Article: Will EU Come Tumbling Down

[LWPD]

Below is an article in Fortune that provides an overview on the state of the sovereign debt crisis. As of Friday, the going market rate yield for a Greek 2 year bond was an astounding 37%. That is in no way, shape or form sustainable, and stands as a prediction of an immediate term default.



Courtesy of Fortune
Will Europe come tumbling down?
By Shawn Tully

The debt crisis that started in Greece now threatens to topple the whole continent -- and kill the weak recovery in the U.S. Inside the race against the clock to fix the euro economy.

FORTUNE -- At first glance, Yiannis Boutaris would seem to be an unlikely free-market reformer. The 69-year-old mayor of Thessaloniki, Greece's second-largest city, has tattoos decorating his forearms and knuckles, short-cropped white hair, and a face creased like worn leather. As we sit and talk in his drab office on a sweltering summer afternoon, he's chain-smoking unfiltered Camels and wearing jeans, a gold stud earring, and black high-top Keds sneakers with no laces. Boutaris was a businessman before he got into politics, and he still owns one of the country's leading wineries (although, as a recovering alcoholic, he can no longer drink his own vintages). But he's hardly a political conservative. He was originally elected to Thessaloniki's city council as a member of the Communist Party.

Even Boutaris, however, has reached a breaking point with his nation's Homeric economic failures. "The Greeks borrowed and consumed recklessly, and got totally uncompetitive at making things and providing services like tourism," he says angrily, jabbing the air with his cigarette for emphasis. "If you want to start a business, you'll do better going to Bulgaria!"

The frustrated mayor is battling to end policies that block Thessaloniki, the industrial center of northern Greece, from becoming what it should be -- a principal port for the world's cruise lines, a favorite resort for European retirees, and a transit hub for the Balkans. Fed up, Boutaris is taking matters into his own hands. For instance, he's threatening to take the radical (for Greece) step of privatizing the city's dysfunctional waste collection business. "The unions are 'striking' against my reforms by picking up one can out of three," grouses Boutaris. "I'm thinking about hiring contract workers. We could save 50% on every ton of garbage!"

The mess that Boutaris is tackling -- and the overwhelming need to take action now -- epitomizes the problems facing Europe. As you've no doubt heard, the continent is trapped in an escalating debt crisis. It began in Greece in early 2010, but in recent weeks it has spread to Italy and Spain, nations that are simply too big to bail out. Those countries -- as well as Portugal and Ireland -- suffer from either crushing debt loads or gigantic current deficits that are piling on new debt, a legacy of their reckless overspending during the past decade. Today investors worry that these nations are so chronically uncompetitive, they can't grow fast enough to pay the future interest on that debt. As a result, global pension funds, insurers, and banks are dumping Spanish and Italian bonds, threatening to drive rates to ruinous levels.

How Washington is destroying the economy

The growing fear that those bonds will plummet in value, or even default, is roiling financial markets. Indeed, the recent plunge in U.S. stock prices -- and the manic volatility -- is as much about the contagion in Europe as the S&P downgrade of U.S. sovereign debt. Rumors are rife that French banks, which own tens of billions of euros in Italian and Spanish bonds, may be struggling to maintain the short-term financing that's their lifeblood.

Even if Europe's banks don't face a liquidity crunch, a drop in the value of sovereign bonds would severely deplete their capital, forcing them to halt new lending. The credit crunch would probably throw Europe into a severe recession. That in turn could kill the U.S. recovery, since the European Union accounts for 21% of U.S. exports. Even a truly apocalyptic outcome -- where one or more weak nations abandon the euro, causing gigantic defaults and a Europe-wide banking crash -- can no longer be dismissed.

What's certain is that growth in Europe is already slowing sharply and will probably keep weakening. The reason: Interest rates will be far higher than predicted, and banks, worried over their capital levels, will be increasingly reluctant to lend. "The rates on corporate and consumer loans all depend on what it costs the government to borrow, and that number is rising fast," says Uri Dadush, an economist at the Carnegie Endowment. "All the uncertainty makes companies wary about making new investments and hiring people. Their plans go on hold."

Most of all the debt crisis represents the stunning failure of the European Union, and especially the 17-nation eurozone, to deliver on its promise. Launched in 1999, the euro currency was designed to bind nations into a tighter economic union so that weaker members such as Greece and Italy would draw strength from their prosperous partners and close the gap in growth and productivity.

What was lauded as the EU's crowning achievement -- its bid to remake Europe as an equal of the U.S. and Asia -- didn't succeed. Instead of liberalizing their markets, countries such as Italy, Spain, and Greece left almost all of their worst, anticompetitive practices in place -- from centralized wage bargaining to restrictive licensing that supports cartels in retailing. Now the only thing keeping the eurozone from collapse is the willingness of rich countries such as France and especially Germany to provide big bailouts and of the European Central Bank to roam far from its charter to support the weaklings. In mid-August the ECB agreed to buy Spanish and Italian bonds to ease the pressure on those countries.

It's impossible to know how long the emergency measures will last. Hence the debt crisis has driven Europe to a historic inflection point. After dawdling for years, governments must race to beat the clock. The challenge is twofold. First, the debt-ridden nations need to close their big budget deficits rapidly so that debt won't continue escalating. Second, they need to prove they can grow fast enough to service, then lower, the debt they have now. That will require a rapid and difficult campaign to modernize their economies by ramming through market-opening reforms they should have imposed decades ago.

I recently traveled to the nation that best symbolizes all the poor choices and lost opportunities that are now haunting Europe -- Greece. The Greeks are dazed that years of prosperity turned so rapidly to disaster. "We recognize that Greece is bankrupt, and if we don't change it's over," says Barbara Vernicos, CEO of the department store division of Notos Com, one the nation's largest importers of luxury goods. But Greeks deeply doubt the ability of their politicians to face down the unions and cartels and deliver. And if they can't, the country that invented democracy might plunge a whole continent of governments into chaos.

From a cheap country to a very expensive one

The Athens Metro system was built in the early 2000s, amid the euphoria of joining the eurozone, heralding that Greece was joining the big time. And it's still an object of awe. Even as rioters crowd central Athens and taxi workers strike, Metro passengers race at 48 mph from the Port of Piraeus to the far suburbs. The cars and platforms are immaculate. Entering the station at Syntagma Square downtown, one gets the calm, ordered feel of a cathedral. Unfortunately, the Metro is just about the only thing left in the country that works.

The problems that befell Greece as a eurozone member resemble those of Italy, Spain, and other weaker economies: a consumption boom that masked big flaws in the economy, a substantial loss of competitiveness, and the madcap government borrowing that created today's crisis. When Greece adopted the euro at the start of 2001, it appeared to reap a gigantic windfall as rates on everything from car loans to mortgages dropped from over 15% in the late 1990s to the mid single digits, in line with those in Germany. The cheap credit ignited an explosion in consumer spending. For the next seven years the economy expanded at a strong annual rate of 4.2%.

But the spending did little to increase Greece's capacity for building durable wealth by selling goods and services to the rest of the world. Instead the euros flowed mostly toward imports of everything from German cars to French TVs. Both the government and private sector rapidly increased wages, helping push inflation well above the average in France and Germany. "Our salaries in Greece doubled in seven or eight years," says Tawfic Khoury, EVP of Consolidated Contractors of Athens, the civil-engineering giant. "Greece went from a cheap to an expensive country very quickly." Greek exports of fish, vegetables, and medical equipment lost ground to products from northern Europe and the Balkans. The big tourism sector was hit especially hard because rising prices made its sun-drenched islands far more expensive than resorts in Turkey or Tunisia.

