Thursday, May 6, 2010

Europe: Time for Plan B

Europe is heading into the abyss. 

The EUR 110B Greek rescue package is a bridge loan that keeps Greece out of the capital market for only 18 months, and then assumes that all will be well. 

At the end of 2011, when the bailout runs out, Greece will have higher debt and a a smaller GDP. A country with an unsustainable debt load will be unable to issue debt at reasonable spreads. 

This is obvious to all observers, which is why the bailout lacks credibility. And as investors lose confidence, they will fly to quality and abandon the rest of the PIGS (or PIIGS, because Ireland looks awful). 

What are the options for the peripheral members? I see three:
  • Rescheduling (default).
  • Rescue by the ECB.
  • Redenomination, devaluation and inflation.

Rescheduling means loss of market access and a massive fiscal consolidation: a nonstarter. An ECB rescue has been vetoed by the  Teutonic bloc and "has not been discussed". Germany doesn't want its currency backed by Mediterranean junk bonds.

I had been under the impression that a unilateral redenomination of government bonds would be treated legally as default. However, Vincent Truglia (former head of Moody's sovereign risk unit) thinks otherwise. He says that (1) redenomination was not default when the euro was adopted; and (2) the election of law on Greek governments is Greek, which is to say debtor-friendly (no default). 

So Vincent argues that the peripherals should immediately redenominate, devalue and inflate. I agree. The open question is whether to continue to service external debt or to do an Argentina and give foreigners a haircut. Vincent says that devaluation will accomplish this without a legal default.

The price of quitting the euro is the risk of being kicked out of the EU, but there is no legal mechanism to expel a member. But you have to ask: is Greece European or Near Eastern? It was part of the Ottoman Empire for centuries. It sure is no Finland. As my Spanish colleague used to say, "It is not a serious country".

The problem here is that there is little public consideration being given to redenomination and resurrection of the drachma. Instead, Europe and Papandreou are wedded to the austerity/rescue plan, which will lead to an even bigger train wreck. 

Oh, and by the way, the Bundestag has not yet voted for the rescue and it's not in the bag. That would lead directly to Plan B. 

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