Tuesday, November 1, 2011

Why is the Greek tail wagging the global dog?

Global financial markets seem to be convulsing over the financial fate of Greece, a country of 11 million people, with a GDP of about $320 billion, and government debt of $475 billion. The entire Greek population wouldn't fill up even half of Southern California. The annual output of the Greek economy is less than half the output of Los Angeles, and it represents only 2.5% of the economic output of the Eurozone countries.

Markets have known for awhile that Greece cannot possibly service its debt, which is why 2-yr Greek government bonds yield almost 90%, and the average Greek government bond has been trading at roughly 35 cents on the dollar for the past two months. If the holders of Greek debt were to mark their portfolios to market, they would realize a loss of about $300 billion on their Greek debt holdings. That would undoubtedly be painful for many, but in the great scheme of things it is less than 3 months' worth of U.S. federal budget deficits, and it would be the equivalent of a drop in the bucket (0.5%) of the $63 trillion global bond market (of which $42 trillion is investment grade and $21 trillion is high-yield, according to Merrill Lynch).

Even a total Greek default couldn't possibly matter much to the global economy. So why all the angst?

As Ed Lazear noted in an op-ed in yesterday's WSJ ("The Euro Crisis: Doubting the 'Domino' Effect"), it's not so much that markets fear a domino effect (e.g., if Greece defaults, then others will follow), it's that Greece's plight is symptomatic of a major fundamental problem that is cropping up in economies all over the world: governments that have grown too big to be supported by their economy. This problem can't be fixed by bailouts or haircuts or bank recapitalizations; it requires fundamental changes in the role and size of government in modern economies, because there is a tipping point beyond which a government that has grown too much begins to suffocate its economy. Too much deficit-financed spending must inevitably result in either higher tax burdens, default, or devaluation, none of which makes for a healthier economy. Greece is not alone in having a bloated public sector and too much debt, but it is the most immediately vulnerable since it cannot print its own currency (i.e., it lacks the traditional easy-out method of devaluation, which forces everyone to tighten their belts), it has no ability to increase tax collections, and its politicians have failed to inspire any confidence in their ability to straighten things out.

So the real reason that Greece is the focal point of market concerns these days is that Greece is the canary in the coal mine for a problem that afflicts many economies, including the U.S. If governments cannot be reined in, economic growth is going to be weaker than expected, because tax and debt burdens will rise. If there is a silver lining to the Greek crisis cloud, it is that markets have forced the issue to the fore, and markets will not be satisfied until there is a satisfactory (read: fundamental and lasting) solution. Either the Greek government tightens its belt, or Greece leaves the euro and devalues a resurrected drachma, or Greek debt is marked down to the point where the economy is able to service it going forward (or some combination thereof). There is no painless solution for Greece, and no painless solution for many other economies either. But solutions will have to be found, and that is the good news.


L.A. said...

The solution according to demand-siders like Paul Krugman is to print, print, print, tax, tax, tax, and redistribute wealth until an economic eutopia is realized, after which time we all live happily ever after.

Of course, Greece can't print. And the demand-siders say austerity is the absolute worst idea, but can't offer an alternate solution.

I think Greece needs to take its medicine and do as you suggest.

Unknown said...

$300 billion.

In the hands of criminal financial institutions these "sovereign assets" leveraged at 80-to-1 represent some $24 trillion in speculative capital which would be suddenly margin-called. Now add derivative exposure.

Of course you can choose to believe that MF Global is just an "isolated incident". Good luck with that.

brodero said...

How about this...

5 years ago 5 year Italian bond
yield 3.85%...today 6.01%
5 years ago 5 year U.S. Treasury
4.55%...today .93%