Saturday, January 30, 2010

Will Greece default?

Remember the East Asian crisis of 1997-8? The crisis was sparked by the famous "fall of the baht", when Thailand was unable to maintain the peg to the dollar, causing a run on the country's short-term debt. This in turn sparked scrutiny of nearby counties with similarly mismatched external positions (too much short-term dollar debt, too little dollar reserves). 

Creditors turned on Korea, Indonesia and even Malaysia (which wasn't mismatched, but was in the wrong neighborhood). Ultimately, the Clinton administration and the IMF organized rescue packages that ended the runs, but not before the virus infected Russia, which did default. 

One of the many lessons of the crisis was "put out the fire before it spreads to the rest of the neighborhood". 

We may now be witnessing the beginning of another financial crisis in what had been one of the most stable parts of the world: the eurozone. 

I think that it is only a matter of time before Greece loses the confidence of the international capital markets and is unable to refinance. This would force the EU to confront an almost impossible situation: either let Greece go, sparking contagion to other weak eurozoners (Italy, Portugal, Spain, Ireland); or, cobble together a rescue mechanism that might need to be extended to others. This is clearly causing huge angst in Brussels.

The Times (UK) reports today that:
Leaked documents have revealed Brussels will publish a plan for Greece this week, under the headline “Urgent measures to be taken by May 15, 2010”.The package includes demands to “cut average nominal wages, including in central government, local governments, state agencies and other public institutions”. 

This isn't going to work. The Greek (socialist, union-dominated) government is in no position politically to implement such a scheme. Most indebted governments have three choices: default, devalue or deflate. Greece can't devalue because it (like Michigan) has no national currency, and it can't deflate by raising interest rates over which it has no control (also like Michigan). The only way it can restore competitiveness is to use fiscal policy to force a deflationary recession, which is politically impossible. 

This leaves Brussels two unpalatable options: default or bailout. If they are smart, they will choose bailout (with strict conditionality). But right now it appears that there is no EU consensus on this question. It should also be noted that the EU has very limited federal revenue and a tiny balance sheet. Any rescue will have to be funded by Germany and France, so this will ultimately be up to Nicholas and Angela. Gordon (not in the zone) has signaled that he will sit this one out.

1 comment:

Anonymous said...

You'd have to label this Mahoney piece prescient.