June 27, 2011

Greece: Closer Than You Think

by Hal Gershowitz

Comments Below

It all seems so remote, not just in geography, but as a unique economic issue affecting only Greece and, perhaps, the rest of the EU.  But it isn’t.  The world is very interconnected.  Many Americans directly or indirectly (through their banks or money market funds) hold Greek debt instruments, which are probably never going to be repaid, or, in some cases, Americans may be invested in funds that hold debt instruments that are, in turn, insured by European banks that have sizeable exposure to a Greek default or restructuring.  A default, restructuring or further downgrading of Greek debt or of the banks that have Greek debt exposure can ricochet through American financial institutions.

European finance ministers and the European Central Bank (ECB) have been wrangling over whether or when to release the final installment of the $157 million bailout loan granted last year when certain austerity measures were imposed on Greece.  Keep in mind that this final disbursement will only carry Greece into mid‑September.  The bigger issue is a fresh bailout loan of $100+ billion Euros, almost the same as the first loan.  In other words, this, in gambling terms, is a double down bet.  Few financial analysts, if any, believe Greece is going to escape an eventual default. So what is going on here? This is Extend and Pretend writ large.

Last year’s package depended on Greece enacting major spending cuts, and cracking down on tax evaders.  Instead the public took to the streets.  Prime Minister Papandreou has based his political future on ramming through a new and more draconian austerity budget, but he has only a five seat parliamentary majority and some members of his party have been on the fence.  Greek debt is now at a staggering 150% of its GNP.

As The Wall Street Journal notes, this is not a liquidity problem but a solvency crisis and that is not a difference without a distinction. Greece isn’t merely having cash flow problems.  Greece is insolvent, i.e., it currently has no prospect of meeting its obligations. Angela Merkel, Chancellor of Germany initially advocated a restructuring of Greek debt, extending the maturity of debt repayment (i.e., stretching out the due dates).  European ministers have resisted, relying instead on a fresh loan and further austerity measures.  Ms. Merkel seems to have relented, at least with regard to the final disbursement of the first loan.  If this whole rescue plan debate isn’t a “hear no evil, see no evil” approach, we do not know what one is.  A new loan package would make other European governments Greece’s largest creditors.  Germany, as the largest economy, has the biggest exposure.  Bondholders (the secured creditors) would not be forced to take a haircut, at least not yet.  Essentially, Europe is embarking on a policy of “too big to fail” and economists will be debating for many years how well that worked, or didn’t work, here.

Restructuring the debt by stretching it out or paying less than one hundred cents on the dollar will be considered by rating agencies to be a default and Greece will then have little or no access to credit markets for quite a while (at least at anything less than confiscatory interest rates). Credit rating agencies are not apt to look kindly on other proposals for creditor banks to accept new Greek debt instruments as payment for current debt about to come due.  If the rating agencies determine that a restructuring or rescheduling plan has harmed the holders of existing debt, there is a strong likelihood that they will declare a default… as, indeed, they should. Interest on Greek bonds reached 17 percent on June 10, and that is before a default.  No one knows what kind of impact a default might have on the debt of other nations whose economies are weak, and whose debt to GNP ratio far exceeds a healthy or sustainable (there’s that word again) level.  Ireland, Portugal and Spain are in similarly weak positions and declaration of a default in Greece might well cause a rush to the exits for holders of the debt of those countries.  That is why many economists and pundits refer to this situation as a Lehman Brothers moment, which caused the U.S. financial markets essentially to melt down.

U.S. financial institutions and their depositors cannot escape the consequences of this, if they are exposed to Greek debt and to the banks that made the loans.  When those holdings are “marked to market,” our banks will record losses.  Even money market funds are not immune from the consequences.  There are no available fallout shelters.

Economist Niall Ferguson explains it this way in the Financial Times:

“It began in Athens and it is spreading to Lisbon and Madrid.  But it would be a grave mistake to assume that the sovereign debt crisis that is unfolding will be confined to the weaker eurozone economies.  For this is more than just a Mediterranean problem . . . . . It is a fiscal crisis of the western world.  Its ramifications are far more profound than most investors currently appreciate.

The greatest failed experiment in economic history could only have been propped up for so long, courtesy of its core beneficiaries:  the very oligarchs and financiers who transferred wealth over the ages from the working class to the “financially creative” product class (i.e., those that “packaged” and managed risk…look where they got us, but don’t look how much they got paid for it).”

