Saturday, September 24, 2011

Greece on the Brink, Euro Should Fall Further

Twenty-four centuries after History’s first sovereign default, that of ten Greek municipalities in the 4th century BC (the creditor was the temple of Delos), the country is at the edge of a major default, five times the size of Argentina’s default in 2001.

The expected “haircut”, could be as severe as 80% of the debts’ amount. But it would still be manageable, as far as French and German banks, as well as the ECB, are concerned, because they are said to be able to weather this magnitude of losses, given the small absolute size of the Greek economy and thus of its debt, compared to the size of the whole European economy and of the banks themselves. Their shares have been savaged nonetheless, for fear of something worse. The real danger would come from investors’ reaction to a Greek default: many would be selling Italian and Spanish government bonds to avoid a similar amputation on their much larger holdings of these countries’ debt, thus making for a fall of bonds’ market values and a rise of interest rates, and further aggravating the state of these governments’ finances. Italian and Spanish haircuts would also inflict much larger losses on the European banks and that would jeopardize the financial system in Europe, and maybe elsewhere too.

Fearing this, European governments, under pressure from the US, appear now ready to issue more bonds (possibly Eurobonds, even though it is not significantly different from pure German bonds) in order to avoid Greece a default. And the ECB is ready to lend more money to the governments (a monetization of their debts).

The question is: while all this would be good for the banks, would it be good too for economic growth? Incurring more debts is not going to help European economies to deleverage, nor reduce the burden of their over-indebted governments. It would increase in fact the debt/GDP ratio. But monetization would help:  is Mr. Trichet, finally, seeing the light and accepting a depreciation of the euro (which has already begun during the past week, the euro falling to less than 1,35 dollars)? There is still, however, a very long way to go to a value for the euro nearing equilibrium … (a one for one value to the dollar or even less in my opinion).

For Greece however, absent a very large depreciation of its currency, the drachma that is, after an exit from the euro zone, one cannot hope a return to positive growth even after default, but on the contrary a prolongation of the economic slump.

To conclude, remember that Japan tried the increased indebtedness policy strategy to get out of depression for a decade, thus avoiding the worse outcome, but accepted stagnation to this day. In a balance sheet recession, more debt is not the solution. A major realignment of exchange rates accompanied and caused by differential, and possibly massive, money creation is required. This is the common element between the 1930s required exit from the gold standard, and the present day required exit from the de facto Deutsche Mark standard. The later the exit, the later will be the return to growth.   

Read a very interesting Bloomberg post covering the very wide range of possibilities here .

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