El-Erian says Greece will default

By Felix Salmon
April 29, 2010
Mohamed El-Erian has an important piece on Greece in tomorrow's FT; if you want to boil his 750-word article down to 3, it's basically "Greece will default".

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Mohamed El-Erian has an important piece on Greece in tomorrow’s FT; if you want to boil his 750-word article down to 3, it’s basically “Greece will default”.

El-Erian comes to this conclusion using three logical steps. The first:

A number of things have to happen very fast over the next few days to have some chance of salvaging the situation. At the very minimum, the government in Greece must come up with a credible multi-year adjustment plan that, critically, has the support of Greek society; EU members must come up with sizeable funds that can be quickly released and which are underpinned by the relevant approval of national parliaments; and the IMF must secure sufficient assurances from Greece (in the form of clear policy actions) and the EU (in the form of unambiguous financing assurances) to lead and co-ordinate the process.

And a squadron of flying pigs dropping 100-euro notes from helicopters across both the Greek and Iberian peninsulas would probably help too. The fact is that far from all of these things happening in the next few days, the base-case scenario is that none of them will. (The “sizeable funds” might appear, but don’t believe for a minute that national parliaments won’t object.) And on top of that, El-Erian notes drily that “the official sector has yet to prove itself effective at crisis management” — or, to put it another way, if you really think the IMF can cope with a Greek crisis, just look at how it coped at previous crises in Asia, Russia, and Latin America.

The second part of the argument is this:

The disorderly market moves of recent days will place even greater pressure on the balance sheets of Greek banks and their counterparties in Europe and elsewhere. The already material risks of disorderly bank deposit outflows and capital flights are increasing. The bottom line is simple yet consequential: the Greek debt crisis has morphed into something that is potentially more sinister for Europe and the global economy. What started out as a public finance issue is quickly turning into a banking problem too; and, what started out as a Greek issue has become a full- blown crisis for Europe.

This, in a sense, hardly needs saying: all public finance crises are also banking crises. The world has never seen an insolvent country with solvent banks, and Greece won’t be the first. But of course it’s not just Greek banks we’re worried about here, it’s also other banks across Europe — French, German and Swiss banks in general, and Fortis, Dexia and SocGen in particular, seem to be particularly at risk. Greece has always borrowed heavily from abroad, and its lenders are now in a very tough spot; needless to say, all those banks will get bailed out before they’re allowed to fail.

Finally, concludes El-Erian:

Absent some remarkable change in the next few days, things will get even more complex for the official sector. It may have no choice but to combine its own exceptional financing efforts with talks on a controversial approach that will be familiar to veteran emerging market observers – PSI, or “private sector involvement”.

PSI is the polite way to talk about the restructuring of some of the sovereign debt held by the private sector. It is based on a concept of burden-sharing in a disorderly world. It can appeal to governments as a seemingly easy way to ensure that massive public sector support to crisis countries does not flow back out in the form of payments to private creditors. Yet PSI is also hard to design comprehensively, harder to implement well and involves collateral damage and unintended consequences.

This is the “Greece will default” bit. El-Erian doesn’t quite come out and say so directly, but that’s how I read his “may have no choice but to” language: it’s about as close as the CEO of Pimco can come to saying that Greece will default without being accused of inciting panic. He even provides the requisite euphemism for the public sector to use: “private sector involvement”.

Consider the alternative, which is that the bulk of any EU/IMF bailout package would go to paying off in full all those speculators who have been buying Greek debt at 18% interest rates. It’s the too-big-to-fail problem all over again, exacerbated by the fact that if Greece gets a bailout, you can be sure that other countries are going to want one too, starting with Portugal, and working on from there. At some point, the German population simply won’t abide it: they’ve got their fiscal house in order, and they understandably don’t want to spend their hard-earned euros on paying off the debts of countries which, as Tyler Cowen puts it, “have been pretending to be much wealthier than they really are and to make financial plans on that basis”.