Keynesianism is starting to unravel.  Although U.S. Treasuries may be a temporary “safe haven” one wag jokingly said that for the longer term, U.S. government debt is as safe a haven as was Pearl Harbor in 1941.

A European debt crisis is likely once again to make banks fearful of lending to one another bringing about the freezing of financial markets similar to the credit crisis in 2009.  And this time a huge stimulus package will not be in the offing.  Nor can Greece resort to the age-old beggar they neighbor approach of devaluing its currency since it is on the euro and not the drachma.  Further complication arises from the fact that the EU has an integrated monetary union and no political union.  Each nation passes its own budget, issues its own debt and largely ignores EU guidelines on those subjects.

The broader implications for the U.S. are set forth in a Congressional Research Service Analysis in 2010.  The report concluded there were five major implications.

First, many expect that if investors lose confidence in the future of the Eurozone, and more current account adjustment is required for the Eurozone as a whole, the value of the euro will weaken.  A weaker euro would likely lower U.S. exports to the Eurozone and increase U.S. imports from the Eurozone, widening the U.S. trade deficit.

Second, the United States has a large financial stake in the EU.  The EU as a whole is the United States’s biggest trading partner and hundreds of billions of dollars flow between the EU and the United States each year.  Widespread financial instability in the EU could impact trade and growth in the region, which in turn could impact the U.S. economy.

Third, a Greek default could have implications for U.S. commercial interests.  Although most of Greece’s debt is held by Europeans (more than 80%), $14.1 billion of Greece’s debt obligations are owed to creditors within the United States.

Fourth, the global recession has worsened the government budget position of a large number of countries.

Fifth, debates over imbalances between current account deficit and current account surplus countries within the Eurozone are similar to the debates about imbalances between the United States and China.  These debates reiterate how the economic policies of one country can affect other countries and the need for international economic cooperation and coordination to achieve international financial stability.

Greece’s solvency crisis cannot be cured by bailouts.  At best they put off for a while the day of reckoning.  Europe’s politicians (just like ours) are simply pushing that day farther down the road, no doubt so politicians can get past yet another election.  But further bloated budgets simply make the ultimate consequences worse.  Sound familiar?  Our Congress and President, while facing the same problems, are doing the same thing.

Democrats have declared Social Security, Medicare and Medicaid “off the table.”  But that is where the money is.  Instead the political left continues to treat our fiscal problems as a revenue issue, which can be solved by taxing those taxpayers they consider to be the enemy:  “the rich”.  Robert Reich, a former labor secretary and in our judgment, an ivory tower economist, has mused that the U.S. economy grew when top rates were 70%. Only economists who breathe the rarified air high in Ivorytowerdom would propose 70% tax rates, even on high marginal income, with the economy teetering near renewed recession, housing prices sinking even lower into what seems a bottomless market abyss and the threat of the current downturn evolving into an American lost decade.

Congress must act and curtail our debt.  It needs to raise the debt limit far enough to cover interest on U.S. debt securities and other required payments so long as it also enacts binding spending cut offsets.  Oddly, the atmosphere to do that may be getting better because the message is getting through.  Recently AARP dropped a bombshell by agreeing that changes to Social Security were necessary.  And the U.S. Senate, in a rare show of bipartisanship, voted to end ethanol subsidies (a boondoggle if ever there was one).  Time is running out, but, at long last, adult thinking has become part of the dialogue. Better late than never.


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3 responses to “Greece: Closer Than You Think”

  1. This is a very timely article & apt. It is the best explanation of the crisis in Greece anywhere.

    Lee greenwood
    NEA council member

  2. Mark J Levick says:

    This piece should be required reading for every member of Congress. The assumption that they can all digest it’s implications is probably invalid due to the mental block which partisanship seems to have created. Perhaps the politcal pundits should be given this educational experience. Same mental block. Same result. Our commander in chief is a learned man. Surely he can benefit from your wisdom. He can but in so doing he will have to reveal that the emperor has no clothes. As it is often said “Let us pray”.

  3. […] with Greece. And what is Greece’s debt-to-GNP ratio? In June of this year, a blogger wrote, “Greek debt is now at a staggering 150% of its GNP.” Ireland, Portugal and Spain are in similar straits. Now […]

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