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.


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