Greece will default, but not this year – W.Munchau

Greece will default, but not this year

By Wolfgang Münchau

Published: April 4 2010

I am willing to risk two predictions. The first is that Greece will not default this year. The second is that Greece will default. The Greek government has demonstrated that it can still borrow at a rate of about 6 per cent but if you do the maths on the public debt dynamics, as I did recently, it would be hard to arrive at any other scenario than an eventual default.

The adjustment effort needed to prevent a debt explosion is extremely large. The Nordic countries achieved adjustment on a similar scale during the 1980s and 1990s, but they had two advantages over Greece. They did it in a different global environment; but more crucially they were, in part, able to devalue and improve their competitiveness. As a member of a large monetary union Greece can improve its competitiveness only through relative disinflation against the eurozone average, which in effect means through deflation. But as the French economist Jacques Delpla* has pointed out, this will invariably produce a debt-deflation dynamic in the Greek private sector of the kind described by the economist Irving Fisher during the 1930s.

So Greece will not only have to make an extremely large public sector deficit reduction effort but it will also have to do this under a condition of disinflation, and possibly deflation, which would push its nominal growth rate to negative levels during the adjustment period. That, in turn, would jeopardise the debt reduction programme of both the public and private sectors. Under those circumstances, there is no way that Greece could ever stabilise its debt-to-gross domestic product ratio, no matter how hard the government of George Papandreou tries.

To get out of this mess, one of five things will have to happen. The first, and most optimistic, solution would be a significant fall in the euro’s exchange rate, say to parity with the US dollar, coupled with a strong recovery in the eurozone. This might just do the trick to sustain Greek growth as it adjusts. The second is that Greece gets access to low interest rate loans from the European Union and the International Monetary Fund. The third would be a private sector debt restructuring to prevent a Fisher-style debt-deflation dynamic. The fourth is that Greece leaves the eurozone. The fifth is default. If you go through the options one by one, you realise that the first is improbable. The EU has in effect ruled out the second. The third would require an unlikely additional bail-out of the European banks. While option four would be most convenient for the Germans, the Greeks are not so stupid as to leave the eurozone. That leaves them with option five: to default inside the eurozone. It is the only option that is consistent with what we know.

But it would throw the eurozone into a potentially terminal crisis. Spain and Portugal have problems of a different kind but of a similar dimension. Spain will have to go through a disinflation/deflation period that will produce a formidable private sector debt-deflation spiral. Without devaluation, or the possibility of a sustained fiscal boost, the Spanish depression could last forever, or at least for as long as the country stays in the monetary union. Portugal, like Greece, suffers from a combined public and private sector debt problem.

When a country such as Greece pays 300 basis points over the yield of a supposed risk-free bond, this means, mathematically, that investors see a probability of around 17 per cent that they will lose 17 per cent of their investment. So in other words, a spread of 300 basis points is a valuation in which default is still considered improbable. If those perceptions changed from improbable to, say, moderately probable, the yield spreads between southern European countries and Germany would explode.

For the time being, Greece can get by because of its excellent debt management, which is why I am confident that Greece is not going to need an immediate bail-out. But given the political economy of the EU, this might turn out to be a disadvantage. Europe’s complacent leaders will only step in if a crisis is both imminent and visible. The really treacherous aspect about the Greek crisis is that the country’s liquidity position is better than its solvency position. Insolvency is a gradual, invisible process. The negative effects of debt-deflation dynamics have not yet begun, but will become inevitable as the Greek public and private sectors go through a simultaneous debt reduction process. In such an environment my assumption of a 2 per cent rate of nominal growth might be far too optimistic. And even with such an unrealistically optimistic assumption, default would be hard to avoid.

There have only ever been two intellectually honest views about economic and monetary union. The first is that it could not work, as it would eventually produce a situation in which a country’s national interest conflicts with the interest of the monetary union at large. The second is that it could work, but only for as long as member states are ready to co-ordinate economic policy in the short run, and move towards a minimally sufficient fiscal union in the long run. The message from the EU, and from Germany in particular, is that the latter has now been ruled out.


4 responses to “Greece will default, but not this year – W.Munchau

  1. «The first, and most optimistic, solution would be a significant fall in the euro’s exchange rate, say to parity with the US dollar, coupled with a strong recovery in the eurozone.»

