS country defaults? Well, banks can be recapitalized, or they can be nationalized, or new banks can sprout up out of the ashes of dead banks. It happens all the time. The failure of a bank is simply the last chapter in a book about money being flushed down the toilet. It's not the end of the world.

UPDATE: The excellent economist Alan Meltzer has an op-ed in today's WSJ in which he argues that Greece and the other welfare states (i.e., those who can't figure out how to control their spending) could effectively devalue without leaving the euro. How's that? The fiscally conservative countries could effectively leave the euro and start a new, stronger currency union:

Although the European Central Bank treaty does not permit devaluation, there is a way for Greece, Italy, Portugal and perhaps others (known by the acronym PIGS) to devalue while remaining part of the euro. The northern countries can start a new currency union limited to those who adopt common, binding or enforceable fiscal arrangements like those that German Chancellor Angela Merkel and France's President Nicolas Sarkozy discussed last month. The new currency could float against the euro, allowing the euro to devalue. Once devaluation restored competitive prices in the heavily indebted countries, they could be admitted to the new currency arrangement if, and only if, they made an enforceable commitment to the tighter fiscal arrangement. If all countries rejoined, the old system would restart with a more appropriate, binding fiscal policy rule.

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