End Game in Greece and for the Euro

I am normally loathe to link to anything in the Huffington Post, but this article by Simon Johnson brings such clarity to the Greek/Euro situation that I feel compelled to quote the article. (H/T The Grumpy Economist):

. . . the Greek failure mostly demonstrates how wrong a single currency is for Europe. The Greek backlash reflects the enormous pain and difficulty that comes with trying to arrange "internal devaluations" (a euphemism for big wage and spending cuts) in order to restore competitiveness and repay an excessive debt level.

Faced with five years of recession, more than 20 percent unemployment, further cuts to come, and a stream of failed promises from politicians inside and outside the country, a political backlash seems only natural. With IMF leaders, EC officials, and financial journalists floating the idea of a "Greek exit" from the euro, who can now invest in or sign long-term contracts in Greece? Greece's economy can only get worse.
. . .
The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies. But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data). This amounts to over 200 percent of the (broadly defined) capital of the euro system. No responsible bank would claim these sums are minor risks to its capital or to taxpayers. These claims also amount to 43 percent of German Gross Domestic Product, . . .

For the last three years Europe's politicians have promised to "do whatever it takes" to save the euro. It is now clear that this promise is beyond their capacity to keep -- because it requires steps that are unacceptable to their electorates. No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.

Sorry for the extended quotes, that is not normally my style; but it is becoming clearer by the day that this crisis is inevitable. Funny thing about financial crises, once they are seen as inevitable, they arrive sooner than later.

Hopefully Team Romney is studying the situation and is readying a plan. I maintain my long held position (here and here) that McCain could have won the 2008 election if he had proposed a radically different plan than the TARP and stimulus that both Bush and Obama supported. If I know anything about Team Obama, they will triple down on these failed policies if the coming euro crisis hits before the election. They might even be foolish enough to try and pledge U.S. aid to help save the euro. We need to keep an eye on the Fed as well. Romney should be ready with his own plan. If it embraces the free market, he wins in a walk.

Greek Default and Leaving the Euro

One of my favorite economists, John H. Cochrane writes in the Grumpy Economist:

Why does everyone equate Greece defaulting on its debt with Greece leaving or being kicked out of the euro? The two steps are completely separate. If Illinois defaults on its bonds, it does not have to leave the dollar zone -- and it would be an obvious disaster for it to do so.

I would agree with him, except that the problem in Greece runs deeper than just a sovereign default. My response from the comments.

But the Greeks seem unwilling to vote for a government that would take the actions needed to stay in the euro zone. If the Greeks default on their euro debt, they will get no new infusion of capital, because they will have broken all trust with their neighbors. Their only way out would be real structural reform. Such reform would include reducing the wages of workers, payments to pensioners and hiving off state businesses. There is no political will to do so. The leftists actually think they can threaten/blackmail the Germans into giving them an endless supply of euros. That's not going to happen. Result, Greece leaves the euro; not because of the debt default, but the refusal to deal with its root causes.

So back to Illinois. What would happen if a state defaulted and did nothing about, continuing deficit spending? Is there a precedent? In the 1840s several states in America defaulted on their debts after investing heavily in canals and railroads. Why can't Jerry Brown learn any history? Arkansas, Florida, Michigan, Mississippi and Louisiana all defaulted on their debts to some extent. But life went on, the states were forced to retrench their spending, and most states passed reform measures that limited debt and gave priority to debt repayment. The difference today, is that states are in debt from high operating expenses. If they were to default, then only a reduction of operating expenses would save them. Even if the federal government were to bail out Illinois or California, such a bailout would be unsustainable without real reform, because the state governments of these two deep blue states have the Greek problem, an overpaid, burdensome state workforce. But a default would force real reform, because these states aren't leaving the dollar zone.

That's Why They Aren't Calling It a Default - UPDATE: It's Official

I earlier had said that the Greeks were essentially defaulting by giving their creditors a "haircut." However, there has been a great reluctance on the part of anyone except Moody's and S&P to call it a default. I thought it was just political correctness and a mistaken belief that it would spook the markets if the politicians uttered the d word out loud. Turns out there's an insurers vs banksters sub-plot in this whole deal. From the Telegraph:

Europe has ring-fenced Greece's debt crisis for now but its escalating recourse to legal legerdemain has shattered the trust of global bond markets and may ultimately expose Portugal, Spain, and Italy to greater danger.

Athens officials last night estimated more than 85pc of private creditors had accepted the €206bn (£173bn) bond swap shortly after a deadline expired yesterday evening. That is enough for the deal to go through, but leaves the possibility the government might have to use its controversial Collective Action Clauses (CACs).

Ratings agencies have warned they will declare a default if Greece activates the CACs, which allow the government to impose the deal on the remaining bondholders. The CACs will be used if the take-up falls below the desired 95pc but above the required 66pc.

The International Swaps and Derivatives Association (ISDA) is poised to convene again to decide if the deal amounts to a “credit event” that would trigger billions of euros of insurance.

