Opinion

Felix Salmon

The depressing outlook for Greece

By Felix Salmon
April 26, 2010

I just had a very interesting conversation poolside at the Beverly Hilton with a couple of high-profile delegates at the Milken Global Conference. The pool, one level down from where all the panels take place: is clearly the place to be: Arnold Schwarzenegger was just a couple of tables away. But I doubt he was talking in great depth about the Greek debt situation and what’s likely to happen there.

I walked away from the conversation decidedly bearish on Greece. Why?

  1. It’s not in the interest of Germany’s politicians to bail out Greece. Angela Merkel is taking a hard line on the subject, and you can see why she would — the German electorate has no particular desire to spend billions of euros bailing out the Greeks.
  2. It’s not even narrowly in the interest of Germany to bail out Greece. If Germany cares only about itself, rather than the full European Union, then in many ways the best-case scenario for Germany is to see Greece and Portugal default, leave the euro, and then re-enter a few years later at a more competitive exchange rate. That’s better than using German funds to try to sustain the national debt of those countries at their present elevated levels.
  3. Even if Germany cares about what might be called “narrow Europe” — Germany, France, Benelux — it still might well rather see Greece and Portugal exiled from the euro, thus making it a more credible currency in the eyes of many.
  4. If Germany can’t be sure that Greece will avoid default, it would be much better off simply letting Greece go its own way, and then bailing out its domestic banks if Greek did end up defaulting. The cost of the bank bailout would be lower than the cost of a Greece bailout, and the money would remain within Germany.
  5. If Greek did default, though, make no mistake that massive bank bailouts would be necessary — if not in Germany then certainly in places like Italy. Hedge funds and distressed investors aren’t going to start buying Greek debt pre-default: they’re going to wait for the default and the inevitable overshoot in prices, and then buy.
  6. Where would Greek debt trade in the event of a default? This is the scariest thing: my highly plugged-in companions both agreed that it wouldn’t just fall to 70 or even 60 cents on the dollar: they saw fair value closer to 40, and said that it would probably fall to 30 before people started buying.
  7. Needless to say, if Greek debt was trading at 30 cents on the dollar, it wouldn’t take long for the Portuguese domino to topple. After that, Spain — and then, it’s easy to imagine, Italy, Ireland, UK. And so the stakes are very high: it’s certainly cheaper to bail out Greece with virtually unlimited funds than it is to risk a fully-blown PIIGS default. But there does seem to be the hope or expectation that a line could get drawn in the Iberian sand, and that Italy and Ireland would not be allowed to default even if Portugal and/or Spain imploded.
  8. A couple of high-profile sovereign defaults in Europe would actually be welcomed by the fiscally-responsible wing of the Republican party — the people who want to raise taxes rather than lower them. The idea here is that there would be a come-to-Jesus moment and lawmakers would suddenly realize how dangerous large sustained deficits can be, and change their wicked ways.

I buy nearly all of this, with the exception of #6 and #8. My feeling is that a Greek default, while it could in theory be a disorderly and chaotic simple failure to pay, would more likely take the form of a public exchange offer, which would help to put a floor on the price of Greek debt.

And I very much doubt that defaults in southern Europe would improve the fiscal status of the US. To the contrary, the flight-to-quality trade would just make it even cheaper for the US to borrow money, and the lesson we’ve all learned many times is that so long as a country has lots of access to cheap money, it’ll go on borrowing.

But I do think that there’s a pretty low limit to how much money Germany is going to spend bailing out Greece. It’s already bailed out one basket-case European country, when it absorbed East Germany. It’s got no appetite to bail out another.

Comments
14 comments so far | RSS Comments RSS

With respect to #1, #2 and #3 – congratulations, you’ve proved the impossibility of not only the 2004 and 2007 accessions, but also of the Common Agricultural Policy.

Posted by dsquared | Report as abusive
 

why does nobody discuss a haircut for the investors? They went into the higher yield intentionally, and yet nobody takes them into consideration.

Posted by Salesby | Report as abusive
 

Salesby- in 2005 you got an extra 15 basis points for lending money to Greece vs. Germany. Is that what you call a “higher yield”?

Felix- there was a good piece put out by Barclays earlier today, and discussed on FT Alphaville, showing that if Greece gives a 90% guillotining (because you can hardly call that a haircut), they still need a 7.5%-of-GDP fiscal consolidation to stabilize debt-to-GDP. No Eurozone country has ever pulled off a positive 7.5% swing in the primary balance over a three year period.

Accordingly the only way for Greece to become solvent is to exit the euro, and given all the obstacles the Eurozone has put in the way, that will likely be about as orderly as Argentina’s exiting the “convertibility” regime.

Posted by johnhhaskell | Report as abusive
 

Felix,

Let me promise you that US debt will not become cheaper to issue after a greek default. The next time a 1st world soverign defaults will be the first time.

At that point the rules change. The risk free rate is no longer risk free and new finance text books get written with hard assets like gold drop below cash on the risk / reward efficent frontier.

Let us pray that Greek does not default!

Good luck in interesting times!

Posted by y2kurtus | Report as abusive
 

Points #4 and #6 are contradictory. 70%-80% of Greece’s debt is foreign, most of it in Europe, which means approximately $300 billion debt held in Europe (with Germany holding the plurality). If a default happens and the recovery rate is 50% (higher than what point #6 is claiming), that’s a $150 billion hole in the European financial system.