The high growth rates also blunted any effort to reform the thicket of regulations hurting competition in everything from pharmacies to trucking. And low interest rates encouraged big public spending that first matched, then far exceeded, the growth of the economy. From 2001 to 2008 public employment surged 15%. Tax evasion, always a major problem, became absolutely rampant in the mid-2000s when the Conservative government eliminated the aggressive core of tax collectors known as the "Rambo" contingent. By 2008 public debt surged to over 110% of GDP and kept climbing.

When the credit crisis struck in 2008, Greece's sudden descent from a fast-growing to fast-shrinking economy made it impossible to service that Olympian debt. In May 2010, the "troika" of the International Monetary Fund, European Commission, and European Central Bank essentially agreed to loan Greece the money to keep operating by providing a $160 billion bailout package. It wasn't enough: On July 21, 2011, the troika pledged a similarly sized package to support Greece through mid-2013. By then, the plan prescribes, Greece will implement a draconian list of reforms that will enable it to start paying down debt.

The reform plan has two main parts: radically lowering deficits and elimination of barriers to true free trade. On the former, Greece has shown progress under Prime Minister George Papandreou, lowering its budget deficit from 15.5% in 2009 to 10.4% last year, and aiming for less than 8% in 2011. The toughest part, just as it will be for Italy and Spain, is shedding a maze of rules that strangle competition. So far Greece has been erratic in showing either the will or the skill to get it done.

A case in point is cruise lines. For decades it's been virtually impossible for big carriers such as Princess to begin or end journeys in Greece, since the law requires that they employ at least 20% Greek sailors on their vessels, at extremely high wages. As a result the big lines start and finish in places such as Genoa, Haifa, and Istanbul rather than in Greece. Last year the Greek government passed a law that waived the requirement to hire the Greek sailors but instead demanded the cruise lines sign three-year contracts guaranteeing numbers of cruises and destinations, as well as a big tax going to the Greek sailors' health care and unemployment fund.

When the EU strongly objected, the government pledged real reform. The job falls to Maritime Affairs Minister Haris Pamboukis. In an interview with Fortune, Pamboukis pledged to fully open the market. "The big international cruise lines are talking about starting their cruises in Greece. We're going to get rid of the restrictions on that contract and make it happen," he says. Another potential boon is a new law that for the first time effectively allows developers to build planned resort developments and sell villas to European retirees, a change that could make Greece the Florida of Europe.

Given the government's halting, uneven record on reform, it's hard to predict if the new rules will truly work. The problem is that even big steps toward genuine free trade won't produce the revenues Greece needs to service its gigantic debt, slated to reach 172% of GDP by 2012, according to the IMF. "It's impossible for Greece, or almost any country, to carry debt that big," says former IMF executive board member Miranda Xafa. Fortunately Greece can fund itself for two more years on cheap borrowing from the troika before it faces restructuring that debt. But it almost certainly has to happen -- and bondholders will need to take a substantial loss. The hope is that by then the crisis will be over, and Europe's banks can absorb the damage.

Too big to bail out

By contrast, Italy and Spain, which pose a far bigger risk to the eurozone, don't have the luxury of time. The rates on sovereign debt for Italy and Spain have recently jumped, hitting 6.3% for 10-year notes, until the ECB intervened to wrestle them back down. The relentless pressure on rates raises a double danger. First, it could cause a banking crisis by hammering the value of bonds owned by lenders. "The Italian banks have large holdings of Italian government bonds," warns economist Dadush. "If they decline enough, the banks will become even more nervous about lending, and they're already extremely nervous." Second, unlike Greece, Italy and Spain are paying part of their bills by floating new bonds, and if rates stay at over 6%, they can't possibly cover the interest on their debt. The only option would be a catastrophic default.

The challenge for Italy is the sheer size of the public debt, a staggering $2.7 trillion, the third-largest number globally, behind the U.S. and Japan. Italy has a relatively small budget deficit at around 4%. But even if rates return to near-German levels, Italy doesn't grow fast enough to keep that debt from increasing, largely because its economy is shackled by many of the same restrictions that are killing Greece.

In Spain the problem isn't the current debt load but where it's heading: Spain is saddled with a huge, 9.2% budget deficit. A housing collapse following the worst bubble in Europe severely weakened its lenders, raising fears of the need for banking bailouts. Prime Minister José Luis Rodriguez Zapatero has pledged to lower the deficit to 6% this year. He's also promising the same kinds of free-market policies that are moving forward in Italy and Greece, including reforms to the centralized wage-setting system for private companies that raises pay faster than inflation.

The brewing crisis for Italy and Spain exposes a striking weakness in the structure of the European Community. The EU lacks a lender of last resort, an institution with virtually unlimited resources to guarantee the survival of the euro. So far the ECB has been going far beyond its mandate of maintaining price stability, with the grudging assent of the Germans, to buy Italian and Spanish bonds. But the ECB is unlikely to veer from its mission for long. The fund created for the Greek bailout, the European Financial Stability Facility, is being granted new powers to buy sovereign bonds. But the EFSF, even with $620 billion at its disposal, is far too small to counteract a sustained attack on either Italian or Spanish bonds, let alone both.

It's possible that the crisis will become so severe that the EU will be forced to issue euro bonds, guaranteed by all the member nations, to cover the debt. That would place a big burden on the taxpayers of the wealthy countries, especially Germany, that pay most of the EU's costs. It's a solution that Germany dreads but may need to shoulder if the only alternative is financial Armageddon.

By far the best remedy is rapid reforms that restore the confidence of investors, a reversal of the runaway spending of the bumper years, and the long-overdue liberation of markets. That's what the EU was supposed to do at its founding. Then it lost sight of the basics while pursuing supposedly loftier goals.

Today a new breed typified by Mayor Boutaris of Thessaloniki are seizing the moment. "Believe it or not, the crisis is very helpful," says Boutaris, lighting another Camel. "We'd never even be talking about these reforms if we didn't have a near-death experience." In this land of mythic tales, it's time for some new heroes to step forward.

[LWPD]

Emerging Markets recently conducted an in depth interview with economist Nouriel Roubini on near terms risks to the world economy. Markets anticipate a 98% chance of a Greek default with-in the next 5 years. Should that happen, credit default swaps could trigger a devastating blow to not only European banks, but the entire global financial system. Waiting in the wings, Italy and Spain are also on a path to their own state of insolvency. The EU is not designed to back-stop crises of this magnitude, and building toward such a level as a fail safe is both politically unpopular and fraught with high risk. Very interesting times lie ahead!

Courtesy of Emerging Markets
Interview with Nouriel Roubini

Fears have grown this week that we are on the verge of a new global financial crisis. What’s your view?

In my view there is a high likelihood that there is going to be another global financial crisis. My data suggests that most advanced economies are already entering a recession. We’re not any more in an anaemic recovery, we’re not any more at stall speed. We’re at the beginning of a contraction. I think there’s a contraction already in most of the eurozone, there is a contraction in the US, also in the UK. That’s the first point.

The second point is we’re running out of policy bullets – monetary, fiscal – backstopping the financial system.

And third, the eurozone is a source of systemic risk. If there is a disorderly situation in the eurozone it’s going to be worse than Lehman.

