As an economist, it’s hard to look at the financial news coming out of Europe recently and not get a sense of déjà vu. In the last few weeks we have witnessed the most severe stock market crashes since the post-Lehman meltdown, a major European bank has needed to be bailed out, the recovery appears to have petered out (on both sides of the Atlantic no less) and frantic discussions are taking place in the upper echelons of power in order to starve off what many believe is another imminent disaster. I don’t want to sound nostalgic but it sure is feeling like the summer of 2008, this time with Europe rather than Wall Street at the center of the gathering storm.
But it’s time to stop and think for a minute. How did we get from a debt crisis in a peripheral member of the Eurozone, to openly contemplate the breakdown of the world’s biggest and most solid economic union? To answer this question, it is necessary to see the current European crisis from two separate angles. The first is through the simple logic of economic fundamentals of debt and growth. As I will try to prove in this post (and its follow ups), the fundamentals are actually not as dire as most people think. However, the second angle is indeed quite frightening. It is that of a market crisis, triggered by a loss of confidence in European policymakers’ ability to effectively address a series of worst case scenarios related to the integrity and future of the Eurozone. Will any of these scenarios actually play out? Only if markets believe they will, thus becoming a textbook case of a self-fulfilling prophecy of apocalyptic proportions. Because if there’s anything to be learned from economic history, it is that when reason and panic collide, panic will always win out.
What follows is my humble attempt at trying to put reason back into the spotlight. So put down the latest newspaper or magazine cover story on the Euro breaking apart, turn off that video with the ranting analyst preaching doom and gloom. Let’s look at the cold hard facts.
Is a Greek collapse really a threat?
There’s no better example of how the market has gotten the best of everyone by understanding the fundamentals of the Greek crisis. First of all, I am hardly one to underestimate the dire situation facing the Greek economy: it is corrupt, unproductive, and by now, clearly insolvent. But why a crisis in a peripheral European state is causing the market (and some supposedly smart economists and journalists) to conclude that the Eurozone is going to collapse is downright ludicrous when looking at the bare facts. With an economy of just over $300 billion, Greece is but a fraction of the Eurozone’s $12 trillion economy and its banks can hardly be considered a critical node in the European banking system as say, even tiny Luxembourg’s would be. According to the latest figures from the Bank of International Settlements (BIS), European banks have about $127.8 billion of exposure to Greek debt, of which only $42.9 billion is actually public debt. Furthermore, even under a scenario of default followed by debt restructuring, at least part of the value of this debt would ultimately be recovered, and whatever losses could surely be covered up at least partially through government-financed recapitalization if they are deemed to put a bank’s solvency at risk. In a nutshell: there’s nothing to suggest that a Greek default would be worse to the global financial system than Argentina’s more catastrophic collapse in 2001. And things weren’t particularly rosy back then either: most of Argentina’s debt was owed to US banks which were feeling the brunt of the dot-com crash.
Back in early 2010, I co-wrote a paper with my former boss at Chatham House (Vanessa Rossi) on the Greek crisis which had erupted just a few months earlier. Reading it over again, it almost seems naïve, given the lack of any apocalyptic scenarios which now dominate the headlines. But back then, the main concern was simple: if the Greek government could make it through April/May when a large chunk of debt was due, then it would probably live to see better days. But in the eyes of the market, that would not be enough. Doubts began to surface over the Eurozone’s leadership, and on how it would manage a potential bailout (or worse, default). Yields began to soar towards the end of the year and the first of many bailouts came to be. By then the media’s doomsday scenarios of a Euro breakdown were quite common and bailout or even default fears had spread to Portugal (which we had actually identified in that paper to be the country closest to Greece in terms of its debt dynamics), and also Ireland and Spain. But looking back on that paper, I am hard pressed to see any fundamental changes to Greece’s fiscal or macroeconomic situation except one: its yields are higher. And its yields are higher because the market has pushed them higher, mostly as a result of poor handling of the crisis by Eurozone policymakers and the uncertainty over the regional mechanisms to manage situations like bailouts and defaults. This is hardly Greece’s fault, and the fact remains that a crisis which at first was merely a liquidity crisis, turned into a solvency crisis once yields got pushed to unsustainable levels (back then yields on Greek debt were only around 6.5%; today they are a soul-destroying 24%).
