Europe’s high-risk gamble

By Martin Feldstein
September 27, 2011

By Martin Feldstein
The opinions expressed are his own.

The Greek government needs to escape from an otherwise impossible situation. It has an unmanageable level of government debt (150% of GDP, rising this year by ten percentage points), a collapsing economy (with GDP down by more than 7% this year, pushing the unemployment rate up to 16%), a chronic balance-of-payments deficit (now at 8% of GDP), and insolvent banks that are rapidly losing deposits.

The only way out is for Greece to default on its sovereign debt. When it does, it must write down the principal value of that debt by at least 50%. The current plan to reduce the present value of privately held bonds by 20% is just a first small step toward this outcome.

If Greece leaves the euro after it defaults, it can devalue its new currency, thereby stimulating demand and shifting eventually to a trade surplus. Such a strategy of “default and devalue” has been standard fare for countries in other parts of the world when they were faced with unmanageably large government debt and a chronic current-account deficit. It hasn’t happened in Greece only because Greece is trapped in the single currency.

The markets are fully aware that Greece, being insolvent, will eventually default. That’s why the interest rate on Greek three-year government debt recently soared past 100% and the yield on ten-year bonds is 22%, implying that a €100 principal payable in ten years is worth less than €14 today.

Why, then, are political leaders in France and Germany trying so hard to prevent – or, more accurately, to postpone – the inevitable? There are two reasons.

First, the banks and other financial institutions in Germany and France have large exposures to Greek government debt, both directly and through the credit that they have extended to Greek and other eurozone banks. Postponing a default gives the French and German financial institutions time to build up their capital, reduce their exposure to Greek banks by not renewing credit when loans come due, and sell Greek bonds to the European Central Bank.

The second, and more important, reason for the Franco-German struggle to postpone a Greek default is the risk that a Greek default would induce sovereign defaults in other countries and runs on other banking systems, particularly in Spain and Italy. This risk was highlighted by the recent downgrade of Italy’s credit rating by Standard & Poor’s.

A default by either of those large countries would have disastrous implications for the banks and other financial institutions in France and Germany. The European Financial Stability Fund is large enough to cover Greece’s financing needs but not large enough to finance Italy and Spain if they lose access to private markets. So European politicians hope that by showing that even Greece can avoid default, private markets will gain enough confidence in the viability of Italy and Spain to continue lending to their governments at reasonable rates and financing their banks.

If Greece is allowed to default in the coming weeks, financial markets will indeed regard defaults by Spain and Italy as much more likely. That could cause their interest rates to spike upward and their national debts to rise rapidly, thus making them effectively insolvent. By postponing a Greek default for two years, Europe’s politicians hope to give Spain and Italy time to prove that they are financially viable.

Two years could allow markets to see whether Spain’s banks can handle the decline of local real-estate prices, or whether mortgage defaults will lead to widespread bank failures, requiring the Spanish government to finance large deposit guarantees. The next two years would also disclose the financial conditions of Spain’s regional governments, which have incurred debts that are ultimately guaranteed by the central government.

Likewise, two years could provide time for Italy to demonstrate whether it can achieve a balanced budget. The Berlusconi government recently passed a budget bill designed to raise tax revenue and to bring the economy to a balanced budget by 2013. That will be hard to achieve, because fiscal tightening will reduce Italian GDP, which is now barely growing, in turn shrinking tax revenue. So, in two years, we can expect a debate about whether budget balance has then been achieved on a cyclically adjusted basis. Those two years would also indicate whether Italian banks are in better shape than many now fear.

If Spain and Italy do look sound enough at the end of two years, European political leaders can allow Greece to default without fear of dangerous contagion. Portugal might follow Greece in a sovereign default and in leaving the eurozone. But the larger countries would be able to fund themselves at reasonable interest rates, and the current eurozone system could continue.

If, however, Spain or Italy does not persuade markets over the next two years that they are financially sound, interest rates for their governments and banks will rise sharply, and it will be clear that they are insolvent. At that point, they will default. They would also be at least temporarily unable to borrow and would be strongly tempted to leave the single currency.

But there is a greater and more immediate danger: Even if Spain and Italy are fundamentally sound, there may not be two years to find out. The level of Greek interest rates shows that markets believe that Greece will default very soon. And even before that default occurs, interest rates on Spanish or Italian debt could rise sharply, putting these countries on a financially impossible path. The eurozone’s politicians may learn the hard way that trying to fool markets is a dangerous strategy.

This piece comes from Project Syndicate.