At this point it’s not any more Greece or Ireland or Portugal. The contagion has spread to Italy and Spain. In the case of Italy and Spain the critical thing is that even if you believe that Italy and Spain are illiquid but solvent, even adjusting from the reforms, they’ve lost credibility in the markets. It’s going to take them at least a year to regain it.

Therefore you need a lender of last resort to backstop the sovereigns until they regain the credibility to avoid spreads going up and leading to a self-fulfilling run. And there are only a very few options, none of them feasible. One of them is the [eurobonds]. It’s going to take at least two years until they can pass that and it’s going to be approved by a treaty.

The other option is the ECB doing the dirty job. But the ECB constitutionally, legally, is not allowed to be a systemic lender of last resort for sovereigns.

The third option is to triple the EFSF (European Financial Stability Facility). But they’re not even able to pass the current extension of the EFSF. If tomorrow the Germans have to triple the EFSF, that is a political mission impossible.

So my worry is that the EFSF is going to run out of money and then there is not going to be a lender of last resort to backstop Italy and Spain. And that could be a source of a systemic break down of the eurozone, with global financial consequences worse than Lehman.

What can policymakers do now to minimize the inevitable fallout?

I wrote a paper recently in which I have an eight-point plan to highlight the kind of policies which are needed. One, much more monetary and quantitative easing, not just quantitative easing but credit easing. Two, short-term fiscal stimulus in the countries that can still do it. The US, UK, Germany, core of the Eurozone, Japan, it’s the periphery that’s doing fiscal retrenchment. You have to postpone the austerity. In the short-run, we need fiscal stimulus. We need to provide massive amounts of lender-of-last-resort support to Italy and Spain to make sure that illiquid but solvent sovereigns do not have a self-fulfilling run. We need an orderly restructuring of the debt of governments, of banks, of households that are insolvent. We need to have a massive recapitalization of the European banks through a TARP (Troubled Asset Relief Programme) type of programme for the European banks. We need to support emerging markets by providing monetary and fiscal support to the countries that are going to get in trouble, and to provide support through the IMF and other international financial institutions. We have to provide credit to small and medium-sized enterprises and households that are squeezed. We need to have also an orderly exit of countries that are not going to regain competitiveness in the eurozone, like Greece and potentially also Portugal. And you have to do this in a clear, holistic and front-loaded way. So there are many things that we need to do. I fear that the politicians in the US, in Europe, in UK are not going to have the political willingness to do it in their own countries, let alone coordinate it internationally.

So what’s the likely outcome given this policy gridlock in the key countries?

At this point the debate is not whether we’re going to have a double dip or not: the double dip has started. The only question is: are we going to have a mild recession that’s going to last for three quarters in advanced economies or are we going to have a severe recession and another global financial crisis? The answer to that question depends on whether you can keep Italy and Spain together. It’s not even about Greece.

That depends on Germany taking the risk of essentially backstopping Italy and Spain – or the EFSF, e-bond, or the ECB doing the job. Because whichever way you do it, today the German taxpayer is backstopping German debts and the ones of Greece, Ireland and Portugal. But you need now to backstop EU3 trillion of Italian and Spanish debt. That implies that if Italy and Spain are not illiquid but solvent, but they are insolvent Germany takes a huge amount of credit risk. Germany and France could both lose their triple-A status. So there is political resistance to this quasi-fiscal union in Germany and the core of the eurozone.

But if you don’t do it, it’ll be a disorderly break-up of the eurozone. So you need to go in the direction of a quasi-fiscal union in the sense of providing liquidity support to illiquid but solvent sovereigns that are too big to fail and too big to be saved. That’s the key issue.

How quickly are markets likely to turn aggressively on Italy and Spain?

Well Italian spreads are already 500 basis points. Even if the EFSF is approved – because right now the backstop is provided by the ECB but the ECB has said ‘it is not my job’ – we need three times the EFSF. Once the EFSF is approved, out of the E440 billion, half of it has already been committed to Greece, Ireland and Portugal and to their banks.

So markets are going to look through it and say there are only E200 billion left and we’re going to run out of those E200 billion, at the rate at which there is pressure now on Italy and Spain, by the year-end at the latest or by March of next year.

If it takes two years until an e-bond is essentially voted, you have a window of two years or a year and a half in which Italy and Spain risk losing market access without there being an alternative. You need either e-bonds or EFSF or the ECB to do the job. So that’s the risk and it’s going to happen soon enough.

People are going to see it as soon as the EFSF is approved and people realize that there is not enough money.

This is clearly a European problem with global consequences – but which nevertheless requires a European solution. Is there anything the international community can feasibly do?

Well you have to make an agreement that we need, for example, coordinated monetary expansion among advanced economies. We need a coordinated agreement that we need a fiscal stimulus in all advanced economies, apart from those in the peripheral eurozone that are forced to do fiscal austerity. We need to have a commitment to a mechanism that provides liquidity support to Italy and Spain that is three or four times larger than the E440 billion. We need to have a European plan to essentially recapitalize, Tarp-style, the European banks.

You need to do lots of things that show that you see what the problem is and you’re willing to do whatever is necessary to avoid a freefall. You need to do it within the eurozone and you need to do some things on a global basis like the monetary and fiscal stimulus.

I don’t think we’re going to get there. Tim Geithner went to the [Econfin] minister’s meeting [last week] and he was told: ‘don’t come and tell us what to do, we want fiscal austerity we don’t want to recapitalize the banks, we don’t want monetary expansion.’

So there is a fundamental disagreement between US, Europe, UK and Japan – even on the necessary policies. That’s the gridlock.

So in light of this gridlock, the paralysis among the big decision-making bodies, where is the leadership in this crisis? Where should it come from?

Well we are in a G-zero world in which the US used to impose its own will on the global economy. Today it is under geopolitical and financial stress and the US cannot essentially impose its own will.

So the leadership now has to come out of Germany – either Germany takes the risk, the credit risk of backstopping Italy and Spain, which is a risk, but saves the eurozone. Or if Germany is not willing to do that then you have the destruction of the eurozone.

At this point the Free Democrats [in Germany] are against it and therefore [Chancellor Angela] Merkel will have to do a radical policy change: changing coalition, dumping the Free Democrats and going for a grand coalition either with the Greens and/or the Social Democrats who are willing to take a chance for Europe.

I don’t know, however, whether within the CDU there are very different views. Some are more Europhile, some of them are less. It’s not obvious they’re going to be willing to make that political decision. That’s the critical thing that has to happen. So there has to be a change in coalition in Germany to make that option viable and likely.

But there is not much time to do it. Because even if the EFSF is approved – and it’s already being delayed – people the next day are going to see through it and see that there is not enough money for Italy and Spain. And we need much more money. That’s going to be the key thing. We don’t have much time. That’s the problem.

How much time do we have left?

We have three months, through the end of the year. Given the current market pressure on Italy and Spain, the EFSF, even if it’s approved, is going to run out of money. By the way, the EFSF is not even pre-funded. It has to borrow. It’s going to run out of money and then you have the same problem. So markets are going to look through it and realize there is not enough money and they’re going to put pressure on Italy and Spain, even if tomorrow the EFSF is approved.

The markets today are telling Italy and Spain we need fiscal austerity and Italy and Spain are doing more of it. Tomorrow, once they do it, there will be an even more severe recession in the eurozone and in Italy and Spain. People are going to say ‘fine, you’re doing the fiscal budget reduction but now you’re spinning into a recession.’

