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The Debt Crisis Around the World

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Republican Senate Minority Leader Mitch McConnell announced the “backup plan” on the debt limit he has been mentioning the last few days.

Under the plan, the President could obtain a total of $2.5 trillion in debt limit increases by specifying spending cuts in an equal amount.  It doesn’t require Congress to consider the spending cuts or to actually cut spending, but it would create a situation in which Democrats would be voting for more debt three times before the November 2012 election.

Speaker Boehner hasn’t commented on this plan yet.  We don’t think the Republican-controlled House will approve this as a backup plan because it increases the debt limit without cutting spending.  However, the pressure on Republicans is mounting fast.  We think the debt limit impasse is building toward a roughly July 26 formal warning by the president of an imminent shutdown of government payment systems for popular services.  Our guess is that Republicans cut a some kind of deal prior to that (see yesterday’s piece on a possible mini-deal).  If not, a gradual shutdown of government payments would start August 2.

Beyond the uncertainty, we don’t think there will be a big market impact from the political drama.  However, shutting down government payment systems is a legal quagmire, so there is a chance of something going wrong as the deadline approaches.

Here’s our understanding of Sen. McConnell’s backup plan.

The House and Senate would pass legislation now giving the President the authority to request increases in the debt limit in lump sums and constraining how Congress would handle the requests. (Under the current system, the President can request increases in the debt limit but Congress is not required to respond).

In making his request under this new law, the President would be required to specify spending cuts he would like to make.  The amount of the spending cuts would need to be equal to or greater than the requested debt limit increases.

The debt limit increase would go into effect automatically unless both the House and Senate passed “resolutions of disapproval.”  Such resolutions would probably pass since many members wouldn’t like the debt increase or the list of spending cuts or both.

The President could then veto the resolution of disapproval which would then go back to the House and Senate to see if the veto could be overridden by two-thirds majorities in each House.  If not overridden (McConnell assumed it wouldn’t be because Democrats would have enough votes to sustain the veto), then the debt limit would be increased by the amount requested.

The approximate timing of the tranches would be $700 billion now, $900 billion in the fall and another $900 billion in June 2012 which would last through February when a new Administration could seek further increases under the old procedures.  Presumably, the President’s list of spending cuts would be cumulative, meaning he would need to state $2.5 trillion of preferred spending cuts in June 2012 as part of his third request.

The concept for this backup plan is that the mechanism could be enacted now by the Democrats with only a few added Republicans in the House to achieve a majority.  All Republican Senators could vote against it.  After that, all Republicans could vote against debt three times while the Democrats would have to provide one-third of each House three times to sustain the three vetoes (though it could be a rolling set of members so that everyone could get at least one or two chances to vote against debt.)

In international debt crisis news:

Bond yields in Italy and Spain have risen with the delay in the voluntary restructuring of Greek sovereign debt. Ireland’s credit rating has just been cut by Moody’s, joining Greece andPortugal below investment grade.  Ireland’s three year notes were already yielding well above 15%, pricing in a large haircut in the event of a restructuring (see graphs in the attachment). 

We note some positive developments stabilizing the euro today including a relatively successful short-term debt sale in Italy; the possibility that the ECB is buying more debt in the secondary market; rumors of Chinese investments; the prospect that Italy will quickly pass some structural reforms, with Spain also considering reforms; and continuing slow work on Greece’s funding gap.   There is some talk of the European Union issuing EU bonds to bring more money into the equation to possibly buy debt in the secondary market, thoughGermany has a constitutional problem with it.

The current strategy in dealing with southern Europe’s debt is to use voluntary reschedulings for now (avoiding CDS payouts) to allow more taxpayer money to be injected through the IMF and European Union and giving European banks more time to divest or reserve against their exposure.  The delay might reduce the shock when the debt is restructured with a loss in net present value (which we expect for Greece and Portugal, perhaps in 2012.)

For Italy, the problems aren’t insurmountable.  Italy’s budget deficit stated at about 4% of GDP isn’t as large as the others.  Its banks don’t have as many bad real estate loans, which should show up in the stress test due Friday.  Its debt has a longer maturity structure and is heavily owned by individuals residing in Italy (a tradition that was reinforced by the smooth handover from lira debt to euro-denominated debt.)

However, the “delay” approach for Greece harms the near-term growth picture for Italy andSpain because new investment will wait until the debt restructuring problems in their neighbors get resolved.

The longer-term problem for southern Europe is the difficulty of trying to grow out of the current debt burden, especially if interest rates rise and populations decline.  Many U.S.states face this. If debt is at 100% of GDP, the fiscal deficit has to be less than the nominal GDP growth rate in order to reduce debt relative to GDP.  For Italy, nominal growth has been running below 3% of GDP (2.7% in the four quarters through March 31) while the fiscal deficit is stated as 4% of GDP.  It will go higher if Italy’s financing costs rise or growth slows even more.  

In addition to fairness questions and politics, a time-consuming part of the Greek workout is the mechanics of sharing the losses -- which are large by Greek standards but not large relative to the economies and banking systems of northern Europe. A portion of the debt has already been marked down in secondary markets, so even though Greece’s debt-to-GDP ratio measured at book value is very high and rising fast, the market value of the debt has taken some dips. In the end, we expect the net present value of Greece’s debt to be reduced (possibly in 2012) with a substantial portion of the reduction absorbed by European taxpayers (through the EU contribution) and public sector debt holders (like German, French and Greek government-owned banks), but not by the IMF which doesn’t take haircuts.

The Greek crisis has created many complicated battlefields that are delaying the resolution:

The IMF has immense lending power due to its resources and unique off-budget status -- mostU.S. contributions to the IMF don’t go through the U.S. fiscal deficit or count as part of the U.S.national debt.  However, the IMF’s rules say it can’t lend into a financing gap, meaning Greece is supposed to explain in advance the sources of finance for its fiscal deficit (e.g. financing bills, draws on the IMF program, EU resources.)  CDS holders, a new phenomenon, have a huge financial interest in cutting Greece off from IMF funds because it would force a quick Greek default and a massive payment to the CDS holders.

Greek public sector employees want to retain full benefits and are pitted at least indirectly against the Greek and European private sectors.

The Achilles heel in these Greek battles is the euro itself.  If Greece converts euros into drachma, it would endanger the entire European financial system.  Depositors in all of the weaker countries would have to immediately withdraw euros from banks and move them elsewhere, creating a financial collapse rivaling the Lehman bankruptcy.  

Assuming Greece stays in the euro and Greek debt is restructured at some point, the losses will be spread broadly among Greeks, European taxpayers contributing through the EU, bank equity holders, some bank creditors, the institutions that underwrote credit default swaps on Greek debt and possibly the central banks who are members of the ECB.

Since the losses already occurred, allocating them shouldn’t change the global growth outlook as long as the process can be carried out quickly enough to allow growth to restart and in a way that encourages growth-oriented structural reforms across southern Europe.  


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