THE DEVIL'S ALTERNATIVE: how to help Governments to spend wisely

 

Turin,July 28^th, 2019

The Devil's Alternative: how to help Governments to spend wisely

DISCLAIMER: the author is not a disinterested party, since his day job involves recommending securities, especially debt securities as that. So, over and above taking it in with a pinch of salt, the Reader will be well advised to avoid assuming that anything in this article is meant as advice. Bear in mind the usual warning about forward looking statements, namely that they are not worth the paper they are written on, and that they are the personal opinion of the author. Or, as Frank Herbert wrote in Dune, “if wishes were fishes we'd all cast nets.”

The easy money policy that all Central Banks have undertaken so far has had enormous effects. Not exactly on what the policy was assumed to be aimed at, mind you: inflation in most advanced economies barely budged, or better, the movement was not proportional with the scale of the intervention.

THE one field where the Central Banks were successful is the drastic reduction in the prevailing level of interest rates, along the whole maturity envelope: recently yields on ALL Swiss government securities went negative, up to the fifty year maturity.

Since the Central Bank buyer ipso facto has access to infinite monetary means, it acts as “market” in all but name (market which more often than not is subjected to regulation by the selfsame authority, even if indirectly), and the help in terms of cost of debt is more favorable the more indebted a country is at the start of the exercise.

After a long period of monetary easing, the Central Banks are facing a conundrum: they are now big league investors, since they told everyone that their involvement was temporary, but not one of them seem to be able to reverse the process. The only Central Bank who tried, the Federal Reserve with the Quantitative Tightening, abruptly reversed course in December last year in the face of a wilting stock market and pushback from every part. In medical terms, they look like surgeons unable to take a patient off painkillers: to be honest, and this is not meant in a bad way, onlookers do not even know if the operation has gone well. My personally personal opinion is that not even the Fed knows: the fall in equity values last year might have been the normal reaction to competition from newly appetizing Treasuries.

Be it as it may, it really looks like a “damned if they do and damned if they don't” situation: the longer rates stay repressed, the more distortions and Zombie investments become prevalent in the economy, aggravating any chance at reversing the policy, and if they DO reverse the policy, a lot of readjustments [re: “bad things”] might happen, in an already weak environment and uncertain political outlook. In the absence of “Mr. Market” to punish extravagant public choices, it might look that Central Banks themselves instigated the profligate spending that, to be fair, they have been vocally against. Personally I may not like Mario Draghi's choices, but no one can say he withheld his opinion for sound public finance policies under the umbrella of “whatever it takes”. Sadly, no one listened, and the generosity of monetary authorities fell on deaf ears and generous handouts.

So, is there a way to link again sound public policies with a market mechanism? I believe that such an avenue exists.

So I dabbled into something inspired by an article by Prof. Guido Tabellini (I thank Prof. Luca Erzegovesi for the information): http://voxeu.org/article/structuring-versus-restructuring-sovereign-debts-eurozone .

The article proposes the issuance of Government Bonds linked to GDP Growth, in order to avoid shocks to public finances. While musing on the fact that such an architecture had a bias towards even more state intervention in the economy, I made some other considerations.

First, before rate repression, the markets themselves scared politicians and voters alike into supply side reforms: Italy had a lesson in that when the Monti Government was established after a storm in the BTP market. Under that system, the incoming “virtuous” government obtained the dividend of said virtue, namely a lowering of funding costs, that allowed to finance further eventual supply side / productivity enhancing measures, etc.

That mechanism has been the collateral damage of QE: to use Italy as an example, the meager 1,5% spread on German government bonds would not be prize enough for the amount of suffering necessary to get there, and STAY there.

So, how do we get out of this problem? Keep in mind that if Italy's success caused “normalization”, the cost of funding at the end of the exercise could be HIGHER than the starting point. Ideally, we should be aiming to restore a market mechanism able to give a prize to virtue and punish the wayward.

Enter the Total Accrual GDP-LINKED Inflation Obligation, in short TAGLIO ( it means “cut” in my native tongue. Ah ah.)

As an example, it would work like this:

Coupon: MAX(0;10% - (2*real GDP growth YOY))

issue price: 100

Legal Maturity: 30 years

Call: At Par, at the first coupon date where the sum of coupons paid >50

coupons are counted towards the 50 total necessary for the automatic call if and only if at the coupon date the public expense/GDP, corrected for distortions, is lower than,say, 60%. Otherwise that coupon is paid, but is not counted towards the total.

Why these complications? If governments do not attain real economic growth, this bond is quite costly....thereby forcing leaner choices. If they manage to induce sufficient growth in the PRIVATE economy, then not only their cost of debt is lower, but if they are quick about it, this bond costs very little for a longer period (the higher the growth, the lower the coupons paid, the longer the maturity).

The perceptive reader will see that, looking at EUROSTAT or OECD numbers, most governments are already under the 60% threshold. Yes, but before enacting this, a bit of candor should be warranted. For one, all economic endeavors which are subject to explicit supervision would be accounted for as “public spending”, including but not limited to all realities subject to preventive public authorization. So, all banks, utilities, insurance companies would be included as “public sector”. No CDP for Italy, it's both a bank and it's in practice controlled by tre Treasury. Alitalia, obviously, and train concessions. Phone licence operators. Highways.

In my mind, the “duck test” would be:

• the first shareholder is public, even indirectly;

• Concessions;

• any company where more than 60% of sales are to the public sector;

• activities subject to authorization regimes / registers;

• Any activity paying anything equivalent to a “concession tax”.

• Of course, pensions.

All of the above would be “public sector”. As an incentive, the first yearly coupon would be set at zero. But it's hard work after that.

Now, who in his right mind would buy this monstruosity?? Well first and obvious target....

ECB: this would be the only kind eligible under QE, and the entire debt stock already owned by the Central Bank would be swapped one to one.

Then, BANKS: this bond type would be exempted from risk coefficients, which WOULD be introduced for the legacy bonds. It would also ordinarily be anticyclical to NPLs: in theory, a booming economy would cut coupons on TAGLIO, but there would be both credit expansion and a lowering in NPLs. Should the economy slow down, Banks would earn higher coupons on TAGLIO.

General public: yes, this should be a retail bond. In fact in Italy, CCTeu are much more complex , without anyone emitting nary a peep.

Once this had been established, the ECB could happily go on helping with liquidity: should any government stray too far from sanity, even uttering things like “minimum salary”, savers would signal their displeasure by exchanging their legacy bonds for the TAGLIO... since government would be obliged to accede to any exchange at equal amounts at closing prices, especially from retail. Oh, and it goes without saying that maximum unit of trade would be 5€ nominal. There's a price to be paid for having these bonds exempted from risk coefficients.

Investors (and economists) would again have a litmus test that has disappeared since the liquidity flood. If the total nominal issued by a country in TAGLIO rises due to retail demand.... locals are bolting, however governments are still able to issue bonds that eventually WILL cost very little... if they behave. And it could also reintroduce some natural selection in politicians.

Central Banks could also view this with interest, because it would partially deflate their “Devil's alternative”, as defined by Frederick Forsyth in the novel with the same name.

At one point, a politician exclaims “this is tragic! Whatever alternative I pick, some men will die!”, and an unflappable MI5 man tells him: “that's true Sir. That's what in the Firm we call the Devil's Alternative”.