A Greek bailout package — any bailout package, really — is much more palatable when there isn’t anybody obviously being bailed out: when the distressed and insolvent borrower has to endure painful austerity, and when its lenders too suffer a certain amount of pain. To put it in US terms, we’re looking for something much more like GM or Chrysler, and much less like Bear Stearns. But of course GM and Chrysler were put into bankruptcy, and there’s no such thing as sovereign bankruptcy, which makes the whole problem that much more difficult and prone to what El-Erian calls “collateral damage and unintended consequences”.

El-Erian talks about how this approach “will be familiar to veteran emerging market observers”, but there’s a lot going on here which we haven’t seen in emerging markets before: a debt-to-GDP ratio of well over 100%; a country facing default which still has two investment-grade credit ratings; and, of course, the formal economic and monetary ties to risk-free developed nations.

It’s worth remembering Mexico’s tequila crisis of 1994-5. That was a liquidity crisis, not a solvency crisis, but even then the US bailout (a now-tiny-seeming $20 billion) had to come from a little-known Treasury slush fund since there was no way that it was going to receive Congressional approval. What’s more, the US ended up making a profit on that bailout, while as every German knows, any Greek bailout funds are unlikely to be repaid in full. And the US aid was extended only after Mexico had devalued and thereby become competitive again.

It’s impossible for Greece to devalue without defaulting, given that all of its debt is in euros. El-Erian doesn’t talk about devaluation in his article, but it’s clearly still a possibility. A default, meanwhile, is increasingly looking like it’s probable in the short-to-medium term, and near-certain in the long term. Countries have come back from high debt-to-GDP ratios in the past. But not with interest rates at these kind of levels, and only through devaluation.

I think I’m going to go join Paul Krugman under that table.


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Maybe I’m a total simpleton, but I think the right choice is clear: Greece SHOULD default on it’s Euro-denominated debt, abandon the Euro and the EMU altogether, reintroduce the drachma, and offer debt-holders whatever payment plan the Greek government decides is in its own interest – paid in its own currency, one they create and control themselves. New challenges would emerge, of course, but the internal fiscal crisis would end overnight. No austerity plan would need be imposed to further impoverish Greek citizens, and Greece would rejoin the ranks of true sovereign nations. Really, what are the consequences of “default?” Invasion? Foreclosure?

Why remain a hostage when you can just walk out the door?

Posted by Sensei | Report as abusive

About the bailout-package… it’s like the story of the dutch boy with the finger in the dike.

Posted by owe.jessen | Report as abusive

I’m with sensei. Greece is going to have to default and that means they may as well ditch the Euro, since that’s what got them stuck in this position. The main problem is printing the drachmas to distribute; they’ll need a long bank holiday for that. Afterwards they can pay off in full in a devaluing currency.

Once the market sees that the issue will be inflation and not a real default, they’ll calm down. (Actually, Greece should default, they should just declare a bank holiday and announce a simultaneous switchover to the drachma at 1:1.)

m, it’s all downhill from there

Posted by sonneblume | Report as abusive

Sensei gets it right. At what point ‘let us default’ becomes the politically palatable option in Greece and German? Greek population is already against foreign aid (because simple self interest demands that who wants to loose 13th & 14th month salary?). Go tell them – fine, let us get out of Euro and start with our own currency….

On German side, either Merkel will be dealt with defeat in NRW state or will eventually comply with German public wish that since Greece cannot fulfill austerity measures Germans will not lend.

The role of IMF is intriguing. They are still in the ‘selling’ mode and saving Euro mode. ECB – it is understandable that that laughable and miserable institute will continue to sell this ‘snake oil’ of let us save Greek otherwise Armageddon will come since they need to get their salaries.

But when the Armageddon has already arrived, IMF to join ECB chorus is bad. What are Republicans in USA Congress doing? Why are they not making the noise? The reason is all the war chest of IMF on Greek will get wasted and when you need money for Spain or any other nation; Americans, Chinese & Japanese of the world will have to fulfill ‘IMF draw down’ requests. In short for World, what IMF is pedaling; that is waste. Somebody needs to rein in IMF from their over zealousness in saving Euro when in the end these are core ‘political issues’ for Europeans to resolve first.

Posted by umeshgeeta | Report as abusive

This whole situation could have been avoided if the EU was not so focused on enlargement, and instead on getting the existing member states, particularly the founders, to work together more cohesively. If this had been accomplished, then when Greece finally gained acceptance to the EU, their profligate spending and deficits would have been addressed more forcefully.

