Is there a famine in Bavaria? No, but Edmund Stoiber, former German state premier, said famine was likely as bailouts in the eurozone. Bailouts reward reckless lenders and governments, and skew society’s limited resources to feckless ends.
Yet propping up Greece with taxpayers money has been top of the to-do list in the chancelleries of Europe for over a year. In May 2010 the European Union (E.U) and the International Monetary Fund (IMF) allocated €110 billion to stave off a Greek default. Any new package would be throwing good money after bad, and prolong Greece’s pain for no gain.
Time and time again European politicians and bureaucrats promised bailouts would never happen. The E.U has an explicit ‘no bail out’ clause in its formative treaty. The European Central Bank cannot fund member state’s deficits. The European Stability and Growth Pact threatens states whose budget deficits exceed 3 per cent.
Canny or stupid, markets thought otherwise. After dropping the drachma in 2001, Greece gorged on cheap loans, frittering the money away on the Olympic Games and a bloated bureaucracy. Spreads on euro-denominated Greek bonds plummeted to a few measly basis points above their German equivalents. Greece routinely ran budget deficits in excess of 6 per cent of GDP; its debt to GDP ratio surged forty percentage points to 148 per cent between 2000 and 2010.
It is delusional to hope Greece will pull through. Its economy is anemic, and interest payments on its €329 billion debt absorb about a quarter of Greek revenues already, not to mention the political impossibility of ongoing transfers from other European (German) taxpayers to Greek. Rolling over Greece’s debt at market rates today, which are above 16 per cent, would mop up the entire budget, an intolerable situation for a sovereign country, where willingness to pay, not ability, matters.
Widespread prognoses that a Greek default will spark economic Armageddon are probably wrong, and certainly wrong-headed. Yes, German and French banks are heavily exposed to Greece. But their combined exposures of €88 billion – according to the Bank for International Settlements – are dwarfed by the total capital of French banks alone.
If losses on bonds don’t “throw the world back into the dark ages”, as one commentator foreshadowed last week, credit defaults swaps will. Payment clauses in the popular derivative contracts, which enable banks to buy and sell insurance against exposures they don’t have, will be triggered if Greece defaults.
But data from DTCC, a derivative data provider, show the net notional exposure arising from credit defaults swaps referenced to Greece is only $4.7 billion. So the maximum net transfer of funds in the event of a default, across many banks around the world, is not much more than the losses National Australia Bank incurred from its Homeside lending fiasco about ten years ago.
These two analyses also assume a Greek (or Italian) default means banks recover nothing, when historical experience points to significant, if delayed, repayment when countries default. Even Russia paid back some of the tsars’ debts when communism fell. European banks, which remain highly profitable, point to ‘contagion’ if they lose a dime on any of their Greek loans. But remember they also have an incentive to scare governments into taking on as much of the cost of any default as possible.
A Greek default would send a salutary signal to lenders and borrowers that bad decisions will not be subsidised by taxpayers. It is fair and efficient that banks lose money on bad loans. A Greek default would also make an example of a country whose approach to fiscal affairs has been continually recalcitrant.
Now more than ever markets need to learn these lessons. In the wake of the financial crisis, governments have rescued financial institutions whose business models would and should have died, poisoning the system further with moral hazard. That process needs to be unwound.
If the world financial system cannot truly withstand the sovereign default of a country the size of Victoria, then it is woefully undercapitalised and a public menace. Bank regulators’ plans to increase bank capital ratios from 4 per cent to 7 per cent by 2019 might not be sufficiently tough or urgent.
The Greek people should reap what they sow too. Greece is a democracy with compulsory voting, whose citizens never saw fit to elect a prudent government. A default could curtail Greece’s access to credit markets; but it would give Greece a balance budget rule with teeth. Some say living within your means is austerity, it is also prudence.
It was a mistake to let Greece in the eurozone, but it should be encouraged to leave. Departure of such a tiny country will not unscramble the rest of the eurozone, and the country’s competitiveness is hobbled while it cannot devalue its currency. Greece can stay part of the E.U.
Whatever short-term costs might arise from a Greek default, it is better that Europe endures them than encourage further bad decisions. These could have consequences that erupt far more damagingly later, and pose a genuine threat to the financial system. Greece led the world with democracy; let’s not make it the vanguard of our fiscal future too.
This article was first published in The Australian Financial Review on July 25, 2011.