    Even a strong recovery in the eurozone would be likely met by a more sustainable and stronger one in USA. Thus, a depreciating euro against dollar is not such an optimistic scenario at least in the short and medium run. This partly might sustain Greek growth as it adjusts. Greece will also get access to low interest rate loans not from the European Union and the International Monetary Fund -not required-, but due to a global and eurozone recovery, funds will be «desperate» to be given as loans to a eurozone member as Greece, given that it would become crystal clear that Greece will remain a eurozone member. Buying a greek government bond is an investment opportunity without any historical precedence, i.e. a 7% return in euros without real default risk and without the fear of a really depreciating currency. («Markets» lend cheaper even at Hungary, a non-eurozone member. «Markets» exaggerate on both sides, upwards and downwards».

    Jean-Claude Trichet said on Thursday 8/4/2010 that «markets are always right». Are they? If we are not, they are not, and Greeks tend not to be right!

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  2. The above first comment is written from Petros Golitsis too.

    «The Greek government has demonstrated that it can still borrow at a rate of about 6 per cent but if you do the maths on the public debt dynamics, as I did recently, it would be hard to arrive at any other scenario than an eventual default.»

    The Greek government can borrow at a rate of about 6-7 per cent, but there is no need to do the public debt dynamics given that the spread «against» german bonds will not remain widened from 300-400bps (basis points).

    Ten-year Greek bonds GR10YT=RR yielded more than 400 basis points over equivalent-maturity Bunds EU10YT=RR, on first week of April 2010, when 4-7 years ago, the extra yield was close to 0bps, thus I repeat that markets exaggerate on BOTH sides and markets are NOT right.

    Petros Golitsis

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  3. Before joining FT Deutschland, Mr Munchau was a Frankfurt correspondent and later economics correspondent of the Financial Times, reporting on the preparation for the final stage of monetary union and the launch of the Euro. Between 1988 and 1995 he held several posts at The Times newspaper, including Washington and Brussels correspondent. In 1989 he was a recipient of the Wincott Young Financial Journalist of the Year award. He holds an M.A. in International Journalism (City University) and Diplom-Betriebswirt (Reutlingen). His column appears on Mondays


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  4. Πέτρος Γκολίτσης

    Being Stupid and/or having no Sovereignty: The Greek case

    By giving up national power in terms of monetary policy making (in order to enter E.M.U.) and by limiting (not really eventually) fiscal policy independence due to the Maastricht Criteria, Greece did gain a credibility that had never imagined and a macroeconomic stability that would have taken decades to be achieved.

    Some weeks ago the newly Greek government did manage eventually to take some structural measures to a proper direction, trying to change the public debt dynamics, without causing any social unrest (an achievement after all). By doing so it gave a proper signal to markets that are always “right” (as J.C.Trichet said) and it managed to decrease the bond’s spread and the Greek government did borrow 5 billion Euros at a 5.9%, a very good borrowing rate, given that days ago it had “managed” to borrow funds at 7%. J.C. Trichet, the central banker of Eurozone repeatedly has been highlighting that Greece will not default. Thus, that was a point that no further political actions should be taken anymore. Decreasing spread was a matter of time and smoothing had started and “others” were already back on growth! The ideal scenario for the given circumstances.

    Unfortunately, at that exact point a “bonehead” move was made by the government, mentioning I.M.F., giving the signal to the markets that Greece has real issues in covering its debt obligations. It should be noted that countries historically avoid considering even as a hypothesis I.M.F., unless they are about to financially collapse (i.e. I.M.F. is identical with saying markets will stop lending funds at this less developed country (LDC), a Eurozone member in our case!). It should be noted also that during these days a Turkish naval ship did almost approach the mainland of Greece by going between Andros and Evia. This “message” could be interpreted as following: “Now, that you Greeks decrease Government spending, do Not consider to decrease your defense spending also.
    At this context, the I.M.F. “bluffing” approach to Germans mainly, was not unfortunately a bonehead move only, but it does also imply that Greeks keep on not being nationally sovereign (to a degree that could not be imagined even by the naïve ones).

    Thus, I.M.F. was used in the case of Greece in order to “attack” the economical integration procedure of Europe and make the political one a further remote scenario that eventually will be forgotten. The Germans seem to have adopted this scenario. The historical perspective, importance and the role of E.U. are adopted mainly by E.C.B. and not by the politicians!

    Overall it is a case-situation that you wish to be governed by just a stupid and impotent government and useless or ineffectual consultants, but unfortunately you are governed by a people that have no sovereignty and are just “means” within a geopolitical game.

    Going back to the subordinate economics to politics: Inflation is not significant within such a short-run context, thus it was not considered. Interesting and disappointing times –as usual- overall.

    Petros Golitsis

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