Thursday, February 4, 2010

Thoughts on Greece and PIIGS

The top chart shows the spread on 5-year Credit Default Swaps on Greek government bonds. Spreads have shot up to over 400 bps on fears that Greece's federal deficit is spiraling out of control (with a deficit of about 12% of GDP) with no fix in sight. Similar fears have surfaced in Portugal, with spreads today reaching 230 bps, Italy (153 bps), Ireland (172 bps), and Spain (170 bps), thus giving rise to the new acronym for fiscally challenged countries: PIIGS.

(Truth be told, the US should be included in the group of PIIGS, since an objective analysis of Obama's 2011 budget implies deficits of 10% of GDP or thereabouts for at least the next several years.)

For purposes of comparison, the second chart above shows the spread on generic 5-year Credit Default Swaps on speculative grade (junk) bonds. For all the fears of a Greek default, Greek government bonds are still trading better than junk bonds, and their spreads are still far below the worst we saw for junk bonds about a year ago. In other words, while the situation does look troubling, we are still far from standing on the edge of an abyss. Nevertheless, European sovereign debt risk has managed to infect the U.S. market, helping send stocks down 3% or so today. For further purposes of comparison, the following chart compares the performance of the German DAX index and the S&P 500, with the DAX priced in dollars. Both markets appear to be moving in lockstep of late, with German stocks made more volatile by swings in the dollar's value.


The problem of Greek deficits is multifaceted. On the one hand, the EU doesn't want any of its members to run large deficits, for fear that it could bring down the Euro. Greece has no authority to print Euros, so if it can't pay its debts it must default, and that could send shockwaves through the other PIIGS and destroy confidence in everything. This might result in great pressure on other EU member countries to effectively bail out the PIIGS, but no one is enamored of that solution. On the other hand, Greece's options appear limited, since it has a socialist government that loves to spend and wants to tax the rich to pay for it. This isn't exactly working out, and the economy is struggling and supposedly very vulnerable to any attempts to cut spending or raise taxes. (If this sounds familiar to US citizens, it should be.)

I'm having trouble with the idea that all of this represents an intractable and grave problem. Why are people so quick to assume that government spending can never be cut? That any attempts to reduce fiscal deficits via spending reductions will cause grave harm to economies? In my view, the deficits are big and awful already, and that is a major problem already. Big deficits imply expanding government intervention in the economy, the risk of major increases in tax burdens, and a less efficient and slower growing economy going forward. Increasing fiscal deficits is only stimulative if they are used to finance a significant and productive cut in taxes; otherwise, higher deficits, especially when they get to 10% of GDP or more, are bad (just look at what they have done to Japan). I believe it is never a bad thing to do the right thing; if higher deficits are bad, then lower deficits are good. Cut the spending, and watch the private sector take off; that's the best way to fix these economies.

The real problem faced by the PIIGS and by the U.S. is political in nature, not economic. The party in power never seems to want to cut spending, but ultimately that is the only solution. The spending is unproductive to begin with, so eliminating it should be a net benefit. It probably requires a near-crisis to cause such a sea-change in fiscal policy, but by the looks of things we are well on the way, both here in the U.S. (with the rise of the Tea Party), and in Europe (thanks to the discipline of the bond market).


Jake said...

the fact that you can even compare the chances of default of a european country that is in the EU and a junk bond is extraordinary and the reason why risk assets are pricing down

W.E. Heasley said...

Mr. Grannis:

Agree with your analysis.

Regarding Greece and their socialist government and their propensity to tax and spend and the consequential debt problem, the common thread error of Marist economics becomes apparent: they do not see that the mere existence of government is dependent on transfer payments from the private sector.

Marxists seeing the transfer payment in a very narrow context of power, make a simple mistake that simpletons generally make: kill the goose that lays the golden egg.

The bottom line in Comparative Economic Analysis is that Marxism always fails as the producer class eventually becomes the recipient class. With no producers left to fund the transfer payments to the recipient class the whole scheme fails.

When you hear the phrase “private sector” you likely think of businesses , companies, or corporations. That is part of the story. The private sector is made up of business and households.

Households means you.

Which is larger in terms of capital goods owned and economic production, businesses or households? Answer is Households. Which segment owns the most wealth? Answer is households.

Hence Marxism is a circular argument accusing you of being you.

Scott Grannis said...

Jake: you are right, but the question that begs is this: is this a serious threat to the global economy? Note that a spread of 400 bps or so implies a fairly small probability of default over the next 5 years. And even if Greece were to default, then what? Argentina defaulted on over $100 billion and world financial markets barely trembled. Greece owes much less.

septizoniom said...

i'm sorry mr grannis. you are incabable of seeing the larger picture, and thus you are an idiot. optimism is not a panacea.

instant said...

