Courtesy of Edward Harrison at Credit Writedowns
Marshall Auerback was on BNN’s SqueezePlay yesterday talking about the crisis in Greece (this time without his banker’s pinstriped suit – but we all know he’s a fund manager anyway!). He made some interesting comments about currencies I wanted to run by you.
Greece is the Bear Stearns of sovereign debtors
I know you have already seen comments from me, Marc, Claus, and the other Edward on Greece today. But this is a very big deal. Marshall calls it the Bear Stearns event in the sovereign debt crisis, a line he got from me. Here’s the thinking:
Talk about Minsky moments. We are facing one right now.
It reminds me a little of the subprime crisis. When it engulfed Bear Stearns, policy makers stepped in with bailout money. The immediate problem of Bear Stearns’ collapse was solved, but the systemic issues remained. Yet, recklessly, policy makers did almost nothing in the few months afterwards to deal with those issues. This was a crucial error given that people like me were warning of impending calamity. I was mystified (see comments at the end of my Swedish crisis post). The Minsky moment came and policy makers missed it entirely.
In fact, many were incensed because they thought Bear should have failed. So when Lehman came around, it did fail. And we all know how that turned out.
So, here we are again. The sovereign debt crisis has been building for three months now – ever since Dubai
Worldannounced it wanted to default on its loans. In my view, we have now reached a critical juncture. If Greece is allowed to default, all hell will break lose. On the other hand, Greece has run a deficit for years. It’s ‘cheated’ to meet the standards set forth in its previously agreed-to treaties and it is unwilling to take austerity measures that Ireland, faced with similar circumstances, has taken. What should the EU do?
The dilemma is this: how do you eliminate moral hazard for perceived free riders while still credibly safeguarding against the destruction and contagion that a Eurozone sovereign default would create?
Whether deficit hawk or dove, pro- or anti-bailout, these are the real issues we all see: moral hazard, safeguards, contagion, default.
The fact is Greece faces an enormous funding gap (at least 60-80 billion euros over the next few years). No rescue plan is credible unless it backstops Greece for the entirety of that gap (see The Economist’s "Still in a spin").
But, Greece has run budget deficits in good times and bad due to its bloated public sector. Meanwhile uncompetitive wage rates mean recovery via exports is a tough road to hoe. So, the ‘bailout’ on offer is not credible in the least.
And since Portugal, Ireland, Italy and Spain have the same problems, Greece is to Bear Stearns as the next of these countries to hit crisis is to Lehman Brothers.
What to do?
Competitive Currency Devaluations
Marshall says there are two scenarios. Watch Marshall’s BNN clip linked at the bottom. It runs just over eight minutes. He explains the scenarios well. I want to add some colour to the discussion.
In scenario one, you eject Greece from the Eurozone, they devalue their currency and, after a turbulent period, they are on the road to recovery. The problem, of course, is that it’s on to the next Euro debtor, Portugal. Do they then get ejected too? Next stop, Spain. And then Italy. Marshall says that France, in particular, would face a serious problem with competitiveness in such a scenario. As I recall, France is a founding member of the so-called Club Med southern European Eurozone countries. This is not a good outcome for France. And it is certainly not a good one for the European banks which hold the sovereign debt of countries like Greece, which has the largest external sovereign debt-to-GDP ratio in the world.
Outcome number two is to depreciate the Euro, of course. The Euro is dropping as we speak. But, I am talking about a more serious decline. As I recall, the Euro dipped to as low as 83 cents during Robert Rubin’s strong dollar policy days. If the EU structures the bailout in the right way (fully backstops the period of increasing debt to to GDP) and floods each country with liquidity (aka prints money), you are sure to get this kind of outcome. Everyone gets a massive boost to competitiveness. Problem solved.
However, the Germans would never go along with this ‘weak currency’ strategy. Moreover, the Americans would cry bloody murder because this is a competitive currency devaluation of the entire Eurozone.
To date, I have talked about the EU as a external-deficit neutral block.
you can’t have Germany and Spain both running current account surpluses, unless the EU as a whole runs a current account surplus. So, if Germany (or the Netherlands) wants to be the export juggernaut and run a massive current account surplus, this has intra-EU ramifications. The most important is that Germany’s (or the Netherlands’) current account surplus (capital account deficit) is matched by current account deficits (capital account surpluses) in Spain (Portugal, Greece, Ireland and Italy).
But, if the Euro fell to parity with the US Dollar for example, the Eurozone would become a net exporter, pushing the US external balance even more into the red.
Neither of these scenarios is particularly palatable as they are likely to increase already mounting trade friction. The other Edward mentions the only other viable alternative: a restructuring or default.