Lessons from a PIG

The three most vulnerable economies in Europe belong to Portugal, Ireland and Greece, sometimes referred to as the PIG countries. You can also throw in Spain and make that a plural PIGS. These are counties where debt loads combined with slow growth and huge structural imbalances in projected budgets are causing real financial distress today.

Let's simplify this down. A country takes on debt to pay expenses. A debtor nation (like the United States along with the PIGS) will use more debt to pay the interest and then, when the principle comes due, will roll over the debt into a new loan. As with a business or a family, loans to governments are made with the assumption that the debt will be repaid. For debtor nations, there is no plan to repay the debt. Future budgets are contingent on rolling the current debt over into a future loan.

When there is no real plan to pay off the debt, lenders look even more closely at the ability of a borrower to make the payments AND the liklihood that they will be able to roll over the debt (that someone else will loan them the principle so they can repay the debt). When growth is slow and when the long-term budget is hopelessly out of whack (such as when there are significant retirement commitments that have already made a claim on future principle payments), then there gets to be a concern over whether repayment is possible.

Just as with a high risk borrower on a car or with a credit card, the supply/demand of money is reflected in the interest rate. The greater the risk of default, the lower the demand for that debt and the higher the interest rate must be to attract a willing lender. For governments that have a high principle balance relative to their GDP, rising interest rates increase interest payments and further impair the ability to repay the debt. This is a downward spiral where each increase in borrowing costs compounds the problem and increaes the liklihood of default.

Governments address the dual risk (missing interest payments and defaulting on the principle) by shortening the borrowing term. When you sign up for a 2 year CD at the bank, the bank will pay you a higher interest rate than if you chose the 60 day CD. The same goes for the governments. A 30-year bond will pay a higher interest rate than a 90-day Treasury bill. They have your money longer and there is more risk. So to obtain lower interest rates, debtor nations start to decrease the term over which they borrow.

You can see this play out in American debt. The following graph from Econbrowser.com shows how the average maturity of U.S. debt has dropped from 5.8 years to 3.4 years since 1990.

This means that we are rolling over the principle (over $14 trillion) more often. The same with the PIGS - they have to find someone to buy all of their debt each time the principle comes due, which is more and more often now that so much of it is short term. The short time frames give the debt the same feel an adjustable rate mortage would give a homeowner.....everything is fine but we hope nothing changes before we refinance.

You can see that this is a very fragile system. There is not a lot of fallback room here.

Which is what makes the debate going on in Portugal interesting, just as the Greek and Irish debates of last year were interesting. Bond traders -- those people buying Portugese debt -- are staying away from Portugal, which is forcing interest rates up. There is only one way for Portugal to keep rates down and that is to demonstrate that they are serious about repaying the debt. The way they do that is the new political buzzword (at least in Europe): austerity.

Austerity. Budget cuts. Tax increases. The whole living within your means thing....blah, blah, blah....

The debate going on in Portugal is over how much austerity. Right now the Prime Minister has a plan, but he is unable to get enough votes to pass it.

Prime Minister Jose Socrates has said he will resign if the plan is defeated. He has said its rejection would force the debt-laden country to follow Greece and Ireland and seek an international bailout, which he opposes.

All opposition parties have proposed resolutions calling for the rejection of the measures, which reduce pensions and state spending.

The main opposition Social Democrats, who have previously backed austerity, have begun talking about a snap election.

The New York Times stated the concerns of those opposing austerity, which will be familiar to any politically-aware American.

But opposition parties led by the Social Democrats have said that they will not endorse further austerity measures because such measures would hurt elderly people and other vulnerable members of society, and could risk further delaying Portugal’s return to economic growth.

This gets us back to the growth projection discussion and our over-reliance on forecasts. All very risky approaches. The PIGS have left themselves little room to move. If they don't take austerity measures and their interest rates soar, they have no cushion. They will be forced into huge, and even more painful, austerity measures or they will default (which will bring on austerity by another name). Either way, it is difficult to see how the elderly and vulnrable are spared.

The United States has an austerity measure it can take that is not available to Portugal, that being to monetize the debt. We can print money, which is something Portugal cannot do as they are part of the Euro zone and do not control the printing press. We do control ours, and so printing away our debt (such as with Quantitative Easing) is an option.

While not a tax increase or a service cut -- those would take political courage by many -- monetizing the debt can be done by unelected officials at the Federal Reserve. The result would be what is known as an "inflation tax". Essentially, your savings would be worth much less and everything would cost much more. Not very good for the elderly and vulnerable either.

So can we avoid austerity here in the U.S? Not entirely, but we have much greater flexibility than Portugal to make decisions, reach compromises, establish priorities and retool. At the local level, there is no question in my mind that we are entering a period where many of our Strong Town principles will be applied, willingingly or not. It is less clear if Washington D.C. or our state capitals will be forced to do the same.

There is a sense, however, that the decisive moment is drawing near. Consider this recent quote from a Federal Reserve official as reported by CNBC:

"If we continue down on the path on which the fiscal authorities put us, we will become insolvent, the question is when," Dallas Federal Reserve Bank President Richard Fisher said in a question and answer session after delivering a speech at the University of Frankfurt. "The short-term negotiations are very important, I look at this as a tipping point."

But he added he was confident in the Americans' ability to take the right decisions and said the country would avoid insolvency.

"I think we are at the beginning of the process and it's going to be very painful," he added.

We have a lot of retooling to do, at every level of society. Do we have the courage?

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