Sunday, July 3, 2011

The Moveable Greek Debt Crisis

The Euro Bloc's strategy for dealing with the Greek (and Irish, Portuguese et al.) debt crisis is becoming increasingly clear. Stall for time, bring in new bailout money, hope for economic growth (with the prospects murky), and hope that taxpayers can eventually be persuaded to bear a large portion of the cost of default.

First, let's be clear that the Greek debt crisis isn't a sovereign debt crisis as much as it is a European banking crisis. The major Greek, German and French banks all hold large amounts of Greek debt. A Greek default would imperil these banks, especially if the Greek debt crisis has a domino effect of putting Irish, Portuguese, Spanish, Italian and whatever else debt (which many banks also hold) under stress. German and French taxpayers would have no choice but to bail out their own nations' banks. That would put a lot of bees in their bonnets.

Even worse, the European Central Bank holds a lot of Greek debt (and debt of other EU member nations). If Greek debt defaults, and especially if there is a domino effect, the ECB could become insolvent. This would mean the collapse of the Euro. That would be a very bad thing.

The Euro bloc has been assiduously cultivating the Chinese, holders of $3 trillion of foreign reserves they need to invest somewhere. The Chinese have bought their fill of dollar-denominated debt, and are looking for alternatives. They have been willing to toss some capital at Greek debt, knowing that the goodwill they get in return is worth more than the losses they'll sustain. But China won't fork over the amounts of money needed to resolve the European debt crisis--their foreign policy is focused on expanding their influence and advantages. Marshall Plans aren't on their agenda.

By the skin of its teeth, the Greek government has signed off on more austerity, paving the way for bailout funding of $17 billion to pay debt coming due this month. The EU has been working on a second bailout package of over $100 billion because Greece has more debt coming due this year and over the next three years which it can't pay. The second bailout was to have been arranged this month, but German insistence on some private sector absorption of losses forced the EU to push back the timetable for completion to September. (The losses would take the form of reinvestment of some current bond repayments into new long term--30-year--debt, but that's economically tantamount to a loss.) Although the Germans and French have been talking about "voluntary" acceptance of losses, the rating agencies have been saying that if it looks, walks and quacks like a default, they're going to call it a default. A default would trigger an immediate banking crisis in Europe, with major banks and the ECB circling the big bowl.

One could say we have a rating agency crisis. The rating agencies, having been revealed to be fools (and maybe worse) during the mortgage crisis, are trying to do the one thing that debtors don't want them to do--be candid. Oddly, in this instance, it's the creditors who are squealing the loudest, because candor will expose the fragility of their banking system and dump shock and awe on their currency.

It remains to be seen who will prevail in this struggle. The rating agencies will come under astronomical amounts of political and commercial pressure to somehow look the other way as the Europeans cover their debts and currencies with fig leafs. Prior history does not auger well for the rating agencies to continue demonstrating backbone. But if the rating agencies can't bring themselves to kiss this pig, we will likely see repeated episodes of stalling and delaying on the question of private sector losses, while the rating agencies are hauled into back alleys, and are threatened direly and offered inducements of many varieties. The can will receive many kicks down the road while the total amount of unpayable Greek debt increases and then increases some more.

Of course, such a dynamic cannot continue indefinitely. But the ending is impossible to predict. One can only rest assured that it will be ugly.

One positive note for America on the eve of its national holiday: the Euro isn't the world's reserve currency and won't become such as long as the sovereign debt crisis threatens to gut the ECB on a moment's notice due a downgrade by the rating agencies. The U.S. Federal Reserve will maintain its as large as necessary currency swap arrangements with other central banks to provide continued availability of dollars, ensuring some stability in international finance, and perhaps just as importantly, preserving the supremacy of the dollar.

Thus, European debt dysfunction allows the dollar to continue its reign as the world's reserve currency. This would be especially so if the administration and Congress resolve the looming debt ceiling problem in a timely manner. The sovereign debt crisis exposes the Euro's true vulnerabilities to Europe's fractured politics. The dollar, for all its problems, still stands tall, and will continue to stand tall if America can demonstrate political maturity. Happy Fourth.

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