So you’re not going to be debt sustainable because you’ve got no growth. So unless we have a strategy to restore growth in the eurozone in the short run, there needs to be monetary policy easing on a massive scale: weakening of the euro, fiscal stimulus by Germany and the core, backstopping Italy and Spain and doing anything else in terms of infrastructure spending to boost the growth of the periphery that’s now spinning into a recession.

Unless all these things happen it’s not going to be sustainable. So liquidity support is not enough. You need to restore growth not three years from now, not five years from now through structural reforms, you’ve got to do it today. Otherwise it’s not going to be sustainable. And the eurozone now is spinning into a recession again.

The signs from policymakers are not encouraging. Germany’s finance minister was reported to have said that the G20 was largely in agreement that a fiscal stimulus is simply not needed now. What do you make of that?

That’s nonsense. The IMF has it right. [IMF managing director] Christine Lagarde has it right. If everybody does fiscal austerity at a time when private demand is falling again you’re going to have another global depression. We’re going to make exactly the same mistake like during the Great Depression, when we took away the fiscal stimulus too soon. That is a huge risk right now.

Where does this all lead us? The risk in your view is of another Great Depression. But even respectable European politicians are talking not just an economic depression but possibly even worse consequences over the next decade or so. Bearing European history in mind, where does this take us?

In the 1930s, because we made a major policy mistake, we went through financial instability, defaults, currency devaluations, printing money, capital controls, trade wars, populism, a bunch of radical, populist, aggressive regimes coming to power from Germany to Italy to Spain to Japan, and then we ended up with World War II.

Now I’m not predicting World War III but seriously, if there was a global financial crisis after the first one, then we go into depression: the political and social instability in Europe and other advanced economies is going to become extremely severe. And that’s something we have to worry about.

What about the countries in the world with relatively healthy balance sheets? What about the large emerging nations? What should their response be this time? What can China do at this time?

China has to change radically its growth model because it’s not sustainable. They talk about increasing consumption, but consumption as a share of GDP has fallen from 50% to 40% to 35%, now it’s 33%. And fixed investment has gone from 30% to 40% and now 50% of GDP.

China is going to have in two years its own hard landing. There’s so much overcapacity, from real estate to infrastructure to manufacturing that unless they change their growth model to rely more on consumption and less on fixed investment, eventually there will be a hard landing in China. So it’s not any more an issue of net exports.

They have reacted to the collapse of their net exports by boosting fixed investment rather than consumption. So they have to radically change their growth model and the sooner they do it the better for them and for the global economy.

Where does that leave China with respect to either a willingness or capacity to react with similar vigour to today’s crisis as they did in 2008?

Well, if there is a recession in the G3, China is going to do more monetary, fiscal and credit stimulus. They’re going to kick the can down the road for another year because in a year from now they’re going to change their own leadership. But that creates even more imbalances because the only thing they know to do is more infrastructure, more real estate, more manufacturing and industrial capacity by the SOEs (state-owned enterprises). So they make the investment bubble even worse and the hard landing is going to be even worse down the line. What they need is radical policies that lead them to save less and consume more. But it will take them 10, 20 years of policy changes to achieve that. I fear they’re not going to do it in time.

G20 leaders are telling us that they simply need to keep markets calm until the EFSF is agreed in mid-October. Are they deluding themselves? If we don’t get a meaningful statement this weekend what are we likely to see in the markets next week?

The uncertainty, the volatility, the risk aversion is rising. I fear they’re not going to reach an agreement along the lines of what I’ve proposed and therefore there will be more turmoil, more uncertainty, more volatility, more risk aversion. And even approving the EFSF in the current format is not going to be enough. So if it’s approved people are going to say ‘hey it’s not enough money.’ Two, there’s fiscal austerity but there is no growth. So Italy and Spain are toast unless we have triple or quadruple the amount of official resources to backstop them. So, much more needs to be done and I fear the G20 are not going to say anything meaningful in this regard.

[LWPD]

Recent events saw the Prime Minister of Greece George Papandreou attempt to put austerity measures up for a public referendum, only to back down in the face of outside pressure from other European powers. On the political front, the collapse of the government appears eminent. It is mathematically impossible for Greece to repay its debt, the only question relating to default is time. Below is an analysis that makes the case that the best course of action for the country and the people of Greece is to bite the bullet, declare default, and begin the painful process of rebuilding their economy outside of the Euro. The consequences and resulting contagion are impossible to fully predict. The composition of CDS exposure on the books of U.S. Banks is a tightly kept secret. Bank of America moved their allotment out of Merrill, pushing it onto FDIC (with losses that would have to be carried by the American tax payer). Same deal with JP Morgan. Morgan Stanley has a known vulnerability to the Eurozone. Interesting times ahead.



Courtesy of rgemonitor.com
Full Analysis: Greece Should Default and Abandon the Euro
By Nouriel Roubini

Greece is insolvent, uncompetitive and stuck in an ever-deepening depression, exacerbated by harsh and excessive fiscal consolidation. It is time for the country to default in an orderly manner on its public debt, exit the eurozone (EZ) and return to the drachma to rapidly restore solvency, competitiveness and growth.

Exit will require a conversion of euro liabilities into the new currency to limit the balance sheet effects that the depreciation of the new national currency will entail.

Greece can exit the monetary union in an orderly and negotiated manner (i.e. limit the collateral damage to its own economy and financial markets that this exit would imply) if orderly mechanisms are used and appropriate official finance is provided. Such official finance to Greece and other EZ members under stress will limit the contagion and the losses for other periphery and core creditor countries, and will ensure that the domestic Greek financial system and economy does not suffer a chaotic implosion.

Default and exit will be painful and costly, but the alternative of a decade-long deflation and depression would be much worse, economically, financially and socially.

Moreover, there are historical precedents for countries successfully taking the route of an orderly default on unsustainable foreign liabilities and exit from unsustainable currency pegs and/or currency boards.

Why a Default/Debt Reduction and an Exit From the EZ Are Necessary and Desirable

Greece is now in a vicious circle of insolvency, lack of competitiveness and ever-deepening depression, exacerbated by draconian fiscal austerity that is making the recession much worse. Greece’s public debt is heading toward a level of 200% of GDP in two years’ time. And while fiscal austerity and structural reforms are necessary to restore medium-term debt sustainability and growth, in the short run they will lead to an even deeper recession, thus making the deficit and debt even more unsustainable. Indeed, the latest economic data suggest that the Greek recession is becoming a near depression, with GDP expected to fall by over 7% this year and with forward-looking indicators of economic activity (such as the PMI, which is at a level of 43) suggesting a deepening recession. Argentina in 1999-2001 fell into the same trap of deficit, austerity, deeper recession, depression, higher deficit, greater insolvency.

Thus, it is time for Greece to orderly restructure/default on its public debt, exit the EZ and return to the drachma to restore solvency, competitiveness and growth.

Default/Debt Reduction

First, the recent debt exchange deal negotiated to bail-in Greece’s private creditors was an outright rip-off for the country: The net present value (NPV) debt reduction was formally only 21% when the country needs at least 50% debt relief, based on RGE’s analysis of debt sustainability. And even that 21% headline is not a true measure of debt relief as a massive sweetener for creditors in the form of a Brady-style principal collateral guarantee will increase Greece’s gross public debt by another €30 billion. So, doing the math right and considering a likely rather than optimistic exit yield, the true debt relief for Greece out of this deal is at best close to zero or, at worst, possibly an NPV increase in its debt burden.