If the event isn't called a default or "credit event" then the insurers are out billions of euros, but if its just a "haircut" then the insurance isn't triggered. This seems like a bad system, as a huge incentive is built in to game the system. Or should I say, yet one more incentive is built in to game the system.

Ambrose Evans-Pritchard calls out the whole enterprise for what it is, legal skull-duggery. He points out that the European Bank has exempted itself from losses on the Greek debt, in effect shifting debt on to other bond holders. (Governments interfering in bankruptcy's favoring certain groups, I could swear that sounds familiar.) Here is an extended quote (I don't normally like to do that, but he is very clear and its important.)

The rule of law has been treated with contempt," said Marc Ostwald from Monument Securities. "This will lead to litigation for the next ten years. It has become a massive impediment for long-term investors, and people will now be very wary about Portugal."

At the start of the crisis EU leaders declared it unthinkable that any eurozone state should require debt relief, let alone default. Each pledge was breached, and the haircut imposed on banks, insurers, and pension funds ratcheted up to 75pc.

Last month the European Central Bank exercised its droit du seigneur, exempting itself from loses on Greek bonds. The instant effect was to concentrate more loss on other bondholders. "This has set a major precedent," said Marchel Alexandrivich from Jefferies Fixed Income. "It does not matter how often the EU authorities repeat that Greece is a 'one-off' case, nobody in the markets believes them."

Anybody for some Portuguese bonds? So given this history and this administration's abysmal record on the rule of law, what's going to happen when Illinois or California head towards default of their bonds? I believe the class already knows the answer. But for added emphasis, we have the previous story of the U.S. Treasury guaranteeing interest on California state bonds. Just as perverse incentives are at play in the EU shenanigans, so too, will this cause the Fed to buy up state bonds should that day come. Of course, by concentrating all of the financial risk of every government entity onto the U.S. Treasury, the meltdown will be all the more spectacular.

UPDATE

The WSJ is reporting that the "special committee of the International Swaps and Derivatives Association, which rules on such matters for the credit-default" has indeed ruled that the Greek action is a default which triggers the insurance provisions discussed above.

Payouts on a net $3.2 billion of insurance-like contracts designed to protect against losses on Greek sovereign debt have been triggered, after the country forced certain private creditors into its debt restructuring who didn't want to accept the terms of the deal, a committee of dealers and investors decided Friday.

Now that the EU Central Bank has insulated itself, and we have a real life actual sovereign default, what will happen to other sovereign debt interest rates in the euro-zone? Here is what we have so far:

Someone Finally Admitted It - Greeks Default

I have been saying for some time that the Greek debt situation is just a slow motion default, but no one wants to call it by its true name. KT alerted me to this gem about Moody's and S&P's view of the matter:

Moody’s dropped Greece’s rating to C from Ca, saying in a statement that investors who participate in the nation’s debt exchange will get about 70 percent less than the face value of their holdings. The deal constitutes “a distressed exchange, and hence a default,” the New York-based rating company said.

The downgrade follows Standard & Poor’s decision on Monday to lower Greece to «selective default» after the announcement of the plan for investors to trade their bonds for new securities. The swap will reduce Greece’s 200 billion euros of privately-held debt by about half if all investors participate.

Haircut my a**. Investors are unlikely to get even the 70% promised.

More Evidence the Greeks Will Default

As Dean is fond of saying constitutional republics, are like, hard. In the case of Greece, no matter what the government does, the people aren't going to accept the necessary measures to pay back their debt, and for good reason, they probably can't. However, in a parliamentary system, such a question should have been put to the people in the form of new elections before the negotiations continue. But the current "unity" government has plunged ahead with voting on austerity measures that seem uncertain to actually solve the debt problem, and definitely won't if too many more buildings are burnt and all the tourists leave. A vote would have the salutary effect of denying legitimacy to the protesters, because they would either have to live with the measures or take responsibility for the consequences of default. Either way, they might receive a dose of reality.

But this all might be mooted because even the Germans don't think the Greeks are going to pay much back, which has been my opinion all along.

The German finance ministry is actively pushing for Greece to declare itself bankrupt and to agree a "haircut" on the bulk of its debts held by banks, a move that would be classed as a default by financial markets.
. . .
Wolfgang Schäuble, the German finance minister, does not believe that any government would be able to implement them.

His pessimism has been tipped into despair with a secret European Commission, Central and IMF report that even if Greece made good on its promises, it would not be enough to reach the target of bringing total debt to 120 per cent of GDP by 2020.

"He just thinks the Greeks cannot do what needs to be done. And even if by some miracle they did what has been promised, he - and a growing group - are convinced it will not pull Greece out the hole,"

The only remaining question is what happens after a de facto default? I think that the Greek economy is going to go through a long depression. The only way they will be able to receive new lending to finance a recovery, will be to pledge physical assets, like their islands and the Parthenon perhaps. Even then, lenders would be reluctant to accept the collateral without constitutional protections to prevent nationalization.