When the EU members cannot even ratify a constitution, cannot come up with common fiscal and economic strategies, nor even a common security apparatus, then what hope do they have when it comes to addressing financial crises such as this?

This is the reason why the US and Asian countries are emerging from the crisis successfully, while Europe is still mired in the mess. Since there is no strong central authority in the EU, there is no clear hierarchy of decision making. Greece should not have been able to run up the deficits it did, just like Germany should not be allowed to hold up a rescue due to internal political divisions. Lets hope that out of this crisis emerges the Phoenix of a stronger more unified EU. Currently however, this crisis makes you wonder whether the EU can even survive.

Finally, I agree with the other posters. Greece should leave the EU/Eurozone, and devalue their new/old currency, the drachma. The main problem with this, which actually runs counter to one of Felix’s arguments, is that it will wreck the comparitively well capitalized Greek banks. With Greece teetering, who will bail out their banks? We could have Argentina all over again, not just the devaluation, but banks collapsing and people losing their life savings and turning to the streets for protests or terrorism. While this is scary enough, we still have not quantified the effect this could have on other European banks, as Felix adroitly mentions.

The only potential benefits I can see from this, from an American perspective, is that the Euro, no matter what, will become more volatile and lose value. The dollar will again become a safe haven currency. Oil and other commodities will experience downward pressure due to the rising greenback. While it could hurt American exports, it will allow the US to better finance its debt.

In the long run though, it is a win for Europe, if the EU still exists. Their exports will become more competitive, and they will be forced to totally re-evaluate the current strategies. Members will have to make drastic changes to their fiscal strategies, and the threat of being kicked out of the eurozone will actually have teeth.

Posted by LucidOne | Report as abusive

The EU needs to do these 5 things”

1. IMMEDIATELY federalize the core function of deposit insurance and bank supervision. Individual States should never have been allowed to retain this function with a common Federal currency in the first place. This error must be corrected yesterday.

2. Impose direct Federal taxes so that Federal obligations can be financed, and institute the required Federal police forces, prison systems, and District courts required to enforce it.

3. Completely take over the core functions of Defence and Social Security to allieviate the burden on the States, and establish the EU Federal Government as the primary soverign. Yes, this must mean direct EU control of nuclear forces, armies, navies, everything – including the appointment of officers. They must make sure Federal taxes are high enough to finance it too. Harmonizing benefit schemes throughout the EU at a level equal to the stingiest State should also cut overall retirement expenditures. No more Greeks retiring at 50.

4. The ECB should do QE as soon as Federal taxation is authorized. They can buy up state bonds, at an appropriate discount to their face value, and finance EU Federal bonds at full value.

5. Require all States to adopt the Euro and pay Federal taxes, or else leave the EU immediately.

Posted by Andrewp111 | Report as abusive


So, having already ceded fiscal and monetary sovereignty, EU member nations should surrender every other sovereign power to the Federal body to avert a crisis? Utter madness.

Your first suggestion and the fourth, okay. The ECB could offer 100% deposit insurance to prevent a liquidity crisis across the Euro zone and prevent a run on banks and a flight to dollars. That’s a monetary policy they can implement – maybe, as long as they abandon this stupid obsession with fiscal austerity. They could provide all the Euros they want to member nations tomorrow – without taxes being imposed, by the way. That’s what it means to be a monetary sovereign: you can spend without “funding.” And they could pay all Euro-denominated debts at face value without worry.

But 2,3, and 5 are just impossible and expose all the flaws of a monetary union without real centralized authority structures. The solution is not “impose those structures by fiat.” The EU has no sanction to take over the functions of a nation-state, and I’d wager that few Europeans are really that excited about joining a Fourth Reich.

Posted by Sensei | Report as abusive

Default and recreate the drachma? really? This plan would work if Greece could be a 100% self sustaining economy that no longer needed to be part of the rest of the world. If a country borrowed money and traded with other countries ran up a big tab and decided rather than working hard and paying it off it would simply devalue its currency by say 10000%, why would countries and foreign companies ever do business with it again?

Posted by outlawnyc | Report as abusive