Okay, here is tonight’s rule: Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform. (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.) The five stages of grieving apply here.
I know I wrote it 8+ years ago, but it feels very live now. At present it is most obvious to apply the logic to the PIIGS, and American municipalities that have overextended themselves.
But consider New Jersey that has cut back considerably, and the Kansas City School District that has cut almost half of their schools. Their backs were to the wall, and they took brave actions to cut back.
But many municipalities remain in denial. They have long distinguished histories, they cannot fail. They just need to tax (or borrow) a little more to make ends meet. Maybe they should raise the rate they expect to earn on pension assets, or offer sweeter pensions instead of greater wage hikes. This is a big part of the crisis now, and is biting hard.
When the taxes do not come in as expected, or budgets were underestimated, and there is more spending than expected (Snow, Flood, Hurricane) there is anger, and anger drives the hopeless negotiations (bargaining) over spending cuts, over which no one wants to budge. Not only are there priorities in what interest groups want, there are things that are guaranteed by statute, and some guaranteed by constitution. Consider the constitutional guarantees on public sector employee benefits in Illinois. Just try to change the Illinois Constitution; that won’t be easy.
The next stage of grieving is depression, and there are some places like California, L.A., Harrisburg, PA, Greece, etc. that are close to the point where one might say, “There’s no hope.”
After that comes the final stage of acceptance, where finally the tough adjustments are made, and solvency restored, or, bankruptcy is entered, with all of the attendant costs. Deals are made to reduce budget items that were previously sacrosanct, such as entitlements, public sector employee benefits and salaries, etc. That is not happening today, not even in New Jersey.
One final note: just as the last refuge of scoundrels that run companies is to blame the shorts, so it is for scoundrels that run governments — they blame the speculators.
This is perhaps more of a comment on your #3, but large corporations imitate governments in this respect too. I just read much of the Lehman bankruptcy examiner’s report and was amazed by how far in advance many people involved new about the problems and chose to delay raising capital, delay true delevering, delay write-downs, and delay cutbacks. Instead they spent time arguing that their marks were fine and engaging in phony quarter-end repos that they treated as sales.
I had assumed that the people at Lehman just had no idea of the risks they were taking, but the examiner’s report is pretty clear that they consciously chose to take more risks in 2006 and 2007, that their models indicated these risks were excessive and put the company at a high risk of becoming undercapitalized, and that they purposefully ignored, overrode, and modified the models to justify taking more risk. It seems like had they done what risk management wanted to do and avoided violating internal balance sheet and risk appetite rules in 2006/2007, plus raised some equity in a timely fashion, they probably would have come through the crisis like Morgan Stanley or Goldman Sachs.
The more we learn about the crisis the more I think we do have a pretty solid idea of what typically causes leveraged financials to blow up, and it’s not mysterious fractals or hard-to-discern distributions. There’s a level of risk that is safe under most reasonable circumstances. Then there’s the higher level of risk that failed financial companies take. Of course there are conditions so extreme that even well-capitalized and well-managed institutions fail, but we didn’t see them in 2007-2009. We saw Lehman writing 100% LTV mortgages into a bubble without documented income. We saw Lehman engaging in multiple times more leveraged loan deals at the moment that prudent institutions were pulling back, buying huge chunks of real estate at 4% cap rates with a ton of leverage and growth rate assumptions that were higher than historical norms. The result, although slow moving and difficult to foresee in all its particulars, is not hard to explain.
very well put, david