A sceptic will say that size doesn’t matter: the linkages do and by virtue of being so closely intertwined within the European financial system, the situation of Greece is not too dissimilar to that facing US banks at the height of the financial panic of 2007-08, when nobody knew the scale of exposure to toxic subprime assets. This is an intellectually dishonest comparison, mostly because back in 2007-08 the exposure of banks to subprime assets was largely unknown – often to the very banks themselves. This is because many of these assets were hidden away from banks’ balance sheets and because the assets themselves were largely illiquid in the first place: banks did not profit from trading these assets as they do with your average bonds or stocks, but rather, they profited from the fees in creating and selling them, and in the interest payments received by keeping them for themselves. Because of this illiquidity, and the fact that they were mostly traded over-the-counter (i.e. between banks themselves), the market value of these assets was almost impossible to assess. But as toxic as Greek bonds might appear today, they share few of the opaque characteristics of their MBS and CDO cousins: they are visibly traded in exchanges, their value is known to the market on every second of every day, and it’s no secret who has them. Allow me to spare you the trouble of googling it. Going one step further, a simple calculator is all that’s needed to find out the likely writedowns which a bank will face from its exposure to Greek debt. Try this for size: imagine a Greek 10-year bond trading at a 10% yield (which was roughly its price a year ago). Now it’s trading at 24%. That’s approximately 40 cents on the euro (i.e. it’s trading at a 60% loss). So if a bank like Dexia holds around €3.4 billion in Greek debt, that’s worth about €1.4 billion at current market prices – a €2 billion loss. Pretty daunting numbers for a bank with a market capitalization of just that after its stock market hammering. But at least we know who’s exposed, and more or less by how much. We didn’t have that luxury back in 2007-08.
Why the worst-case scenario ain’t so bad
So with all this in mind, what’s the big fat Greek deal? So what if it defaults (it will and it should)? So what if it leaves the Euro (it won’t but it probably should too)? In the most likely scenario, a default would put a number of European banks in a lot of pressure, but I find it inconceivable that their respective governments would not recapitalise them, particularly since the cost of recapitalizing them would be a fraction of what was needed in 2007-08 in the US when subprime losses tore even bigger holes in banks’ balance sheets (AIG alone needed over $100 billion – that’s around 30 Dexias). And in the worst case scenario that it leaves the Euro, then the plus side is that whether or not it manages to crawl out of its recession no longer becomes the Eurozone’s business: Greece would be on its own. In fact, the Eurozone would be slightly better off if Greece did leave as its aggregate fiscal situation would improve now that its most imprudent member has left. The benefits for Greece would be mixed. First off, it would probably face only a very modest improvement in competitiveness from a devaluation of its new post-Euro currency, at the expense of facing the wrath of international bondholders who would still want to be paid back in Euros, and the wrath of its own domestic banking system which would call for compensation for the losses caused by a devaluation. But in the long run, the benefits of having its own currency and an independent monetary policy will probably offset the short-term costs. Plus, the trauma of a lost decade is likely to whip some economic responsibility into Greek policymakers. The success of so many macroeconomic basketcases (just look at Latin America for example) in taming runaway inflation and keeping their fiscal house in order over the last decade is testament that, yes, even the Greeks can do it too. Whatever path it takes, Greece is going to have to slug it through. But that’s still a far cry from saying that the Eurozone should be dragged along with it.
So in a nutshell, no, the Greek debt crisis, as bad as it is, should not in itself threaten the existence of the Eurozone. For that to happen, a much bigger cookie would have to crumble. In the next installment I’ll write about what really keeps most European politicians awake at night.