The Making of a Greek Tragedy

Posted by Stratfor - Eric Sprott and David Franklin

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Greece has not had many good days in 2010, but Thursday was a particularly bad day. First, Europe’s statistical office (Eurostat) revised up the Greek 2009 budget deficit, which placed Athens’ accounting shenanigans in the spotlight again. The bottom line is that the situation is even worse than previously thought, and the budget deficit may very well be adjusted up as more Greek accounting malfeasance comes to light. Following the announcement, credit rating agency Moody’ s dropped Greece’s credit rating one notch, immediately prompting a rise in Greek government bond yields, thus increasing Athens’ borrowing costs.

The yield on a Greek 10-year bond shot above nine percent, while a two-year bond rose above 11 percent, both record highs since Greece joined the eurozone. Particularly daunting is the fact that short-term debt financing is now more expensive than long-term funding. This situation is referred to as an “inverted yield curve,” and it is generally considered a harbinger of financial doom. This means that investors are sensing that Athens is more likely to experience problems sooner rather than later.

Higher yields mean that Greece is facing increasingly larger interest payments on an increasingly larger stock of debt. This all but confirms that Athens’ claim that its stock of public debt will peak at 120 percent of gross domestic product (GDP) is simply wishful thinking. Worse still, Greece is also facing continued economic recession, induced in part by Athens’ austerity measures designed to reduce its budget deficit. Given this vicious dynamic, we cannot see how Greece’s debt level will stabilize at anything below 150 percent of GDP range.

The point is that the financial writing is now on the proverbial wall; some form of default is simply unavoidable. Exactly how the Greek default will unfold is unclear, but the bottom line is that the question now is not “if” but “when.” Under “normal” circumstances, when the IMF becomes involved with a country in a situation similar to Greece’s, the standard procedure is to devalue the local currency. By lowering the relative prices within the economy, the devaluation increases the competitiveness of the country’s export sector and helps to reorient the economy toward external demand. Devaluation is also politically expedient because regaining competitiveness does not require employers to slash employees’ wages, as the devaluation adjusts the relative costs silently and discreetly.

However, Greece does not have the option of devaluation because it is locked into a monetary union. The eurozone’s monetary policy is controlled by the Frankfurt-based European Central Bank. The fact that Greece is locked in the “euro straitjacket” raises two questions, the first being how the Greek debt crisis will play out.

Without the option of devaluation, the Greeks will have to implement and endure draconian austerity measures – in addition to the ones it has already enacted – similar to what Latvia and Argentina endured as part of their IMF programs. Argentina in 2000 and Latvia in 2008 also could not go the currency devaluation route because neither country controlled its monetary policy. In Argentina’ s case, the austerity measures were so severe that they caused considerable social unrest – including a brief period of outright anarchy in late 2001, which saw the country go through five heads of government in about two weeks – ultimately culminating in the country’s partial debt default in 2002. To this day, Argentina is still dealing with the fallout of that financial calamity.

Latvia is a case of more recent vintage. In late 2008, Latvia agreed to what the IMF itself has called one of the most severe austerity programs since the 1970s. To accomplish it, Latvia has done everything from slashing public sector wages by 25 to 40 percent, increasing taxes, reducing unemployment and maternity benefits and cutting the defense budget. The crisis has already cost the Latvian prime minister his job and stoked social unrest. Despite all of that, the budget deficit has not budged much, remaining around eight percent of the GDP mark. Spending has been cut to the bone, but Latvia is simply too small of an economy to emerge from recession on its own.

Since the broader European economic recovery remains moribund at best, less government spending has translated directly to less growth. Less growth means less tax income, and less tax income means that the country’ s budget deficit remains stubbornly high. Latvia has essentially become a ward of the IMF, and will remain so until either the broader European economic recovery is more robust or the Baltic state is fast-tracked into the eurozone itself.

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece’s part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

The next question is what the rest of Europe will look like, and there is no shortage of impacts. Europe, and Germany in particular, must decide whether and to what extent it should “bail out” the Greeks. How that might happen is now the topic of the day in Europe. Driving the urgency is this simple fact: In the absence of substantial (and subsidized) financial assistance, Greece will inevitably default on its debts, thus generating write-downs for all those who hold Greek government debt (mostly European banks).

The Greek default therefore is no longer an isolated problem, but a problem that threatens to aggravate an already weakened European banking sector. One of the most misunderstood facts of the international financial world is that even at the peak of the U.S. subprime crisis, in the dark hours when American hedge funds seemed to be snapping like matchsticks, Europe’s banks were in even worse shape. As the Americans stabilized, so did their banks. But Europe never cleaned house, and now a Greek tsunami is poised to wash over the whole mess. [emphasis mine – JM]


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John F. Mauldin