Greece’s annual funding needs are on the order of 50 billion Euros. It’ll be cheaper to fund Greece for 2 years than bail out the European financial industry, and a lot less risky. And could stave off contagion.

Posted by Kosta0101 | Report as abusive
 
 

[7] strikes me as weird if believed by the German government. In order to avoid stumping up the cash it would be OK with Spain, Italy and the UK in sovereign default?

Posted by mjturner | Report as abusive
 

Not sure what the UK’s doing mentioned in 7 either – its debt is denominated in sterling not in euro, so the chances of a UK default are zero. Unless it’s a typo/thinko, I’d be wary of taking any advice at all from anyone who claims otherwise…

Posted by john_b78 | Report as abusive
 

Let’s be honest here, it’s irresponsible to suggest that the UK would default in such a scenario. The pound is free floating and has already weakened dramatically. If Greece’s entire problem is as you say down to being part of the Euro and therefore having an inflexible currency, then how could the UK fall into the same trap?

Posted by drewiepe | Report as abusive
 

@ Kosta: Well, as was being mentioned, it is very unlikely that Greece will be able to consolidate its budget to the amount necessary within 2 or 3 years. Therefore, an early default would save money, because the outstanding amount on which Greece will default is smaller.

I see the problem with contagion, the problem being that Spain would, in the end, have to default, because it is too big to save.

Posted by owe.jessen | Report as abusive
 

It is interesting how the conversation changes over time. What was just hinted at two weeks ago is now openly discussed. What is just hinted at now will be on the table in two weeks.

Greece is going to bailed out by money from Ireland, Portugal and Spain among others? How is that going to work?

All conversations presume that the Germans are on board. As Ambrose Evans-Pritchard, among others, has plainly commented the Germans are NOT on board.

Portugal already has the signs and symptoms of the Greek disease. See my first paragraph.

All conversations presume that sovereigns can never run out of other people’s money (OPM). Is that true? Is there some limit past which even sovereigns cannot borrow and spend?

Posted by Viator | Report as abusive
 

Who is this “fiscally responsible wing of the Republican Party”? I thought they had all been exterminated. Or have they set up a secret network of cells waiting for the right moment to emerge?

Posted by wpw | Report as abusive
 

From Wikipedia:
————
Greece directs approximately 4.3% of its GDP to military expenditures, the 2nd highest percentage in Europe (behind the Republic of Macedonia).[4] In absolute numbers the Greek military budget ranked 28th in the world in 2005. By the same measure, Greek military budget ranked 6th in the Mediterranean basin (behind France, Italy, Turkey, Israel and Spain) and 2nd (behind Turkey) in its immediate vicinity, the Balkans.[5] It must be noted that Greek arms purchasing is among the highest in the world: Greece ranked 3rd in the world in 2004.[6]

These figures are explained[7] in the light of the arms race between Greece and Turkey with key issues being the Cyprus dispute and disagreement over sovereignty of certain islets of the Aegean. For more information see Greco-Turkish relations. Reversly, the foreign relations of Greece as well as many internal policy decisions are largely affected by its arms purchases. The United States, being the major arms seller to Greece has been known to actively intervene in military spending decisions made by the Greek government.[8] The US has at times actively stepped in to help avoid large scale crisis, as in the case of the Imia-Kardak crisis.

The reduction of military spending has long been an issue in Greek politics. The former prime minister, Kostas Karamanlis had proposed a reduction to military spending through a “Defence Eurozone”,[9] referring to the European Security and Defence Policy. The previous PASOK administration, also planned on reducing military spending[10] prior to its failure to be re-elected in 2004, while PASOK politicians usually refer to money saved from reducing military spending as a “peace dividend” (“μέρισμα ειρήνης”).[11] The parties of the Left, KKE and Synaspismos, have been vocal in condemning military spending. Regarding the purchase of 30 F-16 and 333 Leopard tanks in 2005, both parties criticized the New Democracy administration for spending money on weapons while doing nothing to relieve the lower classes and said that high military spending “does not correspond to the real needs of the country but is carried out according to NATO planning and to serve weapon manufacturers and the countries that host them”.[12]
————-

Posted by rootless | Report as abusive
 

@owe.jessen, you wrote “Well, as was being mentioned, it is very unlikely that Greece will be able to consolidate its budget to the amount necessary within 2 or 3 years. Therefore, an early default would save money, because the outstanding amount on which Greece will default is smaller. ”

I’m not sure that “very unlikely” is the best characterization of the situation (also, I’m not sure where it “was being mentioned”, point #4 explicitly mentions a bailout possibility). Perhaps Greece can stabilize its finances, perhaps it can’t, I’m not sure anyone knows for sure. You’re right that if Germany tries to bail out Greece, only to have Greece default in two years, Germany will have only made the problem bigger. How much bigger? About 25%.

Assuming contagion can be contained, then it’s a question of whether having a Probability=1 chance of cleaning up 100% of the mess now is better than having a Probability=?? chance of cleaning up 125% of the mess in two years. If you think the probability of Greece defaulting even with a bailout is higher than 0.8, then it would be “cheaper” to clean up the mess now.

Another consideration is that the world financial system is still quite fragile. Perhaps it would be better to bailout Greece for the time being to let the banks build up their reserves for two years before Greece’s inevitable default? Felix alludes to this in his latest post
http://blogs.reuters.com/felix-salmon/20 10/04/28/roubini-on-greece/

Posted by Kosta0101 | Report as abusive
 

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