If I suggested to you that Greece should be afforded unconditional debt relief, you’d probably meet the idea with amazement.
But that’s exactly what the International Monetary Fund has just proposed.
It has called on European creditors to provide upfront and “unconditional” debt relief for Greece, suggesting a cap of 1.5% on its debt interest payments.
Yet more proof (if any more were even needed) that since the Financial Crisis, the institution has morphed from being a stern (albeit fairly useless) defender of the norms of sound debt management to a reckless enabler of Keynesian boondoggles.
“Unconditional?” Really?
There’s really no good case for providing even more debt relief to Greece.
Serious Pain vs. Intolerable Pain
The country is attempting to do the nearly impossible. While remaining in the eurozone, it’s trying to lower its wage costs and public sector burden sufficiently enough to make the country competitive again.
But it’s the wrong approach.
Without the euro, Greece would endure pain, for sure. But its economic revitalization attempts would be pretty straightforward: It could just allow the “new drachma” to drop to about one-quarter of its previous value, and Greek living standards and public sector costs would adjust automatically.
As it is, however, with Greece remaining inside the eurozone, the amount of deflation and austerity required to affect these changes is impossibly painful. Greek living standards in 2008, with a gross domestic product (GDP) per capita of about $32,000, were three times higher than its neighbors – Bulgaria, Romania, and Macedonia.
And Guess Who Picks Up the Bill?
The Greek people are obviously the losers in this situation – paying the price for years of government fiscal mismanagement.
So last year, the downtrodden people elected a new government dedicated to avoiding the pain – and stiffing Greece’s creditors in the process.
In turn, the rest of the eurozone is now feeling pain, too.
Instead of throwing the country out of the euro – as should have been done – the IMF and, more reluctantly, the European Union (EU), have now agreed to prolong the period of economic unreality, plugging the gap between Greece’s output and its costs with ever larger dollops of debt relief.
Naturally, EU taxpayers and holders of Greek debt will shoulder the cost of this silliness. Although fortunately, most debt holders are EU banks and the European Central Bank, rather than individual investors.
For income investors, though, the message is clear: Our interests take last place in the global debt markets, and we should expect major write-downs and creditor rip-offs in the years to come. Why?
A Global Debt Contagion
Because the IMF’s new reluctance to impose “austerity” on its clients is likely to spread to other countries.
Elsewhere in Europe, for example, Portugal has now elected an anti-austerity government, while Spain is close to electing one of its own.
If the IMF encourages those governments’ resistance to fiscal discipline, we may very soon see defaults in those countries, too.
Needless to say, that would produce an almighty bill for creditors and northern European taxpayers that will run into the trillions – 10 times Greece’s demands.
Large, but badly run, countries like France and Italy will also find their voters demanding similar debt forgiveness at some point, and the demand for debt favors will spread far beyond the traditional impoverished recipients. Of course, debt investors will be portrayed as greedy capitalists throughout this process, despite the fact that they receive meager returns on their holdings.
There’s a similar situation brewing in South America, too.
While there’s probably very little the IMF can do to affect the Venezuelan mess, it won’t take much further deterioration in Brazil to put a default into the realm of possibility. At that point, a compliant IMF could well make things very much worse, allowing an inept government to extract resources from international creditors and taxpayers.
The result of all this irresponsibility will be to further weaken fiscal discipline in states where it’s already weak, and to multiply 10-fold or more the amount of international debt that’s subject to “rescheduling.”
In addition, since the IMF has also damaged creditors’ interests by imposing “collective action clauses” that allow the big banks to rip off retail bondholders in a rescheduling situation, the basis of international debt is being steadily weakened.
As individual income investors, this precedent is clearly worrying.
IMF Triggers Universal Default?
As the European examples show, the debt problem isn’t one that’s limited to emerging market bonds.
Indeed, many emerging markets are managed far better than the IMF would prefer, showing little appetite for mindless “fiscal stimulus” programs and wasteful spending.
Speaking of which, it also highlights the IMF’s waste. The group has never served very much useful purpose anyway. Indeed it was almost completely inactive for two years between 2005 and 2007. And it’s now seriously damaging the integrity of the global bond markets, making some kind of universal default/write-down increasingly likely.
Don’t believe me?
One precedent for such a universal write-down comes from the 1930s. When European countries that owed “war debts” to the United States, they defaulted – an outcome that worsened the already traumatic Great Depression.
Going even further back, another such precedent came in the 1840s, when several U.S. states, including Pennsylvania, defaulted on their debts to European investors.
Both of these partial write-offs worsened major economic depressions, although at least in the 1930s, there were no private investors affected. Nevertheless, the damage to capital markets and the international free flow of capital was severe.
So What’s the Solution for Income Investors?
As income investors, we care less about the global economic damage caused by countries’ fiscal mismanagement and irresponsible IMF debt policies, and more about getting our money back.
However, the message from recent developments is clear: We should avoid being the suckers who are left holding defaulted Greek, Spanish, or Brazilian bonds.
In the debt markets, we should stick to solid private sector corporate debt from the relatively few unquestionably solvent countries.