Thursday, June 16, 2011

Greek default looms

Previously I had predicted that Greece would default within six months. It is now evident that I was a tad over-optimistic. Default will occur considerably sooner than that.

First of all, Germany won’t mount another bailout unless Greece embraces reform and unless bondholders take some pain. Far from embracing reform, the Greeks are rioting and the government is falling. (Video footage of violent riots has become one of Greece’s fastest growing exports.)

It will be difficult to form a unity government committed to reform, because the opposition would rather renegotiate the bailout that Greece got a year ago, which will not be music to German ears. The Greek plan is to demand a new bailout while defaulting on the prior one. Angela will not be amused.

Greece cannot commit to reform because the people won’t accept it. Germany can’t agree to a bailout unless Greece commits to reform. The ECB, Greece’s largest creditor, refuses to participate in any debt reprofiling, which Merkel demands.

Therefore, Greece will soon run out of money to pay its maturing liabilities and will therefore default, along with its banking system which will collapse.

In my opinion, Greece has no choice but to default, exit the eurozone and redenominate its currency and its debt.

The consequent losses to European banks will be large. This would set up another Lehman event, in which the interbank markets freeze. The ECB will be the provider  of liquidity, until the losses are sorted out and the banks are recapitalized.

The Fed will have to step up liquidity operations as well, as in 2008. This will be a deflationary event and may require QE3. Real possibility of a double dip in the 3rd quarter.

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