So Greece finally had its debt reduced substantially, (private) bondholders will have to take a 50 % haircut. This will save Greece 100 billion euro, or about 140 billion dollars.
Problem solved? No. The fact is, there is no happy ending in sight, no matter how things turn out. There are scenarios that involve more pain now, less pain later, and less pain now and more later. As is usual when governments step in to solve economic crises, they’ve already planted the seeds to the next one.
To make things easy, here are a list of problems in the eurozone right now that might ruin the party that is right now going on in the stock markets:
1) The main problem is moral hazard. How are investors ever going to trust Greece, or any other of the troubled countries in the eurozone again? The default (because that is essentially what it is) will remain as a black mark on Greece’s record for a long time. This is a country that doesn’t even manage to collect taxes from its citizens, why would you ever invest there? Even if the risk of default became lower, why would you invest there when there are so many other countries to pick from? What “competitive advantage” does Greece have? Essentially, the problem comes down to greek citizens being irresponsible. What in this deal is going to teach them to be more responsible?
2) The Eurozone has shown that it is not an optimal currency area and that it’s impossible to set an interest rate that suits everyone. Individual countries may adjust this through fiscal policy, but that’s hard to do in practice. This is a structural issue that is not going away. Now that investors know this, why would they invest in an area that is so obviously going to end up in a crisis again within a decade or so? It may not be Greece the next time, but there will always be someone.
3) Greece is likely to remain on life support for another decade. Will there be a political will to support Greece for that long? What if Angela Merkel loses the next election (not completely unrealistic)? In Finland, a new party managed to get 20 % of the votes simply by promising that if elected, Finland would not aid the PIIGS countries. Just the threat that something like that might happen in France or Germany could be enough for them to decide to pull the plug.
4) Still there is little focus on fiscal policy reform in the Eurozone. Unlike the US where the Balanced Budget Amendment is discussed most all the time, nothing like that has ever been suggested here. We have rules for how big the deficit can be allowed to be, yes, but no-one really cares about them (not even France and Germany) and they are not in any country’s constitution. While BBA may not be an ideal solution, the fact that no-one is even mentioning the idea shows that most Europeans are still in denial about what caused this crisis.
5) On that issue, the only thing being discussed is a fiscal union. That would be the end of independence for any European country in the EU. Individual countries would no longer be allowed to set their own tax rates, which, in addition to being an undemocratic nightmare, is also economically insane: If Germany is allowed to set Ireland’s tax rates, then who’s to say they won’t deliberately destroy the Irish business environment and raise taxes in order to attract investors to Germany, who would otherwise have invested in Ireland? France (among others) have already tried to force Ireland to raise it’s corporate tax rate (right now at 12.5 %), arguing that it constitutes unfair competition. For all the talk about “European unity”, at the end of the day Sarkozy cares mostly about France, and Merkel mostly about Germany. Nothing strange about that – but it does make a fiscal (and a monetary) union unworkable.
6) Who will lose when Greece defaults on 30 % of its bonds? The banks who held them (in addition to pension funds etc, but let’s ignore them for the moment). This makes for a more fragile banking system, which isn’t really a good thing when you’re trying to create an economic recovery. If one of these banks need money, it will probably mean higher interest rates for borrowers and/or lower interest rates for savers.
7) There is still a high risk associated with investing in Greece, or really anywhere in the Eurozone. In order to justify a high risk, you must offer investors a high return. This means high bond yields as well as high dividends. The last part is particularly troubling because if a company has to pay out more money in dividends, that means less money left over to be reinvested, for instance in Research & Development (R&D). This means we get fewer technological advancements, which means a lower long-term growth (since technology is the only thing that creates long-term growth).
While investors are happy right now, once they analyze matters they’ll most likely realize that all these above problems remain. Short-term investments may go up, but in order to attract long-term investments (among those are hiring decisions by employers), you will need to solve the structural issues so that investors can feel certain that something like what has happened in the past couple of years will never happen again.
There are more issues that I could bring up, but I still feel it’s time to move on to the issue which I suspect most of the readers care more about: How does this affect the US? Again, it’s mostly bad news. There are basically two scenarios here, and as you can see, the US can’t really be seen as a winner no matter what:
1) The Eurozone collapses. There is still a risk this could happen, and if it does, you’re looking at another credit crunch and banks going bankrupt not only all over Europe, but most likely in the US too as they are exposed, directly and indirectly, to the Eurozone. At the minimum, there will be another global recession.
2) The Eurozone survives and everything goes back to normal. Sounds great, doesn’t it? Well, here’s the problem: A lot of investors have fled the Eurozone and invested in US bonds. If the Eurozone becomes a safe investment again, all that money will flow back, leading to higher yields on American bonds. This means borrowing costs for the US will become higher (although by how much is uncertain), which won’t really improve your already dark fiscal situation. While the net effect of a European recovery is positive (it’s still a better scenario than the one above), this could certainly turn out to be a party pooper. With the US borrowing as much as it is, even a relatively small change in the government bond yield demanded by investors can have a significant effect on the fiscal situation.
Summary
I never believed that Greece was going to be able to avoid a default, or a haircut as they prefer to call it. I’m not surprised by that, but I am surprised by the optimism so many people are showing. Yes, I realize that many of us are getting tired at only hearing bad news, but please: Can’t we fix the underlying problems before we throw a party?
It appears the answer to that question is No. And because of that, mark my words, the party will end in tears. I would not be surprised to see stocks slip back tomorrow already, and if not tomorrow then definitely on monday, after investors get a weekend to think about these issues.
To summarize, the crisis goes on. And the reason, I’m afraid, is that this is a crisis where government is not the solution to the problem, but rather government is the problem.
That’s enough for now. I’ll keep you updated. Thank you for reading.