The Expediency of Cutting Public Spending

One of the interesting aspects of the current problems with Sovereign Debt is that-for the first time ever-it is now politically expedient to talk about reducing Government expenditure as a share of GDP. I am aware that Margaret Thatcher achieved this, but I would question if her popularity stemmed from this or whether it was as a consequence of the economic growth plus populist policies on housing. Perhaps the reality is that Thatcher could not have achieved this without the growth in the private sector and/or selling off state industries. The latter produces a one time benefit to revenues.

No matter. The point here is that there does appear to be a wind of change on the issue. Such sentiment shifts are hard to achieve. If humans were rational, we could all sit down and see the benefit in curtailing excessive Government expenditure. However, abstract arguments are hard for people realise in practice. In reality, ideas have no resonance unless they are accompanied by emotional involvement.

It was the emotional involvement of Germans with hyper-inflation during the inter-War period that has largely shaped their consensual awareness of its dangers today. Similarly, there is no doubt that the UK (an invaded during the Second World War) views the political project of the EU with less stringency. For war bedevilled continental Europe (almost continually at war for at least 200 years) the EU project is about ensuring solidarity and harmony. Another example, can be seen in the reticence of Asian countries to depeg their currencies from the US Dollar. They remember, all too well, the aftermath of the Asian Financial Crisis in the late 90's.

Returning to the subject of this post, it is worth recalling how problematic it has proved to intellectuals to get across the idea that Government Spending should be curtailed. James Buchanan gave the greatest insight with his applications of game theory to public choice decision making. Milton Friedman talked of constitutional adjustments to enforce balanced budgets. Friedrich Hayek warned us over taking the 'Road to Serfdom'. Alan Greenspan endlessly promulgated the necessity to rein in Federal Spending. Nothing worked.

Prosperity begets power and no power exerts itself more forcibly or effectively than that of the control of the welfare state by the middle classes. The transmission mechanism of this power is, inevitably, the willingness, nay necessity, for politicians to have a beauty parade based on who can spend the most money. It takes a shock, similar to current events, for people to finally realise that the public spending that they demand is actually paid for by them. We can only hope that in the UK ,for example, the public realises the wastefulness and inefficiency of the previous regime, and in fact, of many of them before them.

European Sovereign Debt Spreads Before and After ECB Action

After a few days of the markets backing off of fighting the ECB, I thought it would be interesting to review some European Sovereign Debt metrics. Whilst equity markets and are enjoying a relief rally and a return to the bias towards risk assets (propelled by Quantitative Easing 2) it is far from clear whether the underlying fundamentals have been dealt with. This could take time.

Firstly, looking at Spain/German Yield 10 Year spreads...



reveals that they are still elevated. Similarly, Spain 5 Year Senior USD CDS



Portuguese 5 Year Senior USD CDS



However, it appears that the Federal Reserve at the ECB were entirely right to act quickly to avert 'Ireland' turning into 'Greece'. It is my opinion, that there were liquidity problems with some European Banks in Q2 and, some stress metrics for the banking system reflect this. Here is the 'Ted' Spread. In other words, the difference between short term interbank loans (LIBOR) and US Government debt (3 month T-Bills)



So it appears that QE2 was entirely justified!

I think there is a risk that this sort of game could continue in 2011. Spain's recent PMI numbers were signalling contraction recently and their housing market is far from being out of the woods.

I run a hedged portfolio with a bit of a discretionary element by which I play with delta. Right now I have the portfolio positioned with a cautious stance.