Spiking Greek CDS

February 5, 2010

Funny how the market is just waking up to the Euro debt problem. Many have argued that debt levels are unsustainable, yet the IMF has adopted the neo-Keynesian line that governments can spend with impunity so long as unemployment is high. If there are unemployed workers in the economy, then conventional wage-push inflation — i.e. workers negotiating higher wages, which in turn drives up consumer prices — can’t happen. Or so the argument goes.

But this ignores bond market realities. The PIIGS on Europe’s periphery — Portugal, Ireland, Italy, Greece and Spain — have huge budget deficits as a percent of GDP, but don’t have the power to print money to pay it back. So bond markets are bidding up the cost to insure their debt:

kyd77hReaders should offer their own view, but seems to me there are three options here, two bad and one nuclear.

1) The PIIGS cut their budgets to pay back debt. Such austerity programs are typically very difficult to get done in democracies. Deficit spending stays high long past the point that it’s possible to work off debt over any reasonable period. To successfully dig out of the hole requires cuts so deep, voters never agree to them.

2) Europe bails them out, which is the easiest solution in the short-run. Richer European countries certainly have the wherewithal to bail out a small country like Greece or Portugal. But it’s a dangerous precedent to set. What about Spain? It’s 14% of the Euro economy compared to 6% for Portugal/Ireland/Greece combined. If economies keep spending with an eye towards a bailout from the ECB, eventually you get #3.

3) The monetary union breaks apart. The customary way out of a debt crisis is to devalue one’s currency, see Argentina in 2001. It couldn’t maintain it’s dollar peg and still service its debt, so it devalued its currency and defaulted on debt. But this locked the country out of the international capital markets and drove them into a deep, though brief, Depression. For Greece to devalue, it would have to pull out of the Euro, pass a law that it’s debts are payable in new local currency and then devalue.

Some combination of #2 and #1 is probably the only sustainable solution. And that’s what the market appears to expect, what with Greek 5-yr CDS falling back to $389,000 from $425,000 yesterday.

But any help must come with tough conditions. Cuts must be deep enough that further rounds of bailouts won’t be needed.

UPDATE: Nick Gogerty points out that the IMF is another potential source of rescue funds. But whether bailout cash originates from the Germans or the IMF doesn’t change the fundamental problem, which is that Greek state is living well beyond its means…

5 comments

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This is only true if the government in question is monetarily sovereign and is issuing its own currency for its disbursements, and all its debt is denominated in its own currency. The EU/EMU states are not monetarily sovereign and act as the individual states in the US, which are revenue constrained. They must “live within their means” unless the monetary sovereign steps in.

The US government and the EMU governing body are not financially constrained as currency issuers. Essentially the same thing is happening to many states in the US, most notably California, in comparison with the EMU peripheral countries. The solution is for the US government and the EMU governing body to issue currency to fill the gap between nominal aggregate demand and real output capacity that is leading to deflation, resulting in recession, rising unemployment and underemployment, and growing social unrest.

Posted by tjfxh | Report as abusive

[...] View full post on Rolfe Winkler [...]

Maybe the crisis will be resolved with siginificant shifts in the relationship withe public unions, a Thatcher type moment. regardless of the 3 outcomes that is realized it seems historical inflection points are in the making for many developed economies who are over leveraged, over budgeted and running out of time.

Posted by Nick_Gogerty | Report as abusive

[...] great, clear thoughts from Rolfe Winkler on the matter of Europe’s Greek (and Spanish) [...]

[...] three (not so great) ways out of the PIIGS problem.  (Rolfe Winkler also The Money [...]

An IMF bailout is also a potential option. None of these finance options are “solutions”per se but rather band aid options similar to Japanese fiscal policy from 1990.

The other important thing is that Greece and Portugal will set the tone for bailouts down the road relative to EU policy.

Posted by Nick_Gogerty | Report as abusive

Rolfe may be right that the answer is a combo of 1 and 2 and not 3. To break up the Euro at this point would be giving in to the pressure too quickly. It would cause a great deal of pain. It would not hurt as bad as Argentina, but it would very bad indeed.

The 1&2 solution assumes that the budget/growth issues are short term. They are not. This is a very long term problem and 1&2 are just bridges to nowhere.

We will get 1&2, but a year later nothing will have changed and then #3 will have to go back on the table. There really is no other alternative that will work. 1&2 are just band aids.

So if this is to be the case the broader issue of a too strong dollar will likely be with us for a while. I don’t think there could be a more powerful deflationary force in the world than a strong dollar. It will kill us and the global recovery.

Oh well……

Posted by Krasting | Report as abusive

This debt does not just vanish but instead is absorbed within the finances of the rest of the Eurozone. Do you think the citizens of the EU are in any mood to take on the additional debt of the PIIGS? Spain’s citizens will not obediently carry out their public financial obligations after watching the PIIG get bailed out. While the US was willing to absorb Latin America’s debts before, I don’t think you would find Americans willing to do the same now.

The slow unwinding of the international debt crises seems to be a giant ponzi scheme where the liabilities flow to the top, not the assets. And whose on top now…China or the US?

Posted by csodak | Report as abusive

[...] a year from $227,000. The European single currency rose 0.1% versus the dollar to $1.3693.   Spiking Greek CDS Funny how the market is just waking up to the Euro debt problem. Many have argued that debt levels [...]

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