Forget about Dubai. The real problem is in Europe

Willem Buiter has just taken on a new role at Citigroup. The news of Willem Buiter's role as Chief Economist at Citigroup comes via DealBook at the New York Times below. Afterward, I have some comments about Dubai contextualizing reluctance by the government to backstop Dubai World - something Buiter warns against.

Citigroup said on Monday that it has hired Willem Buiter, a professor at the London School of Economics, as its chief economist, effective January 2010.

Mr. Buiter will replace Lewis Alexander in Citi's top economics post, in which he will head the firm's economics research unit and join the management team of Citigroup's Citi Investment Analysis and Research group.

"We are delighted that we have been able to attract a thought leader of Willem's experience and track record to our global platform," Andrew Pitt, the global head of Citi Investment Research & Analysis, said in a statement.

Currently a professor of political economy at the L.S.E., a well-known economics commentator and blogger and a consultant to Goldman Sachs, Mr. Buiter previously held posts at the European Bank for Reconstruction & Development and the Monetary Policy Committee of the Bank of New England.

"As one of the world's most distinguished macroeconomists, Willem's deep knowledge of global markets and economies, and emerging markets economies in particular, will be invaluable to our clients," Hamid Biglari, Citi vice chairman, said in a statement.

I see this as a huge positive for Citi because it demonstrates that Citi is looking for fresh perspectives outside the mainstream. Buiter has been one of the finance bloggers most vocal in decrying the policies adopted before and during the panic in the global financial system.

Buiter correctly anticipated the potential for collapse in the Icelandic banking system. Since then he has warned other small open countries like Ireland and Dubai not to follow in Iceland's footsteps in providing sweeping government backstops to bankrupt troubled institutions. This is what he terms the sovereign debt delusion (see "Too big to rescue" for more on this).

His most recent blog entry pointed out the relative insignificance of Dubai in the global system but it warns of the potential for sovereign default -especially in the Eurozone. He agrees with Credit Writedowns' assertion that the US and the UK, as sovereigns that hold debt in their own currencies, are likely to try the inflationary route to mitigate the mounting debt burdens (see "Inflation: The strategy that dare not state its name").

The massive build-up of sovereign debt as a result of the financial crisis and especially as a result of the severe contraction that followed the crisis, makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral. The Dubai World and Nakheel debt standstill and possible default is of systemic significance only because it may well be a harbinger of future sovereign financial distress, in Dubai and elsewhere.

From Dubai to Iceland, Ireland, Greece, Hungary, Italy, Portugal, Spain, Japan, France, the UK and the USA, the sovereign debt burdens have been at current levels during peacetime only on the way down from even higher public debt burdens incurred during wars.  Watching the public debt to GDP ratios rise to levels likely to reach or exceed 100 percent of GDP by 2014 is deeply worrying, especially with structural primary (non-interest) deficits as high as they are.  The political economy of fiscal burden sharing, inside nations and between nations, will be a major field of enquiry for economists and political scientists during the years to come. I am pessimistic in that regard about countries characterised by deep polarisation and political gridlock.  This includes nations as different as Greece and the USA.

It is clear that nations whose public debt is mainly denominated in domestic currency and whose central bank is either not very independent or can be make dependent by the government of the day are likely to choose inflation and exchange rate depreciation over default as a way out of fiscal-financial unsustainability.  That category would include the USA and, to a lesser extent, the UK.  Because the ECB faces 16 national governments and national ministries of finance, the power and independence of the ECB are much greater vis-a-vis any Euro Area member state than the power and independence of any central bank facing a single national government and Treasury.  That is regardless of the formal independence criteria laid down in laws, treaties or constitutions.

The practical implication of this is that the ECB will not monetise the government debt and deficits of small European Area member states.  Only Germany can really push the ECB around, partly for historical reasons, partly because it is the largest and most powerful Euro Area and EU member state and partly because of the geographic reality that the ECB is on its territory - in the final analysis the German government can order a siege of the Eurotower ...

For small peripheral European nations, the threat of sovereign insolvency is therefore a real one, unless EU fiscal solidarity can be relied upon to bail them out.  When Ireland was about to be swept away by a wave of global financial mistrust triggered by the Irish government's decision to guarantee effectively all liabilities of its banks, the then German Finance Minister Steinbruck made the amazing statement (which he obviously had not checked with his coalition partners, his Chancellor or his voters) that the Eurozone countries would not let one of their own go into default.

The year that has passed since then has made this implicit commitment to a Eurozone, let alone an EU cross-border sovereign bail-out rather less credible.  All EU sovereigns are, to varying degrees, in fiscal dire straits.  We may well see in the next few years the first sovereign default by an old EU15 country since Germany defaulted on its debt in 1948.  If the travails of Dubai wake us up to that possibility, they will have done some good.  Sovereign defaults are not acts of God.  They are the result of choices.  If we continue to play the political game in a business-as-usual mode, there could be quite widespread sovereign debt restructuring throughout the advanced industrial world.  If we grow up, we can avoid the worst.

I agree with Buiter's sentiments. The best post I wrote on this topic was in February called "The European problem." Despite asset market increases, the situation remains critical. Ireland, Greece, Spain, and Portugal are the clearest examples of countries which are storing up major trouble - and without the currency escape hatch - which makes these countries more akin to states like California, Michigan, or New York than the U.S. Sovereign credit ratings have been cut repeatedly in Ireland, Portugal and Greece.  Back in March, everyone was talking about this. But, somehow these concerns have faded from view as equity markets have risen. The exogenous shock in Dubai brought the reality back into the spotlight.

The same is true in the Baltics despite their sovereign currencies because of the Euro currency peg. Here too credit ratings are being cut. This is the reason I continue to be more concerned about Eastern Europe than I am about Dubai. Yes, there could be a butterfly effect with Dubai here but contagion risk is more acute in Eastern Europe where large banks have much greater exposure than in Dubai. I see Dubai as Buiter does - a tempest in a tea pot; the real action is in Europe.

So, hats off to Citigroup for getting Buiter onboard. His blog at the Financial Times, aptly titled Mavercon because of the unconventional ideas he often floats, demonstrates he will bring some critical new thinking to the organization.