Greece should put a halt to this unfair debt-exchange offer and, under threat of outright default, negotiate a better deal (with no credit sweeteners) that offers at least a 50% debt relief to the country. Going for the current deal now and hoping to negotiate something better in a second round is a much more difficult task: Given the full guarantee of the €100 billion principal via the collateral private sector creditors, the credit risk for private creditors would now be limited to the coupon payments, a paltry €5 billion per year. Then, further insolvency and the need for more debt relief for Greece would imply that the official sector (IMF, European Financial Stabilization Mechanism, European Financial Stability Facility and ECB), which is already bailed in via an effectively coercive maturity extension of its claims, would have to suffer a major and draconian haircut on its claims, thus becoming junior to private creditors. Thus, Greece should renegotiate a better deal—and one that keeps its debt under the domestic governing law, unlike the current debt exchange that transfers such governing law abroad—rather than accepting a lousy fake debt relief now.

It would be better if the current debt exchange fails—with less than 90% of creditors accepting the offer—so that the country can target a fresh approach with greater debt relief, rather than going into a debt exchange where additional debt relief would have to come mostly from allegedly more senior official creditors, rather than formally more junior private creditors that end up being more senior. A formal default will not be necessary to achieve meaningful 50% debt relief; a credible threat of default if creditors don’t accept an exchange offer at more favorable terms would be sufficient. Currently, many creditors of Greece are holding out even on the current most generous exchange offer because they hope they will be paid in full as the EU/ECB/IMF want to avoid, at any cost, a technical default. Only a credible threat not to be paid will bring recalcitrant creditors into line.

Exit From the Eurozone

Second, even if Greece were to be given significant relief on its public debt via an orderly but deep debt reduction under threat of default on its debt (i.e. a better debt exchange than the current one under a credible threat of default), the economy would not return to growth unless its competitiveness is rapidly restored. And, without a rapid return to growth, public and private debts would remain unsustainable while the social and political backlash against austerity and continued depression would come to a boil. There are only four options to restore competitiveness and growth, all requiring a real depreciation of the currency for Greece:

First, a sharp nominal depreciation of the euro toward parity with the U.S. would lead to real depreciation; this outcome is unlikely to occur as the U.S. economy is weak, thus exerting downward pressure on the U.S. dollar, while within the EZ Germany is still uber-competitive;

Second, a rapid reduction in unit labor costs via the acceleration of structural reforms and corporate restructuring, leading to a rapid increase in productivity growth above wage growth (the German solution); this option is also quite unlikely as it took almost 15 years for Germany to reduce its unit labor costs and restore its competitiveness via that process;

Third, a rapid five-year cumulative 30% deflation in prices and wages—about 5% per year for five years—(also referred to as the “internal devaluation” solution) would imply an equivalent real depreciation; this path to a real depreciation is unlikely to be feasible as it would be associated with another (socially unacceptable) five years of ever-deepening recession/depression; also, even if feasible, such deflation would make the country undertaking it more insolvent, given a 30% increase in the real value of its debts. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it gave up and decided to default and move off the currency board peg with the U.S. dollar;

Thus, if the first three options cannot restore competitiveness, the only other option left is the exit of Greece from the monetary union. Only a return to a national currency and a sharp depreciation of that currency would quickly restore competitiveness and growth, as it did in Argentina, which rapidly moved from a current account deficit to a surplus and from depression to high growth. The trade losses for the EZ core that a return to a national currency in Greece would entail would be extremely modest as the total GDP of Greece is barely 2% of the EZ total, while its trade with Germany and the rest of the EZ represents an even smaller share of GDP. Conversely, in short order, Greece could restore its competitiveness, turn its current account deficit into a surplus and start growing rapidly again.

Take the example of Argentina: Until December 2001, GDP was free falling, dropping by an annualized rate of 20%; three months later, in March 2002, after a default and move from a currency board to floating rate, the economy started to grow at an annual rate of 8%, and has grown at very rapid rates for a decade since. The usual argument that Greece doesn’t have much of a competitive advantage is as inane for Greece as it was for Argentina; then, it was argued that Argentina, with exports representing barely 10% of GDP, could never compete, even if it had a weaker currency; but that argument was proven to be utterly wrong when Argentine exports boomed following the depreciation. Greece, with a much larger share of trade in GDP than Argentina, could see its trade balance turn around dramatically following a sharp depreciation—and thus support strong GDP growth via net exports—even if domestic demand remains weak in the context of the collateral damage of default and exit from the monetary union.

Real GDP and Wealth in Greece Will Fall Sharply, Regardless of Whether Greece Exits the EZ or Not; But Higher Over Time in the Exit Scenario Compared With the Alternative of Depressive Deflation

The Effect of an Exit on GDP

Some argue that exit from the EZ would be a disaster for Greece as the ensuing nominal and real depreciation of its currency would sharply reduce the real value—in euros—of its output and wealth. These arguments are flawed in a number of ways. First, if Greece has to be stuck with falling GDP for another five or 10 years in an ever-deepening recession and depression, it is better that it is able to grow rapidly, even from a lower level of GDP, than being stuck in a depressive trap of ever-deepening recession and rising unemployment.

Second, Greece’s real GDP in euro terms will fall over time by about 30%, regardless of whether it exits the EZ or not. Since the currency is overvalued in real terms by at least 30% (the increase in Greek unit labor costs that has occurred over the past decade while wages were growing more than productivity), even the supporters of pain and austerity for Greece fully agree that such real depreciation is necessary to restore competitiveness, although they argue that such real depreciation should occur via “internal devaluation”—i.e. a cumulative fall of 30% in Greek wages and prices over a period of a few years—rather than through exit and the nominal depreciation of a new currency. But if such internal devaluation were to occur over time, Greece’s real GDP—or its purchasing power over the goods and services of other EZ members—would fall over time by 30%. So, even if Greece sticks with the euro, its true (terms-of-trade-corrected) real GDP will be lower over time by 30%; that is the sense of the argument (which all agree on) that Greece needs real depreciation to restore competitiveness and growth.

Thus, the only issue here is not whether Greece’s real GDP (in terms of purchasing power over foreign goods) will be lower by 30%, as that outcome is sealed either way; rather, the issue is whether that result should be achieved over five or 10 years via an ever-deepening recession and depression triggered by massive deflation; or whether it should be achieved overnight via exit from the euro. The latter option—exit—has the benefit that economic growth and employment growth will resume right away; the former option—depressive deflation—will lead to another five-to-10 years of socially and politically destabilizing recession, depression and a sharp rise in joblessness. So, since the eventual outcome—lower PPP-based GDP—is the same, a path that restores growth, jobs and incomes in the short run is vastly preferable to another decade of depression that will eventually lead to massive social and political instability.

Resuming growth right away is far preferable to many more years of misery, austerity, rising poverty, falling output and jobs and much higher unemployment rate. And while the exit will lead to an immediate fall in the real PPP value of Greek GDP, the substitution from foreign to domestically produced goods will dampen the impact on true real income and purchasing power that such a devaluation would entail.

