17 May 2012

Global Strategy
Alternative view

Popular Delusions
La Grande Illusion
What kind of return would have to be on the table for you want to lend on an unsecured basis to a borrower with unaudited accounts and a history of playing dirty when the chips are down? Maybe I’m missing something, but 150bp sounds on the low side to me.
Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

When I studied economics at university we spent a lot of time studying budget constraints. We were taught that ‘economic agents’ - firms, households, governments – were ultimately constrained by their finances, which seemed logical enough. The basic models started by assuming agents couldn’t consume more than they produced unless they’d saved in a prior period. Then borrowing was introduced. Now, in any period agents could consume more than they produced but because borrowing had to be paid back, the budget now constrained behaviour over the life-time rather than in any one period. When it came to the algebra of decision making, this life-time budget constraint was the ultimate iron-clad shackle. It was mathematics and you couldn’t get around it. No agent could consume beyond its lifetime production nor borrow beyond its capacity to repay. Unfortunately the real world isn’t so neat. No one knows where life-time budget constraints are. Not with any precision anyway. They’re fuzzy things. Whether or not an agent can borrow £100,000 or £10,000,000 doesn’t depend on its lifetime budget constraint at all, but on the perception of it. And that perception changes. For example, the perception of Greece’s life-time budget constraint has contracted dramatically in recent years. In simple terms, the budget constraint is merely another manifestation of the more fundamental problem of scarcity. Our demands are infinite but the resources we have at our disposal to satisfy them are finite. And the thing is, scarcity is annoying. We don’t like not having. Bumping up against our budget constraint is no fun. It means we have to do something unpleasant like work harder, sell something we own, or go without. Riots in Greece, protests in Madrid, governors recalled in Wisconsin, governments toppled in Rome, Paris and now Amsterdam … it all attests to the pain of a head-on collision with reality. Global Strategy Team
Albert Edwards (44) 20 7762 5890

The simplest way to overcome a budget constraint is through theft. Thus, taking a leaf from the government of Argentina no doubt, the Portuguese government raided its own pension fund to meet its 2011 deficit targets, having raided Portugal Telecom’s pension plan the year before. All in the name of the common good. A more subtle larceny is to misrepresent your underlying financial health to give the impression of being comfortably inside your borrowing capacity. Thus some households will be tempted to gloss their credit card application forms. Certain companies will manipulate their financial statements. So it pays to be skeptical. To paraphrase the great H.L Menken, when the smell of flowers fills the air we should wonder where the coffin is. With ten year yields below 1.5% in the US and Germany, the smell around these sovereigns is pungent indeed.

Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com








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he or she might suggest. are insufficient the government can simply print any money it needs.500 3. how can any sane person even question the solvency of government when yields are so low.000 500 Cumulative increase in Treasury and GSE debt since beginning of 2009 . Since it jealously reserves for itself the right to supply the nation’s medium of exchange. The fly in the democratic ointment.. for example.000 1. it has recourse to the most splendid of all budget constraint avoidance maneuvers: if tax revenues. Bring in the auditor: two measures of the US Federal deficit (% of GDP) 4% 2% 0% Official budget balance (cash basis) -2% -4% -6% -8% -10% -12% -14% -16% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Operating surplus/deficit (accruals basis) Average difference = 2.Popular Delusions Governments are as prone to fibbing about their financial position as anyone else. So they elect liars.000 3. US Flow of Funds 2 17 May 2012 F28051 . Indeed. Maybe one reason is that governments have more tricks up their sleeves than the rest of us. a cynic might say governments are more prone to fib. or the trust of honest creditors. but I do note that the US Federal budget deficit has been flattered by 2.. Indeed. is that people have little interest in knowing the truth. The Fed has monetized around 60% of the increased Treasury/GSE paper since 2008 4. SG Cross Asset Research This all serves to give the happy appearance of a borrower living comfortably within its budget constraint. of which purchased by Fed 0 -500 Source: SG Cross Asset Research.500 2. accrued pension obligations rather than just cash salaries.000 2. So does the yield. I have no opinion on the matter.. like monopoly control of the seniorage industry.. And that it’s likely to be much bigger than we’re told.500 1.4% Source:GAO.) So all we know about the size of US Federal Government debt is that we don’t know how big it is. snort financial ‘astrologers’ like Paul Krugman from their ivory towers.4% of GDP a year over the last ten years by reporting it on a cash basis rather a more comprehensive accrued basis (the latter includes in the total expense of federal hiring. .

or a Mervyn Le Roi. Cumulative deficit misstatements to gain entry into the euro … and today’s comeuppance 3000 2500 Greece 2000 5yr CDS 1500 1000 Portugal Spain Ireland 500 0 0 5 Italy Belgium 10 15 20 25 30 Cumulative accounting gimmickry 1993-2003 (% GDP) Source: Koen. SG Cross Asset Research 17 May 2012 3 F28051 . You can’t escape your budget constraint with financial gimmickry. of which BoE has purchased 100 0 2009-10 Source: SG Cross Asset Research 2010-11 2011-12 But maybe it all just goes to show how dependent our economic and political structures are on the white lie of money printing. the Allied Capitals. since the crisis broke in 2008. The Enrons. maybe the euro debacle could have been completely avoided if the ECB had been headed up by a Ben von Bernanke. What would bond yields in the US and the UK look like without these purchases? Probably like those in the eurozone periphery.Popular Delusions Indeed. But I don’t think they are. You can just make it look like you have for a while. And I think the truth gets out eventually. It makes you wonder. and that our budget constraints are really a safe distance away. current CDS prices correlate well with countries’ cumulative deficit manipulations in the run-up to monetary union. The accounting shenanigans eurozone governments resorted to in order to meet the entry criteria have been found out. . Or at least. as estimated by Paul van den Noord and Vincent Koen at the OECD.. Indeed.. the Bernie Madoffs … they all get their comeuppance. Maybe that’s why so many of my friends agree with Atlantic magazine. it’s what’s happening today in the eurozone. Indeed. Maybe all the Anglo-Saxon central banks have done is create the illusion that our sovereigns are more solvent than they are. . BoE has monetized around 60% of the net gilt issuance since March 2009 600 500 400 300 200 Cumulative gilt issuance since March 2009 .. which praised Ben Bernanke for ‘masterfully navigating’ the financial crisis and avoiding another depression. Van den Noord (2005). the Fed and BoE have printed enough money to buy over 60% of the issuance of their respective government securities since.

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