Pretty nice collateral?

But let's also be clear about the game being played by the rest of the EU. An anonymous commenter previously posted that it is not really that big a deal if the Greeks default, the worry is the example set and the impact to banks. Much of the worry has been about the spread of bank failure if Greek default causes Italian and Spanish bond yields to rise. Once again, too big to fail leads to irrational economic policy. No one wants to learn this lesson, not the U.S. and not the Europeans. Heck even the Chinese prop up their banks with enforced savings and below market interest rates for the working stiff. So instead of too big to fail, why don't we require ever increasing capital reserve requirements as banks become larger? That would make it harder for big banks to leverage access to cheap capital from the Fed to make easy money, but that should be their problem.

Greek Update - Greeks Riot

That's it. What did we expect after new austerity measures were agreed to? Who the heck goes to work in Greece anyway? Clearly they aren't going to pay anything back to their creditors. The Europeans should just give the Greeks the boot and let the banks take their losses as an example to the others. (H/T The Grumpy Economist.)

Some Newer Greek Debt Deal is Hailed

Another day, another haircut for holders of Greek debt, this time for the European Central Bank.

The European Central Bank has made key concessions over its holdings of Greek government bonds, which will contribute to a reduction of the country's debt burden and smooth the path toward a new bailout for the country, said people briefed on Greece's debt-restructuring negotiations.

The decision by one of the Greek government's biggest creditors will narrow a gap in Greece's finances, helping pave the way for a debt-restructuring agreement . . .

The Greeks are saved, hooray. Wait haven't we heard this before? To continue:

But it is still unclear whether Greek politicians, facing public outrage, will accept the tough austerity policies pushed by European authorities and the IMF as the conditions to secure a deal.

If I was a Greek politician, I would just keep failing to get the votes needed for a deal, because every time I did, I would just get more concessions out of the EU.

Rope-A-Dope in Greece?

So the win-win idea to hold a referendum is paying off for Greek P.M. George Papandreou, aka Γεώργιος Α. Παπανδρέου (pictured at left, with Antonis Samaras, aka Αντώνης Σαμαράς). His own socialist party rebelled against the idea, and he barely survived a no confidence vote. But it got the opposition party "New Democracy" to the negotiating table, and look at the result.

In a statement early Monday morning, the Greek Finance Ministry said that delegations from the Socialist Party and New Democracy met on Sunday “to discuss the time frame of the actions” to implement the debt deal, and added that the two parties regarded Feb. 19 as “the most appropriate date for elections.”

In reaching the agreement, Mr. Papandreou agreed to meet Mr. Samaras’s demand that he step down as prime minister, while Mr. Samaras agreed to back the debt deal and a seven-point plan of priorities proposed by Mr. Papandreou that would essentially commit the new government to the terms of the debt deal.

So Samaras's party seemed poised to trounce the Socialist in elections that must certainly come within the next few months. Now, the debt deal and the attendant consequences will be an albatross around the neck of New Democracy. I wonder if the Greek voters will react in a similar manner to American ones in 2008. (The link is to my analysis of why McCain lost.) Given the choice between an unsteady maverick who seems to have no clue or principle as to how to handle a financial crisis vs the representative of the party of government, Americans chose the Democrats. Might the Greeks choose Socialists in the next election for the same reason? New Democracy was against the austerity measures right up to the point of final crisis. They dropped opposition for a chance to share in power. How unprincipled does that look?

Note to Republicans, if you believe in your principles, dropping them in a crisis, like Bush did in 2008, won't bring your party electoral success. In fact, sticking by those principles is the only path to long term success.

In the meantime, one wonders if George Papandreou is a fan of Muhammed Ali, and if Antonis Samaras is ready to lead his nation.

Taking Responsibility in Greece

I had the same reaction as fellow SLOB KT, regarding the decision by Greek PM George Papandreou to call a referendum on the euro bailout package. (By the way, I'd like to welcome KT to the SLOBs, he is a great addition, as well as a good friend.) The Greek people need to face up to their own responsibility for their future. A referendum is a good way to concentrate their attention and take the air out of their childish demands to be bailed out without making any fundamental changes to their system of government or economy.

Further, from a political perspective, the prime minister has little to lose. The New York Times is reporting that his government may collapse over the referendum question. But he was already a dead man walking, politically; new elections would give him a fresh mandate to govern or toss the problem to some other hapless sap who would have to live with the consequences of either default or austerity.

My personal opinion is that the Greeks should just default and exit the eurozone. They have proved they can't live within the rules laid down by the union, and full default, like bankruptcy would give a fresh start. The lack of foreign meddling would also concentrate the minds of the Greeks on solving their own problems, starting by re-instituting real capitalism and getting the government out of the shipping and tourism industries. Where would they get the capital to grow? They still own plenty of assets, including many islands that the wealthy or large corporations would love to lease or buy.


Here is a picture from the Greek island of Ios.


This could be the start of the Greek nation making a comeback. The first step is always taking responsibility for one's self.