Also, although in the short run of the exit scenario, the nominal exchange rate may fall by more than 30% (it will certainly overshoot) and thus reduce (in the short run) Greece’s GDP in euros by more than 30%, over time inflation will return that above 30% nominal depreciation into a 30% real depreciation; so the bigger fall in euro GDP will only be temporary and the final outcome for real GDP will be the same. Also, note that a short-term overshooting of the exchange rate will lead to a stronger recovery of net exports and growth; thus, overshooting can work both ways, with additional costs as well as benefits.

The Effect of an Exit on Wealth

The same logic applies to the argument that the exit of Greece from the EZ will suddenly reduce the real value of the euro-denominated wealth of Greece’s residents. That is as flawed as the previous argument about the effect of an exit on the value of Greece’s real GDP in euros. If Greece does not exit the EZ, the slow and depressive deflation that is needed to achieve a restoration of competitiveness will reduce the real euro value of the purchasing power of Greek euro-denominated assets over foreign goods and assets. Assets in the non-tradable sectors of Greece—such as real estate, whose claims can be traded internationally, but that provides non-traded housing services—would be 30% lower in euro value after the deflation has occurred; and the real value of Greek traded assets—firms in the import-competing and export sectors—would also be 30% lower if a 30% fall in the prices of their goods is necessary to restore their competitiveness. So, Greece will be—wealth-wise—30% poorer regardless of whether the necessary real depreciation occurs via deflation or via exit and nominal depreciation. Again, the end-game result for wealth is exactly the same.

So, it is wrong to argue—as many do—that an EZ exit and the conversion of euro assets into drachma ones will sharply depreciate the real euro value of such assets and wealth. That reduction in their real euro value of wealth will occur even if exit doesn’t take place and a painful deflation does the dirty job. At least in the case of exit Greece can reduce the negative impact on its foreign net worth (assets minus liabilities) via a conversion of euro liabilities into drachma liabilities. Such a capital levy on Greece’s foreign creditors—given the unsustainability of Greek public and private debts—makes Greece better off (wealth-wise) in the exit scenario than in the no exit and deflation scenario. So, Greece is, at worst, as well off (or as worse off) in the exit scenario compared with the deflation scenario; or, more likely after debt reduction, it would be better off under the exit scenario.

In summary, the arguments that Greece’s real GDP and wealth will be much worse in the exit scenario than the deflation scenario are utterly flawed. Quite the reverse is true: By restoring growth right away, rather than being stuck in a decade-long depression, Greece’s real income and wealth is eventually higher in the exit scenario.

Why Conversion of Euro Debts Into the New National Currency (“Drachmatization”) Is Necessary, Post-Exit

The most significant losses that a Greek exit from the EZ would entail are the capital losses for core EZ financial institutions resulting from the balance sheet effects of a return to a national currency: Overnight, the foreign liabilities in euros of Greece’s government, banks, corporate firms and households would surge by a percentage amount equal to the rate, first, of the nominal and, over time, the real depreciation of the new national currency. For example, following a 50% depreciation of the new drachma relative to the euro, Greek public debt would go from the current 160% of GDP to 240% of GDP; ditto for the private sector’s foreign liabilities. Then, there would be only two options available to deal with such unsustainable balance sheet effects: Either a coercive conversion of such liabilities from euros into the new national currency at an exchange rate different from the new floating rate of the national currency; or, a default on and then a negotiated reduction of such euro-denominated debts.

The first option would be legal for liabilities issued in the domestic jurisdiction (where the Greek law governs claims)—that is, most of the assets and liabilities in the economy. For example, both assets and liabilities of the banks would be converted from euros into drachmas. The second option would be available for liabilities incurred cross-border and where the governing law is foreign. This is what Argentina did in 2001 when it moved off its currency board—a “pesification” of its dollar debts—and this is what the U.S. did in 1933 when it depreciated the dollar by 69% and repealed the gold clause. A similar unilateral “drachmatization” of euro debts would become necessary and unavoidable; and even conceptually, once Greece goes back to the drachma, a conversion of all assets and liabilities into the new national currency would be logical: The drachma would become the new unit of account, means of payment and store of value for assets.

Then, losses that core EZ banks and investors would suffer from such a capital levy on their euro claims on the Greek government, banks and corporate firms could be large, but manageable if core EZ financial institutions are properly and aggressively recapitalized and proper forbearance is used to spread their losses over time. Also, an orderly case-by-case negotiated reduction of euro debts issued in a foreign legislation (say Frankfurt or Paris) by Greek agents would be manageable as the number of banks and corporates with such liabilities is modest.

Avoiding a banking system implosion after an EZ exit would entail, unfortunately, the imposition of Argentine-style measures—such as bank holidays (deposit freeze) and capital controls—to prevent a disorderly fallout; realistically, lots of collateral damage would occur, but this could be managed and limited. Banks could be recapitalized by the government through the issuance of recapitalization bonds; while this recapitalization would initially increase public debt, the reduction in public debt from a significant default would give some fiscal margin to achieve such recapitalization.

How to Minimize Contagion to the Rest of the EZ (Both Periphery and Core)

The other type of collateral damage from a Greek default and EZ exit would be potential contagion to the rest of the EZ periphery: Portugal, Ireland, Italy and Spain. Investors will ask: Who is next in line for default and exit? This is a serious risk, but there are ways to manage it:

First, it is not obvious that all EZ periphery members are illiquid but solvent given fiscal austerity and reforms: For some—Portugal and Ireland, in particular—a restructuring of their public debt will be necessary at some point, regardless of whether Greece defaults and/or exits the EZ;

Second, some EZ periphery members have the same competitiveness problem as that of Greece; so, for example, Portugal may also eventually have to follow the path of Greece and exit the EZ;

Third, illiquid but solvent (given austerity and reforms) economies such as Italy and Spain (assuming, and this is a big assumption, that they are solvent conditional on adjustment) should receive lender-of-last-resort support—LOLR—(either from the ECB or a tripled EFSF or E-bonds) regardless of whether Greece defaults/exits; indeed, a self-fulfilling run on Italy and Spain’s public debt at this point is almost certain in the absence of such LOLR. Thus, Italy and Spain will be either rescued and swim via a large enough LOLR, or they will sink regardless of what Greece does;

Fourth, as the collateral damage to Greece of default and exit will be significant, other EZ economies in crisis will have a chance to see and decide for themselves whether they want to follow Greece with all the benefits as well as the substantial costs that this entails; or whether they want to differentiate themselves and remain in the monetary union via appropriate policy changes and reforms. For example, unlike what many opponents of debt restructuring feared, Greece’s decision to have an orderly debt exchange of its public debt did not lead to other EZ members—such as Ireland—asking for debt relief in a “me too, me too” contagion effect. If anything, so far, Ireland has been trying to implement policies that would differentiate itself—in terms of sovereign risk—from Greece;

Fifth, the substantial official resources currently wasted to bailout Greece’s private creditors could be used to ring-fence the illiquid but solvent countries elsewhere in the periphery: More money would be available to support sovereigns and to recapitalize undercapitalized EZ banks;

Sixth, regardless of whether Greece defaults/exits, EZ banks should be rapidly recapitalized via an EU-wide TARP-style program as markets and investors don’t believe the EU’s fudged estimates—through two rounds of phony stress tests—of the capital needs of EZ banks. So, a Greek default/exit should be the catalyst for a much-needed TARP program.