"watch the private sector take off"

My question is : what private sector can do to restore the economy. At the moment, they are not exporting anything. The manufacturing sectors have gone a long time ago. Tourism? The whole world is on fire. Who has the money and mood for holiday.

Although private companies are more efficient than governments. If the wages are too high, they still cannot compete, anyway. It is the time to abolish minimum wages.

狂猪 said...

I agree with Scott. I also have a different reason for my comfort with the Greece situation.

One lesson all central bankers have learned at the end of 2008 is the world cannot afford another Lehman. It is abundantly clear the total cost of mopping up an uncontrolled collapse is an order of magnitude more costly than preventing it. This is true even if people have to hold their noses up while stepping in. On many occasions last year, central bankers around the world used overwhelming force to show us time and again they've learned the lesson well!

Secondly, guess who are the biggest creditors to Greece?! See the foreign banks claim chart in the middle.

Most of Greece debt are held by other European nations. What are the odds that other major European nations will standby and allow Greece to deliver a body blow to other European banks and economies, especially in light of what happened after 2008 and 2009?! Not to mention the debt amount isn't really that big in the scheme of things.

By the way, I find it amusing that Greek banks are selling CDS for Greek debt! I also think they are likely to win their gamble!

The drama and suspense of last year is more interesting and suspenseful than a Hitchcock movie! And how about all the very interesting characters! Anyway, we'll have a lot more clarity of what the ECB will do in a week or so.

Enjoy the show!

brodero said...

First of all you are NOT an idiot
that a gentleman called you earlier....anyway....the use of Debt to GDP as I have talked about earlier is an important metric but
if it is the only one talked about
then the analysis is incomplete.A
metric i use in addition and an equally important one is Household
debt service +Government debt service -Annual personal savings divided by GDP. This metric is now
approximately 8.93%. The all time high was 12.27% in the 1st qtr 2008.

Donny Baseball said...

Government employees in Greece have called a stike to protest the pay freeze that is part of the deficit reduction plan. this is why politicians can't just cut spending because the vested interests raise a ruckus. Only when the broader population is against the entrenched interests of government employees and can give the politicians the courage to buck them will something get done to reign in fiscal profligacy. Thus I am optimistic about the situation here in the US. Most Americans know what the problem is - government employees with fat pensions protected by the likes of the SEIU and AFSCME. The Tea party movement is precisely the type of groundswell that can gives politicians the confidence to take on the public sector unions. There is real possibility in this movement to cut government doen to size. They need a Tea Party in the PIIGs.

Antonio said...

Donny you are right, but alas the problem we PIIGS face (I mean, except my Irish friends maybe) is that we just don't know what Tea parties are. Unfortunately, I guess.


Scott Grannis said...

instant: The private sector can do wonders to restore this economy to health. If the government stepped out of the way and stopped borrowing trillions of dollars, and also cut taxes, there would be gobs of money available to new startups. The private sector is the only true source of jobs. We have to let it work. Instead, we are smothering the private sector in the belief that government knows best how to create work and do things productively. It's time to get rid of the Nanny State.

brodero said...

One final thought....

Greece's GDP is the size of Connecticut's,,,,

Bob said...


Rather than just name calling, could you please enlighten us on the "larger picture"?

This is a forum of ideas and Scott has shown that he is open to differing viewpoints. What is yours?


Steve Fulton said...

I guess my concern is based on the 2 following thoughts.
1. Any realistic attempt to change Greece's tax/spend foolishness can be simply voted out by entrenched interests who may see a return to the Drachma as preferable to either self imposed or EU imposed restraint.
2. I could have these numbers wrong -but I thought Greece's debt was 100% or so of GDP or about $400 Billion. That's pretty close to the cost of our little subprime debacle which definately sent some pretty serious shockwaves through the global economy.

Scott Grannis said...

Steve: your numbers look right, but a Greek default would not likely result in a 100% loss on all Greek government debt, would it? Not even Argentina got away with a 100% default--I think they finally negotiated something like a 60-70% writedown. I imagine that a Greek government default might end up shaving 20% or so off the face value of the debt. A loss of $80 or even $100 billion is not likely to bring about the collapse of the EU, is it? EU GDP is I believe larger than that of the US. Also, the subprime fiasco eventually involved severe losses on much more than a trillion dollars.

Steve Fulton said...

Hmmmmm--good point. I hope it's a tempest in a teapot.