E-piphany

The quasi-default of Dubai’s semi-sovereign entities is unlikely to be the last, just as each routine bank closure in the U.S. is unlikely to be the last.

We have moved into a new phase of the economic debacle. The “financial crisis” phase ended around October 14th, 2008, with the implementation of the Fed’s Commercial Paper Funding Facility and simultaneous strong-arming of certain banks to offer funding for terms more than a day. The “market panic” phase ended in late March this year; although the stock market may ultimately plumb new lows over time (especially on an inflation-adjusted basis) the joint actions of Fed and Treasury (and monetary and fiscal authorities around the world) finally achieved traction at that point and chances of a second crash have receded.

But those actions by fiscal and monetary authorities, a series of escalating programs promising to spend and print more and more money until finally the tsunami of liquidity overwhelmed our best intuition about what sort of market behavior might well be rational in a disaster, were just IOUs. I don’t mean, here, that they were IOUs in the usual cynical sense of the gold bugs that any fiat money is an IOU. They were IOUs in the sense that an athlete (or frat boy, but in a different sense) makes demands on his body that are borrowings against the period of recovery tomorrow. You can’t escape the payback; you can only bargain for a bit more today in exchange for a bit less tomorrow.

Those IOUs, of course, will come due. Fiscal and monetary policies are currently unsustainable – to say nothing of the ultimate sustainability of running up huge public debts once interest rates begin to rise. Dubai is unusual since it doesn’t have anything in common with the future wave of sovereign borrower instabilities (which will happen when those IOUs taken out to ‘save the system’ in ’08 and ’09 come due) but rather should probably be thought of as part of the current wave of real estate debt defaults. However, the chilling effect this episode has had on global markets is instructive. We will probably see this again.

That said, I think it’s important to remember that a debtor who hits the wall has only the bankruptcy code to rely on, but the rules (and list of alternatives) are very different when it is a sovereign state that is overwhelmed. Default is an option, but a poor option if the state controls the currency in which the debt is denominated. It would be absurd for a country that owns a printing press to actually default rather than print the money to pay the debt.

There are, though, many countries that don’t own the right printing press. Lenders to emerging markets, of course, are generally reticent to lend in the local currency. But thanks to monetary union, every country in the EU has the same problem. Greece can no longer print drachmas, and the ECB is not going to monetize its debt. Those are the countries where eventual default is a real possibility.

Raising taxes is an option if a country wants to really crater its economy. Cutting spending is an option if legislators act very un-legislature-like. But the problems we are talking about are too big to solve with little adjustments.

I hesitate to note – but it needs to be noted – that there is another alternative available to some heavily-indebted nations. There is precedent for societies saddled with suffocating debt to lurch towards socialism, to reach for a charismatic leader, and to turn outwards to find a solution to their domestic troubles. I don’t see that coming… but then, almost by definition we won’t see that coming.