Collateral Damage and Contagion Can Also Be Reduced if Default/Exit Is Orderly/Negotiated

The collateral damage to Greece and to the rest of the EZ could also be reduced if, instead of a disorderly default and exit from the EZ, the whole process is negotiated and becomes orderly. So long as the process is negotiated and orderly, the official sector may still want to provide some financing to Greece to reduce the collateral damage both for Greece and the rest of the EZ.

For example, Greece should not formally default on its public debt; rather, it should stop the current unfair exchange offer and renegotiate a new one—under threat of default—that gives the country true debt relief (of the order of 50% of GDP) without any sweeteners for creditors, such as the Brady-style collateral guarantee of principal. Avoiding a technical default and achieving meaningful debt relief via a more generous exchange offer is the way to contain the cost of a disorderly formal default. Similarly, the exit should be negotiated in an orderly manner with the rest of the EZ: Agreement should be reached about the exchange rate—in new drachmas—at which cross-border euro debts of Greece’s government, banks and corporate should be converted into drachmas. Even the exchange rate at which local law assets and liabilities in euros are converted into new drachmas could be discussed and managed to avoid the overshooting of the exchange rate.

Collateral Damage to Greece Can Also Be Reduced if Default/Exit Is Managed With Some Official Resources to Prevent Overshooting and Financial Meltdown

One of the big mistakes of the official sector approach to Argentina must be avoided in the case of Greece. The IMF was very generous with Argentina for years to prevent an unavoidable default and devaluation; but once that default and devaluation eventually occurred, it fully pulled the plug and provided none of the financial support that was necessary to manage the collateral damage of those unavoidable decisions. As a consequence, Argentina suffered a massive overshooting of its exchange rate, a huge temporary increase in its inflation rate and major financial sector disruption and near meltdown. There is a risk the same mistakes will be made now, first wasting hundreds of billions of euros to bailout private creditors and trying to prevent Greece’s unavoidable default and exit; and then providing no support afterwards, ensuring a disorderly outcome and massive contagion to the rest of the EZ periphery.

The right approach would instead be to immediately stop the current bailout program, which only benefits the exit of Greece’s private creditors, and negotiate an orderly debt reduction and orderly EZ exit, while providing some modest but generous official support to Greece to prevent a disorderly financial meltdown once the orderly debt reduction/EZ exit occurs. For example, in Argentina, the nominal exchange went from parity with the U.S. dollar to 3:1, once the move to floating rates occurred, in an obvious overshooting of the nominal exchange rates, as the Argentine peso was overvalued only by 30% or so, not by 200%. Then, the ensuing high inflation eventually returned the real exchange rate to its appropriate equilibrium value. In Greece, the degree of overvaluation of the real exchange rate is probably in the 30% range; so, official resources should be used to minimize the degree of nominal exchange rate overshooting that will obviously occur once the exit takes place. Also, official resources could be used to finance the primary deficit that Greece will still have once the default does occur.

Without such official resources (to be provided in exchange for a credible plan to achieve, over time, a primary balance and then surplus), Greece would be forced to monetize its deficit once it has lost domestic and foreign market access, leading to high inflation. That inflationary burst could be contained if official loans are available to finance a shrinking primary deficit. Official resources could also be used to recapitalize Greek banks; creditors in the core EZ would then benefit from having an equity position in Greek banks as the result of such support. So, the basic qualitative parameters of the current EU-IMF program for Greece—support of the sovereign and resources to recap the banks—could be maintained, but the overall size of the program would be much smaller as the expensive free exit of Greece’s foreign creditors would be completely stopped. The key to reduce the collateral damage to Greece and the EZ is to make the default/exit process orderly and negotiated. Breaking up is hard to do, but the damage from the break-up can be minimized.

Further Risks of Exit/Default to Greece, Both Real and Imagined

Risks of High Inflation or Hyperinflation in Greece Post-Default/Exit Are Vastly Exaggerated and Can Be Contained With Sound Fiscal Policies and Official Support

The risk that a Greek default and EZ exit will lead to high inflation or even hyperinflation in Greece is also vastly exaggerated. The same claims were made about Argentina when it defaulted and moved to a floating rate. But, even in a country like Argentina, with a long history of inflation and hyperinflation, the move to a float did not lead to hyperinflation as some scaremongers had wrongly predicted; inflation spiked for a year after the exchange rate overshot its fundamental value, but then it rapidly returned to low double digits. The way to prevent Greece from experiencing high inflation after an exit from the euro is for that exit to be orderly, to put in place official resources to prevent the overshooting of the nominal exchange rate and to provide some non-monetary financing of the remaining primary deficit. As the experience of Argentina shows, even in the absence of such official resources, inflation—after a first-year burst—can be contained at modest levels as the default and exit leads to growth and to greater fiscal discipline, given the binding constraints of limited domestic and external bond financing. And experience suggests that floating exchange rates provide greater fiscal market discipline than fixed rates or monetary unions as, under flexible exchange rates, policy slippages automatically lead to upward pressure on interest rates and downward pressure on the currency value. Joining the monetary union had disastrous effects on the incentives for fiscal discipline in Greece.

It should also be clearly stressed that default and exit are not a substitute for painful fiscal austerity and needed structural reforms. The problems of Greece were self-inflicted with over a decade of fiscal laxity and structural rigidities. Over time, only austerity and reforms will lead to sustainable productivity growth and success. But as such policies are depressionary in the short run, and as even draconian fiscal austerity cannot reverse an unsustainable debt burden, an orderly significant debt reduction and exit from the EZ are necessary to jump start competitiveness and growth and restore solvency.

Tail Risks of a Default and Exit

We don’t want to minimize the risks of default/exit for Greece. In Argentina, the economy turned from a free-fall depression—with GDP falling at an annual rate of almost 20% at the end of 2001—to positive 8% GDP growth by early 2002 after default and exit from the currency board. But the transition was very ugly and costly: Riots and blood in the streets and dozens of deaths; massive social and political instability and five different presidents in one year; a deposit freeze in the banking system; capital controls; asymmetric pesification and the need to recapitalize insolvent banks; the loss of external market access; a sharp short-term rise in poverty and unemployment (before high growth rapidly cut both); inward-looking economic policies and political economy; the retardation of economic reforms; a sharp fall in inward FDI; and an overall change in economic policies toward long-term populism and policy mismanagement. So, breaking up is hard and costly to do and every country considering it should be fully aware of the risks of such collateral damage. And if a society finds such costs unbearable it should stick to the policy sacrifices necessary to avoid that painful break-up.

But we should also be aware of the important caveats to the costs and risks of breaking up. First, the resumption of rapid growth was better than a decade of depression. And, second, a decade-long depression was not a real alternative, as the same social and political instability and financial collateral damage would have occurred if the path of depressionary deflation had been pursued. So, the relevant comparison to make is to ask the question: Which social, political, economic and financial disaster would Argentina have faced if it had followed a policy of deflation and depression? Most likely, the result would have been a 1930s-style depression that would have resulted in the same social and political instability and unrest—or most likely, worse—than that which resulted from the default and exit from the currency board.

Third, things became disorderly in Argentina because the default and exit was disorderly and, after the crash, the official sector—ever too generous to bailout private creditors before the crash—decided to fully pull the plug on Argentina and provide no further official financing. To limit the collateral damage to Greece and the EZ contagion of a Greek default and exit, such a transition should be orderly and negotiated, and official resources should be generously provided to Greece; not to finance—like now—the exit of private creditors, but rather to contain the fallout and collateral damage of a difficult orderly debt reduction and EZ exit.