Photo: People walk over a world map engraved in marble in Lisbon September 14, 2011. Global markets have been roiled since the end of July by the twin fears of a recession in the United States and Europe’s protracted debt woes, which have forced Greece, Ireland and Portugal to take bailouts and piled bond market pressure on Italy and Spain. REUTERS/Jose Manuel Ribeiro

19 comments

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Very well address,frank and poignant.
French and German bank exposure to said countries, in my view, shares equal billing with the trade surplus both countries have with their struggling neighbors.
A significant percentage of the current account surplus
Germany enjoys would quickly vanish if the indebted countries revert to the natural currencies (Drachma, Lire, etc)

Posted by Econstudent | Report as abusive

I think the author gives Eurozone leaders far more intellectual credit than they deserve. I don’t see the attempt on their part to keep Greece’s default orderly or to postpone it for 2 years.

After all, Greece is being shoved headlong into depression, social chaos and default by Europe’s leaders, who force ever more harsh austerity measures upon the country and who keep threatening not to hand over the next bailout tranche. This is an orderly approach?

How does the author reconcile these facts with his theory that EU leaders are executing a logical plan for Greece and for the Eurozone?

Posted by NukerDoggie | Report as abusive

Unfortunately all this stalling is only to give banks more time to shuffle their cards and move most of the risk onto the taxpayers.

The common citizen wins with a Greece default.

The loan sharking shuffle sliding banks will start to tumble with the default cascade.

What a great way to wipe out the debt worldwide. Just let it all bankrupt and put it moves the burden to the sharks who created this Ponzi scheme.

They had no idea their greed and manipulation would paint them into a corner.

Posted by Butch_from_PA | Report as abusive

Greece is a disgrace to EU. Last 20 years they got used to free everything w cheap European money… their government driven corrupt economy is a disgrace also… European union will collapse… all unions will collapse one day… unions are not good for free markets because they create rigidity and they break fast… arrogant Europeans are getting what they deserve… now their wisdom will save them… arrogance kills… maybe Turkey will buy them all… Ottomans are coming again with money this time…

Posted by Ocala123456789 | Report as abusive

Well Mr. Feldstein, if what you portray in this commentary is true, then you just let the cat out of the bag. That will of course contributes to it failing, as you would know. Looking at your bio in the upper corner, you are a very well acclimated with those who run nations. You know why they do what they do, and spin what they spin. So I ask myself, why would you do that? A quick, disorderly default by Greece may quickly topple the Eurozone triggering depressions in much of the world. I’m not an ivy league type and I can even figure that one out. I cannot believe that a person of your stature would willingly contribute to that much human suffering. Is two years to much to ask? Would it not be prudent to encourage the confidence you know is needed?
Perhaps sir, you were coerced into this in some way?
Let’s face it, you are no Reuters columnist, your words carry weight.

Posted by tmc | Report as abusive

Rubbish

Posted by Butch_from_PA | Report as abusive

Who is short on Greece?

Posted by Gillyp | Report as abusive

I am long on Greece’s future. A quick and painful default will clean house and let everyone move on – free from the burden of millions of Euros on every citizen of Greece.

If they were on the ball – the Greeks would quickly create a law where no foreigner could own a majority of Greek land and assets as a result of the default. This will prevent slum lords from moving in and controlling Greeks when they default (typical IMF tactics).

Posted by Butch_from_PA | Report as abusive

Looks as though some folks here can’t handle the truth. In any instance, the Greek people are in for a world of hurt and pain, no matter if they default sooner or later. I suspect they will get tired of takin one for the team (Eurozone) and default sooner. Then all hell will break loose as Mr. Feldstein lays out. Be prepared for Lehman II, or worse.

Posted by Bunngolf | Report as abusive

There is, of course, another way: to kick the “markets” ass. No country should care about what “markets” (i.e. the guys around the NY Fed) think. Print euros and if necessary, send banks to bankruptcy if debt is in dollars or nationalize if in euros. Let Greece live, finance them with freshly printed euros until they put their fiscal position in order and then (after some 3 years) decide whether to restructure debt or not. Simple and easy. The whole hysteria is largely blown out of proportions by those who are bound to loose from such a solution – Wall Street banks mostly.

Posted by tk2 | Report as abusive

Welcome robots to our story,you even have to spell your name rewritten in the avoidance to obtain credential.
Do I really think you have the answers and who and how are they used is the question that the parliamentarians now refuse for the bond markets and gdp.
Like you have an answer beyond the obvious that semingly becomes revealed according to the finest structure of litirature that your privilages and laws allow without the concensus of the past we are nothing as there was none you have sucedded the mighty state in all it’s antipcations and now are your only solutions.But you refuse and the argument in the coffe shop continues when you are drowning.
It’s much better that there is central monetary control and always has been right.
I would never put an argument as there are none in gravity.
You can try too,but not for long.

