Greece: The bull case

By Felix Salmon
September 1, 2010
noted with respect to Greece that "the bear case is terrifying, and the bull case is very hard to articulate". So it's extremely useful to have a clearly-articulated paper from the IMF, entitled "Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely", which puts the bull case much more vividly than I've seen it before.

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Back in April, I noted with respect to Greece that “the bear case is terrifying, and the bull case is very hard to articulate”. So it’s extremely useful to have a clearly-articulated paper from the IMF, entitled “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely”, which puts the bull case much more vividly than I’ve seen it before.

At its heart is this table:


The idea here is that whether or not you default, you’re going to have to embark upon a large fiscal adjustment in order to get back into sustainable territory. And even if you default with a massive 50% haircut, the size of that fiscal adjustment doesn’t change all that much:

The needed adjustment in today’s advanced economies would not be much affected by debt restructuring, even with a sizable haircut. To be concrete, let us consider by how much the primary adjustment needed to stabilize the debt-to-GDP ratio could be reduced by applying a 50 percent haircut—exceptionally large by historical standards. The haircut would make a limited difference for the required primary fiscal balance adjustment: 0.5 percentage point of GDP on average, and 2.7 percentage points for Greece. In percent of the adjustment in the absence of haircut, the reduction in the needed adjustment would be less than one-tenth on average and less than one-fifth in the case of Greece.

That’s the “unnecessary” part of the headline; the “undesirable” is pretty self-explanatory. But as for “unlikely”, I’m not convinced. Here’s the paper:

The essence of our reasoning is that the challenge stems mainly from the advanced economies’ large primary deficits, not from a high average interest rate on debt. Thus, default would not significantly reduce the need for major fiscal adjustment. In contrast, the economies that defaulted in recent decades did so primarily as a result of high debt servicing costs, often in the context of major external shocks. We conclude that default would not be in the interest of the citizens of the countries in question. Fiscal adjustment supported by reforms that enhance economic growth is a more effective response.

Well, yes, we’d all like fiscal adjustment and structural reforms, and probably a pony to boot. But in the case of Greece, and probably other countries too, it ain’t gonna happen. Which is why they’re going to default.

(HT: Alea)

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8 comments so far

When will we get a nice, proper first world sovereign default to blow up the bond market? All this waiting around like being stuck in purgatory.

The worldwide bond bubble is a cancer that extends across most of the developed world through all of my favorite countries. We have known for some time that it cannot end well, and yet it just keeps getting worse.

The giant flaw is that so many consider bonds to be stores for their wealth when in reality they have no intrinsic value (unlike commodities, real estate, stocks, etc).

If tangible things suffer in market price, they always have their underlying utility to carry them through.

If debtor companies or homeowners can’t pay, you can repossess tangible goods but if sovereign bonds default, there is no recourse.

The greatest wealth destruction in world history is presently occurring in terms of “savings” being plowed into current consumption via the conduit of Federal deficit spending that is not investment. If nothing permanent is being created then how will all that wealth ever be extracted?

Posted by DanHess | Report as abusive

Fantastic Comment Dan,

To weigh in I’ll actually guess that it will be a “semi-sovereign” default… that will get that ball rolling.

I honestly belive that California will refuse to balance their structually unbalanced budget… that they will actually increase social spending (by majority vote.) That they will vote not to increase taxation (which requires supermajority vote.)

They will then become the first state to openly challenge the authority of the federal goverment which constitutionally requires states to balance their budgets.

The bond market will punish them with rates even higher than they currently are forced to pay and rather than roll over their bonds as they mature on a vollentary basis they will make all outstanding bonds perpetual. They will pay the interest but not the principal. It will be a default by any definition but they will spin it as something softer… they may even offer a boost in coupon payment to quiet the outrage among investors.

The real question is will there be any market for the new state debt… that’s where things could get really interesting… could state regulators require that state chartered banks hold a certin percentage of muni debt? How about university endowments… could they be forced to buy state debt? Public penison could be forced to buy state debt. The list goes on and on.

The only thing I am truely sure of is that it will be an increasingly interesting world in the fixed income arena!

Posted by y2kurtus | Report as abusive

Well put, Dan!

The promises won’t be upheld. It isn’t yet clear HOW the default will materialize, but something has to give. (Pension promises, bond payments, and/or inflation.)

Posted by TFF | Report as abusive

Couple of corrections:

IMF View: The sovereign default of Greece is different than anything we have seen in the past few decades. The main reason being that its currency is Euros instead of its own true local currency.

The implications are twofold. One is that in the past few decades sovereign defaults have been accompanied by severe currency depreciations. The IMF piece is assuming default and remaining in the EURO. The true path for Greece lies with default and devaluation (they need the devaluation to restore competitiveness).