As the recent example of Iceland (which is now starting to grow robustly after its severe crisis) suggests, defaulting in an orderly manner on unsustainable foreign liabilities (in Iceland’s case, those of the private financial sector) and experiencing a sharp nominal and real depreciation is the path to resuming growth and jobs, even after a very painful financial crisis.

Similarly, in all the successful resolutions of dozens of emerging market (EM) crises in the past 15 years, the return to competitiveness and growth was rapid—V-shaped recoveries from crises to high growth in a matter of 12 months. This is because, in addition to fiscal austerity and structural reforms, these countries received generous official financing from the IMF and World Bank, performed orderly restructurings of their private and public external debts when they were unsustainable and moved from unsustainable overvalued fixed exchange rates (or currency boards) to floating exchange rates that rapidly restored competitiveness and growth. The lesson of the past is that debt reductions and exits from unsustainable exchange rate regimes do not have to be as disorderly and painful as the extreme case of Argentina. Iceland and a dozen episodes in EMs point to a more orderly and less costly path to growth and competitiveness, which Greece should follow.

Conclusion: A Break-Up Is Painful and Costly, but a Rotten Marriage Is Worse: A Plea for an Orderly Divorce

Some private sector analysts have recently estimated that the cost of exit from the EZ could be as high as 40-50% of GDP for the exiting countries (such as Greece). Such estimates appear to be vastly exaggerated and based on utterly flawed assumptions; losses could be much smaller if the process is orderly, if official support is maintained, if debts are converted in an orderly manner into the new local currency and if sharp currency depreciation rapidly restores economic growth. The alternative—a decade of depressive deflation— would be much worse for Greece. In conclusion, first Greece and then other EZ periphery members may need to exit monetary union and can do so in an orderly and negotiated fashion—i.e. limiting the collateral damage that this would imply—if mechanisms are implemented and appropriate official finance is provided to limit the contagion and the losses for the other periphery and core creditor countries, and to ensure that the Greek domestic financial system and economy does not implode in a disorderly fashion.

Like a broken marriage that requires a break-up, it is better to have rules—divorce laws—that make separation orderly and less costly to both sides. Breaking up and divorcing is painful and costly even when such rules exist. But being stuck in a marriage of convenience that is not working any longer is more costly and painful for the couple and their offspring (children/future generations) than an orderly and civilized break-up. Once the pain and costs of the break-up are managed, both sides can look forward to a more friendly relationship and a brighter future.

[TTX]

This could be very bad if it totally falls apart. I don't know if there's any way to save it either.

[LWPD]

The recent failure of Germany's bond auction has triggered a new doomsday phase in the European sovereign debt crisis. Of the three noted solutions in this article, not one would be politically tenable for the creditor nations. Yet the alternative, doing nothing beyond the status quo, could create severe damage for all parties involved. How this would effect America remains to be seen. Friday December 9th is a date the financial world will be watching very closely!



Courtesy of Financial Times
The eurozone really has only days to avoid collapse
By Wolfgang Münchau

In virtually all the debates about the eurozone I have been engaged in, someone usually makes the point that it is only when things get bad enough, the politicians finally act – eurobond, debt monetisation, quantitative easing, whatever. I am not so sure. The argument ignores the problem of acute collective action.

Last week, the crisis reached a new qualitative stage. With the spectacular flop of the German bond auction and the alarming rise in short-term rates in Spain and Italy, the government bond market across the eurozone has ceased to function.

The banking sector, too, is broken. Important parts of the eurozone economy are cut off from credit. The eurozone is now subject to a run by global investors, and a quiet bank run among its citizens.

This massive erosion of trust has also destroyed the main plank of the rescue strategy. The European Financial Stability Facility derives its firepower from the guarantees of its shareholders. As the crisis has spread to France, Belgium, the Netherlands and Austria, the EFSF itself is affected by the contagious spread of the disease. Unless something very drastic happens, the eurozone could break up very soon.

Technically, one can solve the problem even now, but the options are becoming more limited. The eurozone needs to take three decisions very shortly, with very little potential for the usual fudges.

First, the European Central Bank must agree a backstop of some kind, either an unlimited guarantee of a maximum bond spread, a backstop to the EFSF, in addition to dramatic measures to increase short-term liquidity for the banking sector. That would take care of the immediate bankruptcy threat.

The second measure is a firm timetable for a eurozone bond. The European Commission calls it a “stability bond”, surely a candidate for euphemism of the year. There are several proposals on the table. It does not matter what you call it. What matters is that it will be a joint-and-several liability of credible size. The insanity of cross-border national guarantees must come to an end. They are not a solution to the crisis. Those guarantees are now the main crisis propagator.

The third decision is a fiscal union. This would involve a partial loss of national sovereignty, and the creation of a credible institutional framework to deal with fiscal policy, and hopefully wider economic policy issues as well. The eurozone needs a treasury, properly staffed, not ad hoc co-ordination by the European Council over coffee and desert.

I am hearing that there are exploratory talks about a compromise package comprising those three elements. If the European summit could reach a deal on December 9, its next scheduled meeting, the eurozone will survive. If not, it risks a violent collapse. Even then, there is still a risk of a long recession, possibly a depression. So even if the European Council was able to agree on such an improbably ambitious agenda, its leaders would have to continue to outdo themselves for months and years to come.

How likely is such a grand deal? With each week that passes, the political and financial cost of crisis resolution becomes higher. Even last week, Angela Merkel was still ruling out eurobonds. She was furious when the European Commission produced its owns proposals last week. She had planned to separate the discussion about the crisis from that of the future architecture of the eurozone. The economic advice she has received throughout the crisis has been appalling.

Her own very public opposition to eurobonds has now become a real obstacle to a deal. I cannot quite see how the German chancellor is going to extricate herself from these self-inflicted constraints. If she had been more circumspect, she could have travelled to the summit with the proposal of the German Council of Economic Advisers, who produced a clever, albeit limited and not yet fully worked-out-plan. They are a proposing a “debt redemption” bond – another candidate for this year’s top euphemism award. The idea is to have a strictly temporary eurobond, which member states would pay off over an agreed time period. At least this proposal would be in line with the more restrictive interpretation of German constitutional law.

Ms Merkel’s hostility to eurobonds certainly resonates with the public. Newspapers expressed outrage at the commission’s proposal. I thought both the proposal itself and its timing were rather clever. The Commission managed to change the nature of the debate. Ms Merkel can get her fiscal union, but in return she will now have to accept a eurobond. If both can be agreed, the problem is solved. It is the first intelligent official proposal I have seen in the entire crisis.

I have yet to be convinced that the European Council is capable of reaching such a substantive agreement given its past record. Of course, it will agree on something and sell it as a comprehensive package. It always does. But the half-life of these fake packages has been getting shorter. After the last summit, the financial markets’ enthusiasm over the ludicrous idea of a leveraged EFSF evaporated after less than 48 hours.

Italy’s disastrous bond auction on Friday tells us time is running out. The eurozone has 10 days at most.

[TTX]

Hopefully they figure out something.....it's definitely a gut wrencher for everyone even if most don't realize it.

[Mr. Hyde]

I'd just like to say that even though I don't comment on nor watch all of your current event updates, I appreciate them very much. Things like this are very important, and having multiple analyses provided by multiple sources, you being one of those sources, is a great thing.

Thanks!