Posted by johncscott | Report as abusive

It’s probably right to conclude that ‘Greece is being shoved into … depression’. But what alternative is there? At the moment they (the Greek) are getting help under certain conditions, and they can cut themelves loose from this forced austerity (a much needed restructuring of a corrupt and inefficient economy is a better description) by defaulting and stepping out of the Euro. They then have a penniless government to whom, please don’t doubt it, nobody is going to lend anything. EU-led poverty will seem like heaven.

Posted by Lambick | Report as abusive

Greece has become the whipping boy of the world financial system. No one is wondering how come such a small economy is capable of bringing the whole system down. At the same time the Chinese the Russians etc are lecturing us on how to run our economies. We better forget about Greece and try to bring capitalism to its senses instead.

Posted by gsot | Report as abusive

Crude nationalism has no place in the club of civilised nations Ocala..

Posted by gsot | Report as abusive

Response to Lambick: Greece’s “corrupt and inefficient economy” sounds just a little like our own tenuous situation, Congress just having approved only enough of a budget to keep our government running to mid-November.
To tk2: Greece doesn’t have three years, it’s insolvent–bankrupt–dead weight.
To tmc: “Letting the cat out of the bag?” The cat got out and ran away–why Wall Street has been tanking–investors are liquidating assets in anticipation of losses and more defaults.
To nukerdoggie: You almost got it right. What Europe is doing is piling more debt (loans) onto a country that can’t pay off the debt (loans) it currently has. Which is why the Greeks are protesting, as well as burning their new tax bills. Basically the Europeans are telling them to go to work just to pay taxes. And this is the real reason Greece will default: Because the Greeks refuse to do this, and because they can’t.
What Feldstein hints at is that a Greek default will cause other Eurozone countries to default. And when this happens, the US will be impacted, because our economies are connected with the larger countries of Italy and Spain (Ireland is also at risk) with more exposure to their bad loans–again why investors have begun cashing out.
Thus the only issue really is–How fast can all this happen? By next year, 2012, we’ll know. Is this what the Mayans meant by the end of the world’s status quo? Maybe. And Obama will NOT be re-elected, regardless.

Posted by contrarymary | Report as abusive

Response to Lambick: Greece’s “corrupt and inefficient economy” sounds just a little like our own tenuous situation, Congress just having approved only enough of a budget to keep our government running to mid-November.
To tk2: Greece doesn’t have three years, it’s insolvent–bankrupt–dead weight.
To tmc: “Letting the cat out of the bag?” The cat got out and ran away–why Wall Street has been tanking–investors are liquidating assets in anticipation of losses and more defaults.
To nukerdoggie: You almost got it right. What Europe is doing is piling more debt (loans) onto a country that can’t pay off the debt (loans) it currently has. Which is why the Greeks are protesting, as well as burning their new tax bills. Basically the Europeans are telling them to go to work just to pay taxes. And this is the real reason Greece will default: Because the Greeks refuse to do this, and because they can’t.
What Feldstein hints at is that a Greek default will cause other Eurozone countries to default. And when this happens, the US will be impacted, because our economies are connected with the larger countries of Italy and Spain (Ireland is also at risk) with more exposure to their bad loans–again why investors have begun cashing out.
Thus the only issue really is–How fast can all this happen? By next year, 2012, we’ll know. Is this what the Mayans meant by the end of the world’s status quo? Maybe. And Obama will NOT be re-elected, regardless.

Posted by contrarymary | Report as abusive

So,how much money do they print. 100 billion, 500 billion, heck lets print enough so Greece will never have a problem with money again. Let’s print ten trillion for the Greeks. Make them all wealthy so no one has to worry again. Oh, wait, what about the Italians, What the heck, print 30 trillion for them. And the Spanish, 35 trillion for them. They’ll be rolling in the dough. Heck, they can just buy Germany with all that money. Anybody else see how ridiculous this all is. I hope so because the people who are running the world banks are a bunch of crooks who specialize in legal counterfeiting. Let’s lock up all the criminals in the IMF and World Bank. The world will not collapse. It was fine before the world bank and IMF criminals took over. It will be better off when they are all in prison.

Posted by gotham1883 | Report as abusive

Is this the same rule used for GM and Chrystler… Dogs barking.. Hungry children… Walk away from commitment.. No that is Congress I think… Can you do your job…

Posted by mward1921 | Report as abusive

Turkey and other Black sea countries might just march west.
Along with Chinese money, The Ottoman empire could reappear, but this time without the Kaisers assistance.
Turkey w/o the arabs, but with new trade routes could be something to be reckoned with.

The old dutch, british, French, Spanish colonies can
reappear in a different fashion in middle & western europe.

Will they haul the nobility back to Manchuria this time; probably not.

Posted by harb123 | Report as abusive