EUROPEAN leaders have tried to characterise the October writedown of Greek debt as “private-sector involvement”. While the writedown would appear to be a default in all but name, efforts to maintain investor confidence have so far been surprisingly successful. Yesterday, US stocks and Asian stocks rallied amid optimism that European leaders are taking steps to deal with the crisis.
Recent history provides plenty of examples of people systematically over-estimating the likelihood of positive outcomes. In 2000, the dot-com bubble pushed the NASDAQ above 5,000 (it currently sits at around 2,500). In 2004, Moody’s held its credit rating for Greece steady after the country admitted that its budget deficit had exceeded the EU’s ceiling of 3% of GDP every year for 8 consecutive years (source: NYT). In 2007, median house prices in the US hit an all time high based on a widely held belief that “house prices always go up”.
Optimism will buy European leaders some much needed time. But it is difficult to see how Europe will managed to quickly or painlessly repay combined public debts which stand at more than €9 trillion. Europe’s enormous debts might be thought of not as a mountain but as a towering house of cards. It was fairly easy to build but now appears almost impossible to deconstruct without knocking the whole thing over.
A house of cards is a fragile arrangement, it will collapse, not only under the burden of one card too many, but by mere want of carefulness.
THE MARKETS have been temporarily buoyed amid optimism that European leaders will find a solution to the debt crisis. Unfortunately, the optimism is likely to be short lived because the problem with Greece is not just that they owe everyone a lot of money. Greek debt is a symptom of a more endemic problem rooted in the Greek culture.
Michael Lewis, writer for Vanity Fair, revealed the story of how Greece meandered towards its current nadir: tax evasion the norm, bribery a way of life, and the Vatopaidi monks obtaining a gift of Greek commercial property worth over a $1 billion.
His intriguing and insightful article, “Beware of Greeks Bearing Bonds“, uncovers the human story behind the Greek debt crisis. It is not a short piece, but if you have 15 minutes and are interested in the current affairs then it is well worth reading.
WITH the Occupy Wall Street movement still in full swing, we have to stop and think for a moment about the distribution of wealth in the world.
One of the slogans of the Occupy Wall Street movement is “we are the 99%”, which is a reference to the fact that the top 1% of households in the USA hold more than 40% of the wealth.
This sounds incredibly unfair. How could they be so selfish?
Well, as Milton Friedman pointed out, people are often selfish out of a concern for their families (albeit perhaps subconsciously). And this concern for family is the same for both the rich and the poor.
As you will see in the video, one solution that could be proposed to the income disparity is an inheritance tax. People would be allowed to earn as much money as they want while here, but would be forced to give it all back to society (read: the government) when they check out. This may sound reasonable, but as Friedman pointed out this would undermine one of the key incentives that encourage people to work hard and save for the future, a concern for family.
Clearly many poor families are hurting financially as a result of the ongoing financial crisis, and things look set to get worse before they get better. However, it is not clear that camping out in Zuccotti Park and vilifying the wealthy is a productive answer to the problem.
At the same time, those in the top 1% (or even the top 10%) hold a privileged position in society. The current sentiment of the Occupy Wall Street movement is that the wealthy have not held up their end of the societal bargain to justify their privileged position. While this may or may not be the case, it would seem incumbent, or at least highly prudent, for wealthy families in the States and elsewhere to consider how they might use their privileged positions to create opportunities for those who have none.
IN OCTOBER 2011, private banks accepted a 50% writedown on Greek debt. European leaders negotiated the writedown to avoid a technical default.
It is surprising that ratings agencies did not classify the writedown as a default when you consider that S&P defines sovereign default as “the failure to meet interest or principal payments on the due date…contained in the original terms of the rated obligation when issued”.
In your author’s opinion, the writedown of Greek debt falls clearly within the S&P definition of sovereign default.
Undeterred however by rating agency definitions, European leaders have characterised the writedown as a voluntary “private-sector involvement” or PSI. This is clever politicking because a “private-sector involvement” sounds like a positive development. However, in reality, it means that private investors have lost 50% of their investment in Greek bonds.
European leaders are now using the same brand of financial wizardry which created the global financial crisis in the first place. Over the last few decades, countless risky financial products were sold to investors using harmless sounding terms like “credit default swap”, “mortgage backed security”, “special purpose vehicle” and “off-balance sheet financing”.
Characterising the writedown of Greek debt as “private sector involvement” is more of the same financial manipulation, but it is also shrewd politics. European leaders know that a Greek default could have devastating consequences for the Euro-zone.
ON WEDNESDAY November 23rd, an auction of German government bonds (known as “Bunds”) managed to sell only €3.6 billion out of a total €6 billion worth of Bunds on offer (source: Economist).
Germany is one of the most financially stable countries in the Euro-zone, so its failure to sell all of its Bunds is worth examining. In the context of an ever worsening European sovereign debt crisis this could be cause for concern. However, there are three reasons why the news does not raise concerns about Germany. Firstly, the German Debt Agency (Finanzagentur) normally retains part of any new Bund offer, so a partial sale of Bunds is pretty standard. Secondly, German Bunds are expensive. With a current 10-year Bund yield of only 2.26% it is no wonder that investors have a weak appetite for German debt. Thirdly, European banks are currently focused on building their balance sheets not on lending. European banks have until the end of June 2012 to get their core capital ratios up to 9%.
While Bunds may still smell sweet, weak financial markets in Europe are a cause for concern.
Weak financial markets increase the risk that one or more European banks will fail. In fact, one already has. Dexia fell victim to the Euro-zone debt crisis in October and was rescued by Belgium and France. This is particularly concerning because only a few months ago Dexia was rated 12th safest bank in Europe by European Union stress tests. How could Dexia fail? The short answer is, surprisingly easily. Dexia has around $700 billion on its balance sheet, but like many banks it requires access to short term funding. With banks becoming increasingly nervous as a result of weak credit markets, Dexia simply failed to secure the short term funding it needed to stay afloat. Dexia’s problems stemmed in part from its exposure to around $25 billion of Greek debt.
There is every likelihood that Greece and other countries may default on their debts. Greece and Italy both have a debt/GDP ratio exceeding 100%, but they are by no means the only countries that need to balance their books. Debt levels are worryingly high in Japan, the UK, USA, Portugal, Ireland and Belgium (among others). Greece represents less than 2% of the EU economy, but the effect of a Greek default could be worse than the sub-prime mortgage crisis. There are three reasons for this:
Integrated financial markets: As we saw during the sub-prime crisis, credit markets are highly integrated. France alone is exposed to more than $56 billion of Greek debt (see graph below). If Greece defaults then this could drive a number of European banks into bankruptcy;
Nervous markets: As it is not clear which European banks may fail, nervous banks may stop lending money to each other. As a result, this would drive up interest rates or, in the worst case, may completely stop the flow of short term credit and put the viability of many banks and businesses in jeopardy;
The Domino Effect: Greece is the first domino. Following a Greek default, financial market vultures will turn their greedy attention to other beleaguered countries. Italy may be second in line.
