Tuesday, May 11, 2010

Greece, Banks, and Immoral Hazard

Monday’s euphoria about the bailout plan negotiated with the European Union and the IMF is waning today. Stock markets worldwide come to a more sober evaluation of the situation and many commentators wonder if the plan can succeed, who is responsible for the mess, and who is going to pay for it.

The New York Times editorialist notes that Greece is supposed to reduce its deficit to less than 3 percent of GDP by 2014, “an adjustment equal to one-tenth of its economy. At the same time, it is supposed to remain current on all of its debt service payments. It is hard to see how that is fiscally possible.”

Who is responsible? According to the editorial:

“The quasi official diagnosis is built upon a distorted narrative: profligate governments from Europe’s less responsible nations spent beyond their means and now can’t repays their debt. Except for Greece that is not what happened.
In 2007, before the financial crisis, Spain had a budget surplus of 2 percent of GDP. Ireland had a balanced budget. Portugal’s deficit of 2.6 percent was well within the euro accepted limits. Today their budgets are deep in the red because the global collapse slashed economic activity, boosted unemployment and required large-scale government response.”

And, one must add, absent independent monetary policies due to the euro, and thus adapted monetary response to the shock being out of the question, only budgetary policy could dampen the effects of the crisis. The euro and the corresponding ECB one-size-fits-all policy are thus responsible for the predicament of southern Europe.

But the banks have been instrumental in the consequent excess financing of these economies. They profited handsomely from the euro-induced disequilibrium that led to deficit finance. And while they helped create the current mess they “are getting all their money back. A more equitable approach would require the banks to pay at least part of the bill – writing down the debts of some European governments or extending their maturities into the future to allow battered European economies time to recover”, writes the editorialist.

Arvind Subramanian, of the Peterson Institute for International Economics, reaches a similar conclusion:

“the burden of adjustment is now being spread to include European ($105 billion) and international ($40 billion) taxpayers. China, India, and Brazil, among many others will contribute—which is as it should be—given their growing economic status and the cooperative nature of the endeavor. But there will still be no contribution from European banks that hold large amounts of Greek debt. That taxpayers in much poorer countries should contribute so that rich financial institutions can get away with reckless lending seems unfair and perverse. One might call this "immoral hazard": heads the banks win, tails much poorer taxpayers thousands of miles away pick up the tab.

What is worse is that this bailout of European financial institutions increases the already high odds of failure of the IMF program. Greece's fiscal predicament requires not just adjustment and financing but devaluation and debt restructuring. And with devaluation being achieved through painful deflation, the case for restructuring looks only stronger. Substantial debt write-offs are necessary and will probably remain so even if Greece exits the eurozone.”

I could not agree more.

Read the complete paper here.

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