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The Troika Has No Clothes

Posted on October 16, 2012

"Let us not delude ourselves: without growth, the future of the global economy is in jeopardy."  - Christine Lagarde, Managing Director of the IMF 

Last week the International Monetary Fund (IMF) released their latest Global Financial Stability Report.  The report was fairly dire (by IMF standards) as it warned of increasing financial instability while at the same time cutting the growth forecast for the global economy. The report emphasized the importance of developed nations cutting their sovereign debt levels while still maintaining growth. Of course everyone wants less debt and more growth, but any Greek will tell you that this magical recipe for recovery is easier said than done.

Oddly enough, the release of the IMF’s report comes on the heels of a Greek request for a two year extension on the austerity provisions attached to their recent bailout package. Greece is now in the 5th year of a recession with 25% unemployment and no real light at the end of the tunnel.  No surprise to anyone, German politicians balked at the proposal for an extension. What is a surprise is that the IMF changed their tune and is now supporting the Greek request for an extension on the grounds that it is in line with their new growth mandate. At first glance, some might applaud the IMF’s efforts for being forward thinking and having the willingness to change their stance. We would agree that the IMF is taking an unpopular stance with the European core (read Germany), but they are still missing the big picture.

The real issue that no major decision maker in Europe (or anywhere else for that matter) is willing to address is the fact that the recent recession and recovery isn’t of the normal, garden variety business cycle. The current recession and recovery is the aftermath of a multi-decade credit expansion that peaked in 2008 and will take years if not decades to unwind. In a business cycle recession credit temporarily contracts as growth slows, but it quickly picks up again after interest rates are lowered in response to the slowdown in growth. In a credit cycle the response mechanism to lower interest rates is broken because the end user (e.g. businesses and consumers) is not willing to take on more debt because their focus has shifted to paying it down.  John Mauldin pointed this out beautifully in his recent letter:

A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past or in a manner that the models would predict.

The easiest way to think about the difference is that the focus of the credit end user shifts from their income statement (how do I maximize profits?) to their balance sheet (how do I stay solvent?). This is the definition of Keynes’ phrase “pushing on a string” when it comes to monetary policy’s effect on the real economy.

So that being the case, why aren’t all the smart cookies in power over in Europe coming out and saying this? The answer is simply that they are not in the business of relaying facts to the public, but rather they are in the business of managing public sentiment. I think any major decision maker in Europe would be hard pressed to admit they ever actually believed that Greece could grow its way out of their black hole of debt. The chart below shows the official real GDP growth projections for Greece published by the IMF every spring in their World Economic Outlook (WEO) report. The black bars represent growth projections one-year in advance (e.g. predicting 2011 growth in the spring of 2010), the grey bars represent current year projections (e.g. predicting 2011 growth in the spring of 2011) and the green bars represent what actually happened. 


The key takeaway from this chart is that the IMF is doing a horrible job predicting growth rates for Greece. This is either because they don’t understand the difference between a business cycle recession and a credit cycle recession or they have a separate agenda that goes beyond forecasting accuracy. We would argue that the latter is much more likely than the former.

The IMF is working with key decision makers to try to prevent another Lehman Brothers type event in Europe. They are one of the three members of the “Troika” which has been responsible for negotiating and approving all the financial assistance for struggling European nations. Most importantly, their growth forecasts are the baseline for the bailout packages and austerity provisions. The only way to justify writing several multi-billion Euro checks to Greece is with the promise/belief that in the not so distant future Greece will once again be growing and able to pay back the funds they have received.

What has actually unfolded is quite a different story. One would be naïve to think that the Troika didn’t consider the current state of affairs as a real and likely outcome. Truth be told, they probably thought the current state was the most likely outcome, but they couldn’t come out and say it because it isn’t a story that can be sold to German taxpayers. The next logical question to ask is why is the Troika working so hard to keep Greece afloat? The answer is that if Greece were to default and exit the Eurozone today, speculation would spread throughout the Eurozone on who might be the next domino to topple (e.g. Spain, Italy, France, etc.). In order to stem this contagion, the Eurozone needs to put more safe guards in place like a banking union, deposit insurance, and an expansion of the ESM or a change in the ECB mandate to be the lender of last resort. These things take time to develop which is why “kicking the can down the road” is a perfectly viable solution in the Troika’s eyes.

Which brings us back to today’s headlines. The IMF will continue to forecast growth in the not too distant future for Greece and preach the importance of pro-growth policies while German politicians make statements of austerity that cater to their voting base. More hand ringing and summits (the one thing European’s are experts at are summits) will result in more bought time against the backdrop of a deepening Greek recession and growing debt load. How will it all end? No one knows for sure, but eventually the game will stop when people realize that the Troika “isn’t wearing anything at all!”

Contributor: Elliott Orsillo,CFA

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