Well we thought we had a deal

Last Thursday there appeared to be a breakthrough deal to recapitalize banks, manage Greek sovereign debt and insure against future defaults.  Actually was starting to prepare a blog entry on it last night.  Good thing I waited.  Today the Greek PM George Papandreou announces that there will be a public referendum on the deal.  Given the public resentment that Greeks (see this WSJ article from Saturday on how tough things already are in the private sector) have about bankers and politicians in other EU countries dictating their living standards, the analyses I have seen so far suggest one of two outcomes: (1) Papandreou made a rash emotional decision without consulting anyone and his government will fall in the next 48 hours or (2) Papendreou never intended to live by any agreement and is using the referendum to hold onto power. 

Dilemma for the average Greek thinking about how to vote in the referendum (if it ever takes place): the deal offered last week called for a 50% markdown of sovereign debt in return for continued borrowing from foreign parties -- how does that compare for an Argentine style 100% markdown that would then cut Greece off from foreign sources of capital?  Lack of access to foreign capital would mean that the Greeks would have to balance their budget deficit cold turkey OR print lots of the new currency and run the risk of hyperinflation. 

Happy days are here again?

Well maybe we should not put the champagne on ice quite yet, but there were two very good bits of news today.  One day after being unable to agree to meet for a pre-summit summit, the European Union has come up with a plan to (hopefully) deal with the sovereign debt crisis.   Greek bond holders are going to take a 50% hit, European banks will need to raise new capital, and there is now a bigger fund to try to stop the Greek crisis from spreading to other countries.  We will need at least 48 hours to digest all of the details of this deal, but at least they came up with something. 

The other good bit of news is the third quarter GDP report which showed a decent 2.5 percent growth rate.  Given all of the fears of a double dip recession, this is about the best we could hope for.  Consumer spending and business investment both picked up. 

The stock market celebrated with a 3 percent increase.  Let's hope it sticks

Want a deal on a Greek bond?

The consensus in the economics and finance community is that Greece will at some point have to default on some of its bonds, the only questions being when and how much.  Not so fast, says an NYT story earlier this week.  It turns out that hedge funds are buying large amounts of Greek bonds that days ago were trading at 36 cents per euro of face value.  The anticipated bailout deal will lengthen maturities that will be worth almost twice as much.  About 30 percent of the bonds that are involved in the deal were acquired since July 21, presumably by people who were well aware of the riskiness of the investment. 

Beware Greeks bearing bonds

Many of you thought that last year's Greek debt crisis was "solved" with a bailout package from the European Union and the IMF in May 2010.  Guess what?  Without further help soon, the Greek government will have to default on some bonds.  Chicago booth finance professors John Cochrane and Anil Kashyap spell out in an op-ed in yesterday's WSJ what we should expect:

1. Greece cannot and will not (even if it could) pay off its current debt obligations (150% of GDP).  Some bondholders are going to get burned.  
2. Count some large European banks and the European Central Bank among the parties that will get burned, despite the so-called improvements in financial regulation that took place after the 2008 meltdown
3. Greece is a small country, so a Greek default would not be that big a deal.  But Portugal, Ireland, Spain and Italy are in basically the same boat and this is where it starts getting ugly.  Private individuals and corporations will (if they have not done so already) dump their bonds on governments and government-insured banks, thereby shifting the liabilities to the taxpayers in various European countries.  

To prevent a total meltdown and a new global financial crisis, Cochrane and Kashyap suggest the following --

Prepare for the worst. Europe needs to expunge the rot from its banks so that the inevitable write-downs do not imperil its financial system. Sovereign debt and sovereign exposure must face large capital buffers. Sovereign debt must be marked to market. Banks must run serious stress tests to find implicit sovereign exposure. Banks with inadequate capital must raise it, find buyers, or reorganize. If that means bailouts of "systemically important" banks, then governments must do so, face their taxpayers, and make their regulators explain how they let this happen.

Why the euro's days may be numbered

My former professor Marty Feldstein has a great column in the Weekly Standard about the euro.  He does a good job of explaining why the euro was always bound to cause trouble.  One of the key reasons: all euro-adopting nations have to have the same monetary policy and the same exchange rate, even though all nations have their own unique economic situation.  Nations with budget deficits and high unemployment are locked into the same monetary and exchange rate policy as those with budget surpluses and low unemployment.  Of course the US has the same issue with the dollar -- all 50 states and D.C. must have the same monetary and exchange rate policy too.  But Feldstein points out that the US gets around this issue because of greater wage flexibility and higher labor mobility than Europe.  Also each US state, unlike Greece, must have a balanced budget each year. 

What does the future hold?  Severe economic retrenchment may or may not happen in Greece.  It remains to be seen whether that country will be able to balance its budget and grow economically.  This is not so much an economic problem as a political one.  The government that adopts the economic policies that Greece needs to return to good standing in the euro-zone runs the risk of being quickly voted out of office and replaced by a populist regime supported by unions and government employees.  Such a government might instead decide to default on its bond obligations and issue a new currency that effectively lowers Greek purchasing power by a substantial amount.  The Argentines did the same thing in 2002.

Today Greece, tomorrow the US?

Over the weekend the European Union (EU), the IMF, the Fed and other parties put together a trillion dollar line of credit for EU members who are at risk of defaulting on their debt.  The stock market reacted favorably on Monday, reversing most of last week's losses.  Today NYT writer David Leonhardt draws comparisons between the Greek economic situation with that here in the US.  At an abstract, qualitative level the two situations are similar: both countries are living beyond their means and are borrowing from foreigners to make up the difference.  Fortunately for the US, the scale of the problem here is more manageable than in Greece.  Nonetheless we face unpleasant choices; we cannot have more government programs and spending (as preferred by Democrats) AND more tax cuts (as preferred by Republicans).  Who elected these politicians anyway?  Oh, we did. 

Greece is the word

Paul Krugman's NYT column today does a great job explaining the sources of the Greek economic crises and pointing out the limited options available to deal with it.  The essence of the problem is that even though Greece's economic issues may not be as severe as those facing some some states in the US, states such as California can rely on federal programs such as Social Security, grants and stimulus packages whereas there is no European central government with taxing and spending authority to help Greece out. Krugman believes that Greece will ultimately have to go off the Euro and issue a new devalued currency that will reduce real wages and make Greek exports economically competitive.  A debt default a la Argentina in 2001 is also in the cards.  Other European governments (Portugal, Spain, Ireland in particular) could be in the same boat.  Krugman seems to think this will not be as disruptive as the fall of Lehman Brothers; I hope he is right.

Why Greece matters

Good column by Washington Post economist Robert Samuelson about the economic situation in Greece and how it is affecting the euro. In a nutshell if Greece had its own currency it would be falling in value and interest rates would be rising reflecting the growing risk that Greece will default on bonds that must be paid off this spring. Other EU countries have to decide whether to bailout the Greeks and thus stabilize the euro versus cutting them loose to revert to their own currency. Greece's situation is not unique to the EU; it is shared by Portugal, Ireland, Italy and Spain (the five countries now have the unwanted acronym of PIIGS). States such as California and Michigan may very well be creating a similar problem here in the US in the very near term.