Going to the Mattresses

Crises have a way of overthrowing old verities. The recent stresses affecting Europe reflect growing doubts about some heretofore settled ideas concerning credibility. Sovereign credibility was essential to stemming the first wave of the crisis. But past credibility may prove a root of future vulnerability. And the sovereigns that until recently lacked credibility-the emerging markets-may be thankful they did.

In hindsight, it has become clear that several aspects of the 2008 crash had as much to do with credibility as with fundamentals. The rottenness of a significant fraction of American mortgages was fundamental, as was crazy leverage and positioning at Fannie, Freddie, Lehman and AIG-time has done nothing to change that truth. But back in 2008, the inferno of panic burned much more broadly. The entire banking system teetered, the commercial paper market ground to a halt, money market funds faced runs. The government contained the flames by creating a fire break out of its own credibility: the F.D.I.C. money market guarantee program, the Fed’s commercial paper purchase program, the TARP’s capital purchase program and associated stress tests (backed up by the promise of more government support).

Nearly two years later, the results suggest how much the credibility issue trumped fundamentals. The CPP disbursed $205 billion, of which $137 billion has been repaid-and it may end up profitable. The money market and commercial paper programs have not imposed losses. The support in these instances was more a transfusion of credibility than cash.

Europe picked up on the lesson. In response to the run on Greek debt, the E.U. announced the €500 billion European Stabilization Mechanism. Spain is trying its own version of the stress-test magic to deal with its faltering cajas, backed by a restructuring fund. Both the ESM and Spain’s FROB rely on future funding rather than cold, hard cash. Credibility serves as a force multiplier. A credible government merely says what it is going to do and causes an effect similar to what would have happened if it had actually done it. Declare you’ll stand behind your banks-and maybe you won’t need to.

Unfortunately, it is also a wasting asset, diminishing in effectiveness with use. For Europe, the credibility cure hasn’t elicited as vigorous a response. Write enough checks on the credibility account, and the market eventually will want to cash one. E.U. membership was once enough to ensure market access for Greece and Portugal. No longer. U.S. credibility remains powerful, but its power is not limitless. Right now, its apparent strength may reflect nothing more than the absence of any alternative source of credibility.

Some have suggested that alternatives are to be found: among the emerging markets. Sovereign credit spreads have undergone what I like to call “the Colonial Inversion.” Mexico, Peru, Colombia and Panama trade at lower spreads than Spain, and Brazil is tight to Portugal. The realization (or, as the skeptics might say, the belief) that certain emerging-markets countries are the new safe havens is one of the more intriguing outcomes of the post-crisis period, and one intimately connected to the credibility question.

EM countries have never enjoyed credibility, so they have often been forced to over-tighten fiscal and monetary policy at inopportune times. They’ve had to over-deliver on promises or face the swift wrath of markets. They could never build up the mountains of debt that developed markets have supported on the strength of their credibility.

EM and DM are like a pair of problem drinkers. EM is shabbily dressed and starts to sway and slur after a few beers, so the bartender knows to cut him off. Nattily attired, DM stays charming cocktail after cocktail, until he suddenly falls unconscious off his bar stool and covers everybody around him in puke. The dark side of credibility is that it can allow bad behavior to persist to the point where the damage isn’t easily remediable.

The post-crisis world is one of less credulousness and scarcer credibility. Institutions that have evolved for a high-credibility world-whose very functioning depends on that credibility-are going to find themselves in a tough spot. They are like the dinosaurs after the meteor strike. EM countries evolved to live without credibility. Their citizens are used to lurching fiscal adjustments and big output swings. Their savers don’t use debit cards drawn on brokerage accounts for daily expenses-they have cash in the mattress. They have relatively low government debt loads and central banks stuffed with foreign currency reserves. They are like the early mammals. They’re better adapted to the bleak post-meteor environment.

The DM dinosaurs have managed to survive the impact, but they face a serious challenge. They must work extra hard to rebuild credibility in an environment where it isn’t easily granted. Or they’ll have to learn, like the EMs did, to operate without it. If the latter is the case, we’re all going to have to learn to live a little more like EM citizens, with volatility and uncertainty. Fill up your mattress!


HFM’s Diary of a Very Bad Year: Confessions of an anonymous Hedge Fund Manager is out this month.


Going to the Mattresses