Now,as with the previous cases of sovereign default and currency devals, is if Greece leaves the Euro, then its default on EURO debt would have a massive positive effect on its Debt Stabilizing PB.

I seem this all the time. It is assumed Greece would only default and not need to devalue (ie leave the Euro all together).They need to do both!

Finally, the assumption of low interest rates is ridiculous. Greece is currently backstopped by the ECB. If that wasnt the case, Greece would be rolling over debt at very high interest rates, which would lead it to default. So the IMF assumes the ECB will guarantee Greek debt for a very long time.


Bonds could be in a bubble, but lets be clear about your alternative stores of wealth.

1) Real Estate: We have had a housing bubble that extended from the US to parts of Europe and many other countries. So buy real estate where there isnt a bubble popping.

2) Stocks: Sorry, but here you cannot tell be stocks are a more tangible asset than bonds. Bonds are senior to stocks in a company’s capital structure. So if there is a default by a company, the stocks should go to zero or near zero and creditors take their haircut. Bonds are a better store of wealth than stocks (maybe not a better investment at a particular point in time).

Posted by Marcus180 | Report as abusive

Marcus, neither stocks nor bonds are truly “tangible”. Can’t eat them, drive them, or live in them.

A bond is a promise to fork over a certain amount of currency at a certain point in time. Even if there is no formal default, the purchasing power of that bond is not guaranteed. If I buy a $50k 20-year bond I will be unhappy if, at the end, if that $50k is merely enough to buy an economy sedan.

A stock represents partial ownership of an ongoing concern. That stock is worth nothing if the business ceases to be profitable, however (especially for a multinational corporation) the long-term value of the stock is not tied to any currency. It is tied to the value of the business.

Finally, sovereign debt is different from corporate bonds. When corporate bonds default, the stock is worthless. Sovereign states default on their debt LONG before the country is worthless.

Posted by TFF | Report as abusive

@y2kurtis: there is no Federal requirement that the states run balanced budgets. Vermont has no such requirement and is still a state; furthermore you seem to understand that California has a large budget deficit and a large stock of government debt yet has not been expelled from the Union. Check yourself before you wreck yourself.

@TFF equity can be reinstated after a bankruptcy. General Growth Properties is a particularly large, high profile and recent example.

Posted by johnhhaskell | Report as abusive

Thanks for the correction, John.

Still, that doesn’t alter my fundamental point. There are risks to ALL types of investments. Fund managers generally arrange their offerings along a linear continuum, but that doesn’t capture the complexity of the reality.

Imagine a decade of global growth but domestic turmoil, with round after round of “stimulus” and “unemployment aid” and “homeowners aid” and “retirees aid” feeding a growing debt monster. At some point the house of cards collapses, with bondholders taking a massive haircut and the dollar collapsing in value as the Fed prints money to pave over the mess.

In such a scenario, would US Treasuries (or corporate dollar bonds) or well-capitalized multinational stocks weather the storm better? I don’t know how likely that scenario is, but I’m pretty sure that a 2.75% 10-year yield doesn’t adequately pay me for that risk.

Posted by TFF | Report as abusive

Marcus, yes, it is true that bonds are senior to stocks in the event of bankruptcy but there are many ways that bonds are ‘junior’ to stocks.

(1) After bonds and taxes are paid, every penny of additional profit belongs to stockholders. This is unlimited upside. Microsoft understood this when they issued debt recently and promply bought their own stock. If Microsoft’s business does well, its bondholders enjoy none of the benefit. Meanwhile, since the chance of an MSFT bankruptcy is nil (with cash far exceeding its debt), its bondholders are senior in no meaningful sense.

(2) As long as debts are paid, every bit of a company’s assets belongs to shareholders. For many companies, these cash assets, factories, buildings, land holdings, machines and patents have enormous value. It has been noted that McDonalds is an enormous real estate company first of all. With the exception of cash, all of these assets trend upward in value with inflation.

(3) Shareholders run the company, as long as it is solvent. Therefore they can make decisions to benefit shareholders at the expense of bondholders. Suppose business plan B has a 50% chance of a 10x return and a 50% chance of bankrupting the company? Let’s do it! This is obviously a good idea for shareholders and a horrible idea for bondholders, but too bad for bondholders. The number of seats in boardroom of a solvent company reserved for bondholders is zero.

Folks wouldn’t be singing bonds praises as loudly if markets had been allowed to function freely in 2008 and 2009. Investment bank bonds would have taken a bloody bath and we would have seen what (3) above really means. With this round of bailouts, we have now taken things one level up, to sovereign debt. Bailing out sovereign debts (by money printing, “monetary policy a l’outrance” as per Keynes) leads to inflation, so bondholders can’t expected to be protected from their mistakes like last time.

Posted by DanHess | Report as abusive
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